In this episode of Investment Strategy Made Simple (ISMS), Andrew and Larry discuss a chapter of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this first series of many, they talk about mistake number one: Are you overconfident in your skills?
LEARNING: Don’t be overconfident. Look for value-added information when researching an investment.
“When you trade, understand that you’re competing against the market’s collective wisdom.”
In today’s episode, Andrew chats with Larry Swedroe, head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today Andrew and Larry discuss a chapter of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this first series of many, they talk about mistake number one: Are you overconfident in your skills?
The majority of people are naturally overconfident
There’s a lot of research showing that human beings tend to be overconfident in their skills. If you ask people, are you liked by others more than the average person? Are you a better lover than the average person? Can you drive better than the average person? It doesn’t matter what the question is; the answer from a vast majority is that they think they’re better than the average person. According to Larry, this is actually a good healthy thing. Imagine getting up daily, looking in the mirror, seeing yourself, and thinking you’re dumb, ugly, stupid, and nobody likes you. You’d live a sad life. So it’s good to feel better about yourself as long as you don’t make mistakes.
Overconfidence isn’t such a good trait when it comes to investing
Larry says that the market is made up of all types of investors. If some investors are going to outperform, then some investors must underperform. The market must have victims to exploit. Most investors tend to be overconfident and think they’re a lot smarter than the average person, so they will be able to control them. But according to evidence, that’s dead wrong because people are not competing one-on-one.
Female investors get better returns than men due to underconfidence
Women are not better at stock picking than men. The stocks they buy perform just as poorly as those that men buy. And the stocks they sell go on to outperform in equal measure. However, men have overconfidence in skills they don’t have, while women simply know better. They don’t overestimate their skills as much as men do, so they trade less and have fewer turnover costs, resulting in better returns. Interestingly, married women do worse than single women because they get influenced by their husbands, while married men do better than single men because they have the influence of the sage counsel of their spouses.
Does hard work, training, and knowledge play any role in outperformance?
Generally, the more knowledge you have, the wiser you become. But the game of investing is very different than, say, the game of tennis, where you’re playing one-on-one. During a one-on-one match, whether tennis, chess, or any other similar game, minor differences in skill lead to considerable differences in outcome. As the competition gets more challenging, it becomes harder to win. And luck becomes more determined.
According to Larry, when we’re playing a game of investing, we’re not competing one-on-one. We’re competing against the collective wisdom of the marketplace. That’s a much different competitor. That’s why Warren Buffett today has difficulty keeping up his winning streak of the 80s.
The second related mistake is when researching a company, a famous person or a newscaster gives investors enticing information about a company he’s touting, and the investor decides they should buy that. They’re confusing information from this person with value-added information. They assume they’re the only ones who know this information. Yet thousands of other people could be watching this famous person or newscaster. The truth is the average person doesn’t have value-relevant information, and they’re competing against the market’s collective wisdom, which is a much tougher competitor than one-on-one. This is why only a few active managers can outperform persistently.
Know who is on the other side of the trade before you execute
Whenever you buy a stock, you should stop before you execute and ask yourself who’s on the other side of the trade. Ninety percent of the trades are done by sophisticated institutions that hire world-class mathematicians and scientists with PhDs in finance, invest in massive technology, and have more access to information than an individual investor. So are you seriously going to be overconfident and believe you know more than these institutions?
Investing has become a lot harder than it was 20 years ago
Larry says investing is much more complex today and will continue getting harder. There are several reasons why this is the case.
1. Increased financial innovations
Before the 1980s and around 1990, the only operating model we had for asset pricing was the capital asset pricing model (CAPM). This model could only explain about two-thirds of the differences in returns of diversified portfolios. This meant there were tremendous opportunities to generate alpha.
Along came a bunch of researchers who found two characteristics that added explanatory power. One of them was that small stocks outperform large stocks. The other was that cheap stocks outperformed expensive stocks. So now, on top of CAPM, there were two other factors: size and value. Now investors could no longer claim to outperform just by buying small companies.
Research by Jegadeesh and Titman found a momentum factor. This was that stocks that had outperformed in the past six months to a year roughly had a tendency—a bit more than half the time—to continue outperforming over the next short period, on average, five-six months. So now active managers couldn’t claim alpha by buying positive momentum stocks, avoiding negative ones, or shorting them.
Then in 2013, Robert Novy-Marx wrote a paper on profitability. He found that you could outperform your position by buying more profitable companies—Just as Warren Buffett did.
