ISMS 41: Larry Swedroe – Focus on Managing Risk Not Returns

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 story in Episode 645. Larry deeply understands the world of academic research, especially about risk. Today, we're going to discuss three chapters from His books, His book, one of his many books, investment mistakes even smart investors make and how to avoid them. We're gonna be talking about Mistake number 32. Are you subject to the money illusion? Mistake number 33. Do you believe demographics are destiny? And Mistake number 34? Do you follow a prudent process when choosing a financial advisory firm? Larry, take it away.

Larry Swedroe 00:48
Yeah, so the first one is what is referred to the money illusion that people get confused about inflation returns and nominal returns or real returns, and how the economy is impacted differently. Stocks and bonds are impacted differently. So there's something I think most investors are familiar with. Because Edward your daddy coined the phrase the Fed model, when Greenspan was head of the Fed, and the Fed model was designed to tell you if stocks were under overvalued. So the model was based upon using the 10 year treasury. So the 10 year Treasury Well, I'd say it is 5%. Or you could use Fed funds. I know I forgot, in fact, what we should have those metrics the US, but let's use the 10 year treasury. So if the 10 year Treasury is four is yielding 4%, then stocks, if you take the inverse to get an earnings yield of the you know, of stocks, you would have a P E ratio of 25. So that would tell you if the 10 year Treasury or Fed Funds was, you know, at 4%, if the market PE was above 25, then stocks are overvalued. And if it's under 25, it's sorry, it would be overvalued if it was above 25, undervalued if under 25. Now, let's imagine that of course, if rates went up 1% to five, then you have an earnings yield of just 20. So now, if the P E was 25, the market would be vastly overvalued. Okay, because the P e should only be 20. Now, let's think about how this really works. So the empirical evidence, and the logic is pretty simple, that corporate earnings grow in line with the GDP, right? If they grew much faster than always and forever, then corporate earnings would dominate the whole economy, and there'd be nothing left for wages, right? We know that. corporate earnings tend to grow in line with nominal GDP over the long term. So now let's imagine that the economy is slowing, or you get a systemic change in the market. And, for example, we could see slowdown in productivity, which aligns with real growth, right. And so let's say productivity was 2%. And now it's one and a half, while real interest rates should come down by 50 basis points, right? And that one, and use the Yardeni model that would say, lower interest rates, stock prices should be higher. But wait, we just said the stock prices, you know, earnings grow in line with earnings tied to the GDP. But now if you have lower productivity, that means lower GDP growth by that same half a percent. So it makes no sense because you're forgetting that there is this relationship, right? And bonds are affected differently than stocks because stocks, nominal earnings are tied or correlated with the GDP. Now, how does that work for bonds? Well, if the economy slows 50 basis points, or is slower growth from two to one and a half, then we would expect real rates to go down. Well, that's good for bonds. But it's not good for stocks. It's you'd have no impact. Now let's also look right and inflation going up. Now, here's what people think interest rates swing up, say from four to five. So the fair value, according to the Fed model should move from 25 down to 20. But we just talked that corporate earnings move in line with nominal not real GDP. So if inflation goes up by 1% in that environment, that's bad for bonds, because yields are gonna go up. But it's not bad for stocks, because corporate earnings are gonna go up with that. So the whole fed model is really a money illusion, because people don't understand the correlation between nominal and real growth in earnings. I'll give you one other example. Let's say you have population growth slows, that's the other factor in GDP growth, right? It's productivity times population change. Well, the population growth slows, like it did in Japan and pop company countries shrinking. Well, what's gonna happen to real GDP growth, it's gonna go down. But what's gonna happen to interest rates should also go down. Alright, so you have to understand this impact on both sides. So there is this money illusion, we hear it all the time, stocks are rallying because interest rates move. Well, you have to ask why they're moving. If interest rates are going up, because the Fed is tightening, that's usually bad for short term bonds, might be good for long term bonds, because people now expect ultimately the economy to slow and inflation to slow, but it's certainly not good for stocks, because we have higher real rates of interest. Right? Right. If the Fed is easing, that could be good for stocks khana, me could take up, get loose, or could be good or bad for bonds depends on what's happening to the economy, the Fed is easy, you get inflation going up, that's bad for the economy, there are easing, and that's going to, you know, just trying to turn the economy, it's possible rates could continue to fall for some time. But eventually, that easing will stimulate economic growth, and interest rates will go up. It's a bit of a complex. That's why people get confused all the time, they don't understand this relationship. And maybe