Most recent research by Cliff Asness and the team at AQR combined profitability with other factors related to what Buffett had been saying; you shouldn’t just buy cheap, profitable companies. You want to buy them when their earnings are more stable. Such companies don’t have a lot of financial leverage, making them quality companies. So now we have a factor called QNJ: quality minus junk. So you buy the quality stocks and short the junk ones.
With all these financial innovations in place, investing as an individual gets harder because stock selection strategies are not a privilege to a select few. Anybody can invest in small-cap stocks en masse. Therefore anybody can capture that alpha or cause it to disappear.
2. Increased financial knowledge and competition
There was no financial theory until the late 60s and early 70s. People managing money were not finance majors and didn’t know finance theory. Today, everyone managing money has easy access to financial knowledge. With increased knowledge comes tougher competition and the paradox of skill. When competition is tougher, it becomes harder to differentiate yourself.
It’s the smarter, more informed people playing the game now making it harder for others to outperform by a wide margin.
3. Retail investors have been channeled into hedge funds
For there to be winners in the market, there must be victims to outperform. In 1945, after World War 2, 90% of all stocks were held by individual investors in their brokerage accounts. So they were doing most of the trading. There were only 100 mutual funds in the US in the 1950s. Today those numbers are entirely reversed. Most of the trading is done by institutions. This means when you’re trading, you’re likely trading against giants like Renaissance Technologies, Citadel, or Morgan Stanley. Whereas in the 40s and 50s, you were trading against another naive investor. Today, retail investors have been channeled into funds managed by the most innovative people.
4. Dollars are growing while sources of alpha are shrinking
The sources of alpha are continuously shrinking while the supply of dollars chasing them has grown dramatically. In the late 90s, there was $300 billion in hedge funds. Today, there’s over $5 trillion. On the other hand, the sources of alpha are shrinking because the academics have converted into beta—which is just a systematic characteristic that’s replicable. It’s no wonder it’s becoming harder and harder to trade.
Will the largest hedge funds remain the top players, or will another group rise in the next 10 years?
Larry predicts that the largest hedge funds, such as Renaissance and Citadel, will grow as more people go into systematic passive strategies. A few active managers who are becoming successful will likely continue to gain market share. This is likely to create a problem for the managers. This is because the only way they can continue generating alpha is to stop taking assets. Otherwise, they’ll get too big and have to diversify or increase their market impact costs. Very few managers will turn down the chance to earn higher AUM fees.
Final thoughts from Larry
Don’t be overconfident. When you’re overconfident, you’ll think you can outperform when the odds say you’re not likely to be able to do so. Also, don’t confuse information—something everybody knows—with value-added information—something nobody else knows or you can interpret better.
About Larry Swedroe
Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Andrew Stotz 00:02
Hello fellow risk takers and welcome to my worst investment ever stories of loss to keep you winning. In our community. We know that to win an investing you must take risk but to win big, you've got to reduce it. Ladies and gentlemen, I'm on a mission to help 1 million people reduce risk in their lives to join me go to my worst investment ever.com and sign up for our free weekly become a better investor newsletter where I share how to reduce risk and create grow and protect your wealth. Fellow risk takers this is your worst podcast host Andrew Stotz from a Stotz Academy, and I'm here today, continuing my discussions with Larry swedroe, who is head of financial and economic research at Buckingham wealth partners. You can learn more about Larry's story he was episode 645. Now Larry has a deep understanding of the world of academic research and investing and especially risk. Today we're going to discuss a chapter of his book investment mistakes even smart investors make and how to avoid them. And today the topic is mistake number one, are you overconfident of your skills, Larry, take it away.
Larry Swedroe 01:03
Yeah, so there's a lot of research showing that human beings it's an all too common trait, that we tend to be overconfident of skills. And it's regardless of the type of question you ask. So for example, there have been studies that have looked at asking this question, are you a better than average driver? And of course, we know the answer. If you do enough, people should be 50%, which a better and 50% should be worse. But the answers come back typically more like 85% are better than average, which of course is impossible. We don't live in Lake Wobegon, where we're all better or most of the people are better than average. And we get the same answer. If you ask people, are you liked by others more than the average person? Are you a better lover than the average person? It doesn't matter? What the question is, the answers tend to come back that a vast majority think they're better than average. So that's actually a good healthy thing when it comes to being a human being. Because imagine getting up and looking in the mirror and seeing that person and then saying I'm dumb, ugly, stupid, and nobody likes me. Their suicide rate would be through the roof. All right. So it's good to feel better about yourself. As long as you don't make mistakes and in our daily lives, we tend not to make them. For example, you might think that you're better than average driver. And that might cause you to drive it 80 or 90 miles an hour on an empty freeway in the middle of a perfectly Sunday afternoon. And you'll probably be okay. But that overconfidence probably will not cause you to drive that same 95 miles an hour in a busy city street in a downpour and rainstorm with 50 miles an hour when your brain would take over and moderate your overconfidence. So what does that have to do with investing? Well, the answer is pretty simple. All investors make up the market and if some investors are going to outperform, that means some investors most underperform, you have to have victims to exploit. Well, for all or most of us that are overconfident. We think we're a lot smarter than the average person and we trade we're going to be able to exploit them. And the evidence says, of course, that that's dead wrong, because you're not competing one on one. If Warren Buffett, for example, is competing with me, picking stocks, he's probably going to outperform it. But Warren Buffett today is competing against Renaissance technology, and Citadel and all these high frequency traders. And the academic researchers caught up with Buffett and as uncovered, you know, all of his secret sauces and reverse engineered them. So for the last 20 years, if you bought stocks that Warren Buffett told you to buy, meaning cheap, profitable, high quality companies in screen for them, the way professional fund companies like dimensional Avantis and others do, Buffett has not generated any alpha in the last 15 years or so
Andrew Stotz 04:51
horrible. Larry, yeah. I went back and looked at his record and one of the things I could see is that if he hadn't had such a good performance in the 70s, he probably wouldn't we wouldn't even know his name. He just be another really good, you know, good fund manager for sure. You know, but
Larry Swedroe 05:11
he did pretty well right up until academic research caught up with him. So the problem is, the evidence shows, for example, that the average stock bought by individual investors goes on to underperform after they buy. And the average stock they sell goes on to outperform after they sell him. That's not exactly. You know, what you want to do. And you know, the thing is, they have to recognize that when they're trading today, 90% of the trading is done by the Goldman Sachs and Morgan Stanley's and Citadel and renaissances and all the high frequency traders, who have massive amounts of databases, high tech computers, they most of the people managing money, they're a world class mathematicians or scientists with PhDs and finance, what are the odds you the amateur investor, are going to be able to outsmart them, and every time you buy a stock, the odds are 90%, roughly that the person on the other side is more skilled than you? So why trading? Why do you think you'll have an advantage? Now it's even a bit more interesting. And the women listening to this call will appreciate this, that women their stock picking skills, interestingly enough, are no better than the stock picking skills of men. The stocks they buy, do just as poorly as the stocks that men do. And the stocks they sell go on to outperform? Yeah, women have higher returns than men. Andrew, you want to tell us why you think that's the case?
Andrew Stotz 07:01
Well, the trade less they have less confidence. Maybe? Yeah, I
Larry Swedroe 07:07
think it's what I would call the testosterone factor. Men have confidence in skills they don't have women simply know better. They don't overestimate their skills as much as men do. And so they trade less, so they have less turnover costs. And so they ended up getting better returns. What's interesting, though, is that married women do worse than single women, because they get influenced by their men and married men do better than single men, because they have the influence of this age spouses. Yeah, that's a good example,
Andrew Stotz 07:45
that the words from your book are the obvious explanation is that single men do not benefit of the same, the spouse is sage counsel to temper their overconfidence. Let me ask you a question about the overconfidence, bias, because one of the problems that it's an intellectual difficulty for many people to see is that so when we say that the average person thinks that they're, you know, a better driver, let's say, the question that people would ask when we, when we go into this, as they'd say, says, what you're saying is that what I do really has no impact. I mean, if I, like my father, as an example, worked for DuPont all his life, and DuPont sent him to driver training, because he was driving around for selling all the time. And he was a very safe driver. And doesn't hard work and training and knowledge produce out performance?