Andrew Stotz 07:35
I'll tell it to my own personal experience right now robust, the prices of coffee, robusta coffee had been going through the roof. And in my business, coffee works in Thailand, we are scrambling to try to increase prices for our customers to say, we don't control the raw material price, we have to make this adjustment. In addition, we have to accept it, we're not going to be able to increase everywhere, at all times. And therefore my team is looking how do we become more efficient? How do we cut costs some other place? All of these things are attempts to manage the business in relation to what's happening with inflation, or in this case, the increase in price of a certain part of our business. But the idea is a management team of a company is constantly trying to deal with the inflation that comes along. And therefore, when you say, you know, when we look at changes in inflation and expectations of inflation, generally corporate earnings, the nominal corporate earnings, which is what we usually think of are going to be able to try, you know, try to match the nominal level of growth of the economy. And that's so in the formula for discounting, what you've explained is that we probably don't need to worry too much about inflation's impact on future growth of the numerator of the you know, whether that whatever cash flow that is dividends or the like, it'll over the long run, which is how we value a company, it'll wash out. What about the discount rate? How does we look at that, that's

Larry Swedroe 09:13
why we have to look at differences in stocks and bonds and think about it and inflation goes up, then the numerator should go up because it'll earnings will move in line. So you would say, if the numerator is going up, that's good for stock prices, but you have the offset, that the discount rate has to go up because bond yields are going up, and they should wash. That's and that's why the Fed model never made any sense. But yet it's quoted all the time.

Andrew Stotz 09:43
And another way of looking at it if you compare two countries, Thailand and Indonesia, I used to many years ago when I was a young analyst, Thai in Thailand had maybe a 15% return on equity and Indonesia had a 25% return on equity for a long period of time. And as a young analyst, I wasn't exactly sure what why was this. But then I looked at the ongoing inflation rate, I found out that in Thailand, it was about 3%. In Indonesia, it was about 10%. And what I realized was that every interest rate we look at has an inflation component in it. That's already there for everyone that we look at. Yeah, that's exactly. One other question I have related to this. When we think about a growth rate of earnings or that type of thing. And we think about a yield on a government bond. Is the yield on a government bond the same as a growth rate? Or are those is

Larry Swedroe 10:40
the way you should think generally about interest rates? Right? So the first you have two components a real rate and a nominal rate. Okay, so let's think about the yield on US Treasuries as the example. Yep. So we can look at the real rate. Very simply, we know exactly what it is. Because we can look at the real rate on tips. Okay, yep. So we know what the real rate is. Now, people think there's only two components, the real rate plus expected inflation. But that's wrong. Right? You have to add the expected inflation if the real rate was 2%. And the expected inflation was three, you would say that in five, you know that the nominal yield should be five. But there's something missing. We don't know what the inflation rate is. So tips yields in their real return should be lower than the real return in nominal bonds. Because the real rate is guaranteed in the tips, but it's not guaranteed and nominal. So you should require our risk premium. Now, if inflation is very stable, like maybe in Switzerland, maybe that risk premium is tiny, could be 1020 basis points. What if you were in Argentina? How much would you pay to get a guaranteed railroad could be dozens of basis points? Right? So it just it's going to vary over time. Even in places like the US, I would say, you know, the gap between tips and not nominal bonds, that difference was probably pretty small, in the decade from 2010 through 2020. Now, it might be wider. And

Andrew Stotz 12:37
how do we think about that in countries where there is no inflation protected? Security from the government? Yeah,

Larry Swedroe 12:45
you don't know you, all you could do is estimate because you don't have enough, there is one thing, if there are no tips in that marketplace, there are often inflation swaps, that you can engage, and people want to bet on inflation being higher or lower than some benchmark. And they'll swap that someone will take the benchmark and someone will receive or payout, you know, the actual one or the other side. So in those inflation swaps, you could say, that's what people expect. That's where the market is the, you know, the wisdom of the crowds, where is the average price on those trades. But even there, there, it's not exact, but you might have credit risk in that swap. So it'll at least give you a good picture. So that's the way it could be done.

Andrew Stotz 13:39
What's great about this chapter is I think you end it with some real clarity, which is above average historical PE, generally means below average future stock price return. Yep.

Larry Swedroe 13:52
Because you're, it's no different though. It's simple. It's nice, and which we've tried to provide in the book, and in our discussions, think about a building, if you own a building, and you're renting out each apartment for 1000 bucks a month. Right? Okay, what if you, so you got 10 apartments? So you got $10,000 in income? That's 120 grand a year? What if you paid a million dollars for that? Well, your return before your expenses is 12%. But what if you only paid 500,000 For now your returns 24% Before expenses, so the price you pay matters a great deal. And if you have a high cap rate, then you have a high expected return. You have a low cap rate or capital as the discount rate and you have a low expected return. Right? Pretty simple to price. Playing it to them about buildings and Rent, but they don't think about it. What's that? Yeah.

Andrew Stotz 15:02
Okay, let's go to mistake number 33. Do you believe demographics are destiny and I just want to highlight, you know, you talk about Harry Dent. And I remember reading his books in the past that were pretty sensational. So let's talk about that. Well, I'll

Larry Swedroe 15:19
just mention Harry Dent, all you have to do is read every one of his books. And in every one of the books, he's been dead wrong and everything he's ever why people continue to read Harry Dent is beyond me like a broken record, you know, eventually, maybe he'll get something right. But he has been dead wrong, his entire career about everything, right, including, you know, there was a demographic bust in the US in the stock markets with crashes. First rule of investing that we've tried to convey here we've discussed about in the book is investors need to avoid the mistake of confusing information with value added information. Information is Duke's a much better team basketball team than army does, you know, good, it's not valuated information, because I could go on the internet and look at the point spread. And I find out that if I want to bid on Duke, I have to give away 28 and a half points that equalizes the risk.

Andrew Stotz 16:22
In other words, the price is

Larry Swedroe 16:25
just something that you can exploit. So what is the issue about demographics? So the logic that then my, you know, wants you to believe is okay, I know the population of Japan is shrinking. Or the population in the US is now aging. And therefore, the following things are going to happen. First of all, there's a million other things that can affect the economy and markets. But let's assume everything that Harry Dent says there, in his analysis is true. You know, let's say for example, the baby boomers are going to sell their homes and shrink and move into apartments and stuff, and housing prices are going to collapse. I read that in the early 2000s, from a bunch of economists, including Nobel Prize, and I said, it's all garbage. All right, I don't think it makes sense. There's lots of other factors. But the important thing when it comes to stock prices, you have to as Harry Dent just told me these things that he's figured out

Andrew Stotz 17:33
in a best selling book, and

Larry Swedroe 17:35
a best selling book, right? I want that is Warren Buffett know these things. There's a guy that, you know, at Morgan Stanley and Goldman Sachs, they know these things. They're the high frequency traders and all their PhDs and math whizzes they know these things. Or is just Harry Dent, the genius has figured this out, and no one has read the book yet. And now the answer is obvious. Right? It's everybody knows that that matters. They built that into the prices. And therefore it's irrelevant. You can't exploit it. It's no different than knowing that Duke is a better basketball team. Because the market in its collective wisdom knows that as well. If it was easy to take information, and exploit it, how come the act of managers with all their skills and talents and training and resources failed persistently? Let me give you two other quick examples of why I'm so let's say, demographics are going to predict, let's say India's population is growing, it's going to boom, etc. And, you know, XYZ country is going to do poorly, because they're shrinking their population. Okay. Is that any different than knowing that great companies like Google are going to grow their earnings faster? Likely, then, you know, Ford Motor? No, it's exactly the same thing. Is it any different than believing that countries that grow their economies faster, are going to have higher stock returns, that countries that grow their economy slower? In fact, they're related, because we know population growth impacts country's GDP growth? Japan has been hurt by that other countries may be less so. Okay. But here's a bit of evidence for people. If you were able to predict with 100% accuracy every year, which countries would grow faster, then, you know, see by this countries that have higher GDP growth and you sell the one, you don't outperform? There's no evidence of that. Why? Because everyone knows it. It's built into the price The only thing that matters is that the country GDP growth faster or slower than was already expected. And guess what that's by definition, a surprise. Which people by definition can't forecast. So most important thing, whether you're talking about demographics, or whatever it is, if it's just information, even if you think it's going to have a positive or negative impact, ask yourself again. Am I the only one who knows this?

Andrew Stotz 20:36
Yeah, so like, you know, let's look at I was just only looking, checking something while you were talking, oh, India's going to explode. It's going to be amazing growth and all that, you know, they're going to do with China, you know, did and all that. Well, the Indian stock markets already trading on 25 times PE.

Larry Swedroe 20:52
Why I'm by the way, which was the fastest growing country in the world in the decade, the last decade, right, say from 2010, up to 2020. China, right. How do you like to own Chinese stocks in that decade? Well, that's

Andrew Stotz 21:08
a great example of how there's the correlation between economic growth and stock market growth is not there. It's

Larry Swedroe 21:14
not there at all. It doesn't exist. And yet people think, even burden math yield, a world class economists wrote, you want to buy China, their economy's gonna boom. And I wrote to Burton and said, No, I know

Andrew Stotz 21:29
why you put that in the book. You know, I just couldn't understand that. Why he went so hard on that. But let's just say that some people say, look, China's in trouble now and dadada. Well, the Chinese stock markets trading on 13 times PE, it's already in the price.