Larry Swedroe 08:48
Well, in general, of course, the more knowledge you have, the smarter you become. But the problem is that the the differences the game of investing is very different than say the game let's use an example of tennis, where you're playing one on one, Roger Federer, it's probably the greatest tennis player of all time, or maybe now some people would say yoga vich might be the best player of all time. But interesting. Roger Federer may be the greatest player ever had never lost the money knowledge, a single match in the first round of a Grand Slam tournament. That's pretty amazing. Because he's playing against not me, are you? Okay? He's playing against one of the top 128 best players in the world, and yet he never lost the match. Clearly, they're thinking about their skill sets. These are some of the greatest players. So they are so much better than you are and I you and I might play with one of them. We would never win a game maybe never get a point. against them or not many. And yet Roger Federer beats them every single time. Because when you have one on one matches, whether it's tennis, or chess, small differences in skill lead to huge differences in outcome. Now, as Federer went through the rounds, and you have to win, I think six matches to win a Grand Slam tournament, of course, his winning percentage would go down, because the competition got tougher. So as the competition gets tougher, becomes harder to win. And luck becomes more of a determined, even if Roger Federer wasn't feeling particularly well, one day didn't matter, he was going to win that first round match. But he better be at his absolute best playing against Nadal or Djokovic, right? When we're playing a game of investing, we're not competing one on one, we're competing against the collective wisdom of the marketplace. That's a much different competitor. And that's why Warren Buffett today even has a very difficult time, as we said, the research and I published them in my most recent books, he hasn't generated any alpha in about 20 years now. Because the academics have caught up with them. Reverse Engineering allowed them to figure out what types of stocks to buy. So we know today, for example, Buffett's skill was not picking individual stocks, or timing the market, it was identifying the traits of the types of stocks to buy, which he was telling people for decades what they want. And once you identified them, then fund families like conventional Avantis, and others, simply said, we could buy all the stocks that have these characteristics. And they have in fact generated the same types of returns without any statistically significant difference that Buffett has generated. Now, that doesn't take anything away from Buffett's genius, of course, but the world caught up with them. And the mistake that people make all add is they think they're playing a game of one on one. And maybe if they're trading against me or you, they may be no more, but then not. And the second mistake that's related, is, let's say they're doing research on a company. And then Jim Cramer comes on TV and gives them 15 things about some company that he's touting, the management is great, the balance sheet is great. They're got all these great new products. And so you decide you should buy that. Now, whenever I hear somebody telling me, they've won, they bought a stock, I asked them to tell me why. And I'll say let's assume for the moment, I agree with all of your ideas, all of your reasons to buy are correct. And then I tell them, it's completely irrelevant. And the reason is, I asked them very simply, are you the only one who knows this? Everything heard this by the way on national television or read it in Barron's which tells you know before the markets know, which is about absurd a fillip marketing tool is I've ever heard. And, you know, that's the problem. You know, if you're buying a stock for these reasons, you could be sure the smart people at Citadel and Renaissance and Morgan Stanley Goldman know every single thing you do, and if they don't, it's likely it's inside information. And Martha Stewart found out what happens when you trade on that and make money. That's the problem. They're confusing information with value added information, meaning stuff nobody else knows. Or somehow you can interpret it better. And the average person doesn't have value relevant information, and they're competing against the collective wisdom of the market, which is a much tougher competitor than one on one and use the analogy I will use to help people think about it. Maybe the greatest hitter of our generation was Albert pools probably is the greatest dinner now imagine. So who is he? I would pull offs was the best Major League Baseball hitter. Okay, the last one he is he just retired. He batted over 300 The best first 10 years of any hitter in history. Now imagine out the pools as a bat Other and I excuse the reference, if you're not familiar with baseball is imagine he was facing a pitcher who had Randy Johnson's fastball. He had the fastest fastball of any pitcher, Sandy Cofax, his curveball, which is the greatest ever Hoyt Williams knuckleball. Greg Madison's changeup all in one pitcher, that's the collective wisdom of them, he would probably have hit 180, not 320. That's the problem. It's like raw to use a tennis analogy to be more familiar. Imagine Federer having to compete against a player who had, let's say, you know, a yoke of its return to serve Andy Roddick serve the bet whoever the best backhand the doll is the best backhand had the speed of the greatest, you know, athlete, federal could not beat that person. But he's not. He's playing one on one against individuals. When you trade, your half done understand, you're competing against the collective wisdom of the market, with each investor providing their input to help prices come to what is called the best estimate of the right price. Nobody knows the right price. But the markets price is likely the best estimate of their eyebrow, which is why so few active managers are able to outperform on a persistent basis.