Larry Swedroe 21:43
That's exactly that's what you have to have. Am I the only one knows this? In fact, I was just asked advice. This is important. I hope your listeners will pay attention and follow this advice. The vast majority of individuals and professional investors make investment decisions based on their forecasts, ignoring all the evidence that there are no good forecasters just think about the Fed, which controls at least short term interest rates. And look at how God awful their forecasts of interest rates have been for the last decade. I mean, disasters, they missed the two big turns, right? Going up and going down, and then up again, right? Disastrous, and yet they controlled it. If they can't get it, right, what are the odds, you're gonna get it right? And again, the evidence against active management is so strong. So what should you do, you should stop trying to forecast and instead, think about what risks are you're most concerned about. So if you're most concerned about, let's say inflation, because you live on a fixed income, then you need to build a portfolio that's more resilient to an inflation risks. So you don't want to own long term bonds in your portfolio, you probably want to stay more short floating rate debt, things like that, you may want to have a little bit of commodities in the portfolio, maybe even some people might want a little bit of gold, in case you get crazy and flush, you know, it's okay. And then you don't worry about what the market, you don't ever want to make the mistake of confusing before the fact strategy with after the fact outcomes, because you're designing a portfolio to protect you against the risks you are concerned about, not what somebody else's, which means you shouldn't care what the market is. Because if you wanted the market, you would own it. And then you would live with the rest of the market, which might be the wrong risk for you. People need to focus on managing risk, and not on managing or trying to manage returns. And that's the key lesson, the way you manage risk is hyper diversify, adding unique sources of risk, as we've talked about before.

Andrew Stotz 24:09
Alright, let's move on to the final one for today. Mistake 3040. You follow a proven process when choosing a financial advisory firm.

Larry Swedroe 24:19
Yeah, so this is a big problem for investors. You know, they when they choose advisors, they're looking typically at somebody's track record and investing and they are going to project that into the future or ignoring all of the evidence that that past performance is, you know, if you're an active manager anyway, is meaningless, basically. Okay? And if you're a passive manager, you're accepting market returns, then you're designing portfolios to accomplish the client's goals. And if the client thinks, Well, I'm wanting to diversify and own small and value in real State and reinsurance. Well, if reinsurance and real estate happened to do poorly relative to the market, then the prospective client says your portfolio underperform. Now the portfolio did exactly what you wanted it to do, because you're just buying the asset classes. Right? And we know there are no good forecasters, I can tell you, which will do well, when. So I created a list of 11 things that you should ask an advisor and get them to commit to when you do an interview. So we'll walk through them. All right. Number one is that their guiding principle, their mission statement, their values has to be that they're a fiduciary, they need to put that in writing for you. They need to put in writing that all of their advice will be solely in your best interest. That means that not selling any product, not earning any commissions, right. They benefit whether you when you do well. And if it's an annual or assets fee based on assets, they'll earn more when your portfolio does well, and they'll earn less when you go down. If it's an hourly, it won't make any difference. Okay, second point, they need to tell you that, like I said, they've got to provide this legal standard of care, this fiduciary standard where one party and is only you was the one that giving advice, make sure you get that in writing. Number three, we are a fee only advisor avoiding all the conflicts of commission based compensation. Number four, we will disclose any potential conflicts of interest. Number five, our advice is based always on peer reviewed empirical academic research, not our opinions. Why don't we want opinions because the research says they have no value. Number six, we're client centric. We don't sell products. Only advice, go to a lot of investment firms. They're there to sell you Morgan Stanley's products, you know, Merrill Lynch's products, you know, and because they will make more money, the firm will make more money, you don't want to work with anybody who is selling products of their firm, because now you've got a bias. Number seven, we provide a high level of personal service. Each client works with a team of professionals that will develop a strong personal relationship with the team members, not a one man band, but a team because not any. Nobody knows all of the issues, whether it's taxes, insurance, estate planning is my opinion, you want to work with a firm who either has all of those talents, or there may be a firm that has one or two people only, but they contract to get advice. Like we have over 150 firms that contract with us, we provide them with all the technical expertise, they tailor that to their individual client, so they can deliver it in a cost efficient way. They don't have to hire all of that town. Number eight, and this is critical, everyone should listen carefully, and demand that if you're talking to an advisor, they will are prepared to show you their own personal investments. And by that I mean you want to see that they are committed to investing in exactly the same vehicles that they're mentioning. They've got a profit sharing plan, show me the choices in the plant and show me what you own. Now, so it's based on the same set of principles, the same comparable securities that they're recommended to the client. Now I don't expect them to have the same asset allocation that they'd recommend to me because my ability, willingness and need to take risks, but they sure better be the same vehicles. Right. Number nine, we will develop an investment plan that is integrated into an estate tax and risk management insurance plan. And the overall plan will be tailored to your unique situation to make sure it gives you the best chance to achieve not only your financial goals, but your life goals, which should include things like if you have children, passing on your family values, like whether you care about donating to charity and those kinds So things number 10. Our advice is always goal oriented, evaluating each decision not in isolation. But in terms of its impact on the likelihood of success of the overall plan. And number 11. And this is, I think, is key that their comprehensive wealth management services are provided by individuals that have a CFP, PFS, or other comparable designations. So you know, you're dealing with people who, number one, have done the work, gone through the courses, gotten a knowledge and are required by their profession, continue to get continuing education credits, to stay up with the latest advice. Those if you can't get all 11 of those points, just simply walk out the door

Andrew Stotz 30:55
and inquire incredible list, and I'm gonna put that in the show notes. But it's also in the book in the chapters. So for those people, I'll also have the link to the book so you can get it and make sure you have all of this great stuff. What what value? I mean, I think if I think about my mother, today is her 86th birthday. And my mom and my dad had a great, you know, advisory company that's been working with them from the beginning. And the biggest first value that they provided was they got my dad out of massive overexposure to DuPont stock where he was working.

Larry Swedroe 31:32
So you're of course, confusing. The familiar with the safe. We've gone over that one. Yeah. Your intellectual capital to your working capital, and financial capital. Yeah.

Andrew Stotz 31:43
And so I, you just made me think I really want to send an email to our advisor just to say, send the picture mom's 86. Today, thanks for all that you've done, to help us maintain, you know, and she and my dad's wealth that they created, she's been able to live off that and maintain that to a certain extent as she's drawing it down in her later years. And so by getting a great, take your with you, you can't take it with you, that's for sure. That's for sure. Well, I think that that's a great way to end this segment. And I really appreciated that last bit going through each one of those, because I think it's so critical for everybody out there as you're choosing somebody to help you in the area of investing.

Larry Swedroe 32:28
What amazes me, Andrew is I can't think of anybody who has ever asked the advisor to show me how they invest personally. And to me, that's an absolute simple, you know, necessity, if they're not putting their money where their mouth is and eating their own cooking, why should you?

Andrew Stotz 32:49
Great, great advice on

Larry Swedroe 32:51
that subject and a good way to wrap it up here. The investment banking community has made fortunes ripping off investors selling them garbage products, which are designed to be sold never bought things like variable annuities and structured notes, the research on these structured notes. So typically they're overpriced from three to six per 7% or more. So every time I was shown one by a client, you know, it said, Larry, you know, what my friend is showing me right, I should just call back and ask the firm was showing this product, if they own any or their parents own any, and or just asked as a single institutional investor, who has the skills and resources hooked on this? And the answer is never, no institution is they don't own it themselves. And all you had to do was ask that instead of being, you know, suckered in by some sales pitch about this bells and whistles, right? It's

Andrew Stotz 33:53
a great question. And I know, in Asia, in particular, the selling of these types of interest, you know, let's say, equity, linked notes, and all kinds of stuff that they come up with, really is these banks just coming up with very, very expensive products to sell. So stay away,

Larry Swedroe 34:12
is that I'll give you a lesson Thrawn. That's all mentioned that vary. So this is a good simple example. So let's say, you know, it's XYZ bank, and they come out with some index link product, right? Now, what's the job of the CFO with that bank, it's to raise capital at the lowest possible costs. So if the lowest possible costs would be just the bank note, go to the bond market issue of public security, which is daily liquid, and people are willing to pay a higher price to get daily liquidity, it'll be rated, so you know if it's safe or not, right. And if that gets you the lowest rate, that's what they should issue. So how come they issue these structured notes? Because it's got bells. whistles that you can't figure out Scott, I costs in there, and they're screwing you. That's all you have to know, just as why are they issuing this? Because you're getting screwed and they're raising capital, lower cost. That's it.

Andrew Stotz 35:14
And on that note, I want to thank you for another great discussion about creating growing and particularly that last note about protecting our wealth. For listeners out there who want to keep up with all that Larry is doing. You can find him on Twitter at Larry swedroe. And also on LinkedIn. This is your worst podcast host Andrew Stotz saying, I'll see you on the upside.