Andrew Stotz 16:34
There's a couple of points I wanted to ask about. But before I do that, I just tell a story of when I started in the stock market in 1993, in Bangkok, Thailand, you know, every single broker had the trading floor, you know, it was all right there, nobody would do it by online. And so, but what was fascinating was, it was like grandma and grandpa would come down. And all of these people would just come to the trading floor, they'd bring their lunches and their pails and stuff. And they'd sit in front of these boards, where they were flashing lights. And you know, all the quotes going on. And you could see them the excitement in the room, particularly when the market was booming, right? In 1993, when I started in the stock market in September of 1993, by 1994, January, stock market had just doubled in Thailand. So it was on fire. But what you started to realize as I spent time in those trading rooms was that a lot of those people thought they were trading against each other. Yes, you know, and they're kind of like, oh, I won this time you were selling that and I was buying that. And I always try to tell them like behind that number. Or, you know, there's a million people out there looking at that one stock, you know, and you don't even realize it. But you know, when I was a young analyst, I went traveling all the time to visit fund managers around the world. And I went to talk about Bangkok bank, because I had done a lot of research on it. And I will talk to a guy in New York, and I was like, telling him all about it. And I said, I asked him, he said, Yeah, I've held Bangkok bank for a while and they said, how do you get your information, he says I called the chairman. And I was like, okay, he held it for like 20 years, and he has a direct line to the chairman. And he's sitting in New York. And I'm just thinking that myself that most people think that their trading against you know, it's, you know, it's one on one or a smaller thing, but whenever you
Larry Swedroe 18:26
buy, I tell people, whenever you buy a stock, you should stop before you execute, and ask who's on the other side of the trade. And there's an old saying about poker players, right? If you don't know who the sucker is at the table, you're it. And since we know that 90% of the trading base, are these done by sophisticated institutions, who will hire world class mathematicians, scientists? have PhDs in finance and investing in massive computer power, and all this talent that much more access to information than you do? Are you really seriously going to say, you know, more than they do and are more likely to be right. And if you answer, you know, with humility, the answer is probably going to be no. So then why are you trading? So one question want to do it as an entertainment account, you know, I find people go to the Las Vegas and they've made these put $500 or 1000 and willing to lose it and for the pleasure of going and being in company and try to beat the house or go to the racetrack, that's fine. But you don't take your IRA account or your retirement account, wherever it's called, wherever you're an investor, to the stock brokers office, because he's likely to be one who's confiscating you know, your assets, transferring them from your pocket is
Andrew Stotz 19:57
one question is based upon The research that you've read and looked at and you know, the things that you've seen is this. Is it just, it just got a lot harder over the last 10 or 20 years as big institutions have computing power and the big brains. And if you go back 20 years or 30 years that you could have outperformed?
Larry Swedroe 20:19
Well, I wrote a book, which I'd urge your listeners to recall the Incredible Shrinking alpha, co authored with a good friend, Andy Bergen, who, by the way, is a PhD in physics and Head of Research for a major investment firm who manages billions. So that's an any one the NASA Award for Best Software of the Year. So that's the kind of people you're competing against. So in the book, I point out four key reasons why it's actually gotten much hotter and present the evidence. So I'll give a brief little synopsis of the book here. I wrote my first book in 1998. Around the same time, Charles Ellis wrote his famous book, winning the losers game. So what he meant by that is, you can win in Las Vegas at the roulette wheel or the craps table, but the odds are against you. And the surest way to win a loser's game is don't play. When Ellis wrote his book in 98, one 80% of the professional fund managers were beating risk adjusted benchmarks in a statistically significant way before taxes. If you're a taxable investor, because taxes, at least in the US are the biggest expense of active managers, more than their trading costs more than their expense ratio, then that number was probably half that. Now, I don't know about you, but I don't like that Zots playing with money I want to retire on. So L is called that winning the losers game, you're better off accepting market prices using index funds are similar strategies and pick the assets you want to invest in the risk factor. So if you want small value stocks instead of the s&p, you don't buy the s&p 500, you go buy the s&p 600 value index. So you decide which risks you want, and then invest in that in a systematic, transparent, entirely replicable way?
Andrew Stotz 22:32
And how does that get over the tax costs?
Larry Swedroe 22:35
Because there's very little turnover. So that makes it more efficient. And today with ETFs, for every type of index funds or other systematic strategy, their ability to watch capital gains, beings, there's virtually no distributions,
Andrew Stotz 22:53
what does that mean a wash capital gains.
Larry Swedroe 22:56
So what happens is, there are what are called approved participants in that market when they go through redemption and creation. And these, what they do is they can, when they distribute out stock, they can give it to say, a charitable institution like Yale's endowment, and it's their low basis, they don't care that much, right? So they just got rid of the capital gains from the fun. Everything in kind instead of selling this give the share. So that's a simple explanation, and allows them to watch the capital gains
Andrew Stotz 23:35
out. Okay, so just to review, you were saying, and you wrote your first book in 1998, Charlie Ellis came out about his book and talking about the loser, basically, ultimately, it's a losing game. And at that time, 20% of fund managers were beating their benchmarks before tax. But after tax, he was maybe half that because tax is a huge cross is interesting. The Thai market, as long as some other markets around the world are tax free, there are no capital gains in the Thai tax market, but that still, you know, other other factors. So over time now, what does it look like today?
Larry Swedroe 24:14
Yeah, so today, that number several studies. In fact, as early as 2010, fama and French wrote a paper called luck versus skill. They found that right around 2% of active managers were outperforming the risk adjusted. So just within that 12 year period, there was another paper in 2014. And that found the same thing. Morningstar has published plenty of stuff, etc. There, the evidence is very clear. And the reasons are, as I go into great detail and present the evidence in the book number one, is that them academics have been very busy watch what was once Alpha opportunities and converted them into beta, which is just a systematic, straight or characteristic that's replicable. We talked about this with Buffett. So prior to the 1980s, and right around 1990, the only operating model we had for asset pricing was the capital asset pricing model cap in, which only was able to explain about two thirds of the differences in returns of diversified portfolios. So meant there was huge opportunities to generate alpha. Along comes a bunch of researchers, and they found two characteristics that added explanatory power. One of them was that small stocks outperform large stocks. Okay, and the other was that cheap stocks outperformed expensive stocks. So we now have two other factors called size and value. And fama and French orphan given credit for discovering this did no such thing, they just wrote a paper summarizing that research, put it into a new model, called the fama French three factor model. And now we're able to explain about 92% or so of the variance in returns of active managers. So only 8% was left. Now what's important here, that is
Andrew Stotz 26:35
92% was just those two factors or you're saying now as additional
Larry Swedroe 26:39
market beta, plus market betas, you have the threat. So, the important thing is this. Prior to the fama and French publishing their paper in 92, you're an active manager, you could buy cheap stocks, value companies, low P E, low price to book, whatever metric and claim outperformance and over time we know value stocks have outperformed. So in most years, about two thirds of the time, value outperforms in those years, you claim Alpha? Well, you can't do that anymore, because I can own an index fund of value stocks and get that exposure. So you have to find the value stocks that outperform now much harder than just buying value stocks, and used to be able to claim out performance by buying small companies can't do that anymore, because you have a benchmark there. Then mark cod comes along in 97. And he summarized further research by Jagadish and Tippmann, which found a momentum factor, which was that stocks that had outperformed in the recent past six months to a year roughly have a tendency a bit more than half the time to continue to outperform over the next short period, on average, five, six months. So now active managers used to be able to claim alpha by buying positive momentum stocks, avoiding negative ones or shorting them even I can't do that anymore, because I can own a momentum fun. All of the fun families that I invest with incorporate this research. Then in 2013, Robert Novy Marx writes a paper on profitability. This is taking along on Buffett, if you will, saying you should buy more profitable companies they've outperformed. Well, prior to 2013, you could claim Alpha. By buying more profitable companies. You can't do that any longer and more recent one last bit of research. Cliff Asness and the team at AQR combined profitability with other factors that are related, that Buffett had been saying you shouldn't just buy profitable companies and cheap ones. You want to buy them where their earnings are more stable, they don't have a lot of financial leverage. They're, they're a quality company. And now we have a factor called QNJ, which is quality minus junk. So you go along the quality stocks and short the junk ones. And so all these opportunities are gone, because all of the font families like those of Avantis dimensional and many others, Blackrock now incorporate that. So the opportunities to claim Alpha strength dramatically, we now can explain more than 95% of the variance of returns just by telling me what stock types of stocks you own. I can virtually guess your performance without knowing which of those stocks with those characteristics you want. So that was the first
Andrew Stotz 30:05
and that stop at the first one for a second, just for the listeners out there that may not get all this, I'm going to try to summarize the what you've said. And the first thing I think it's most important is that, let's say before, we had a lot of financial innovations where it was easy to set up ETFs, or these types of funds. In the old days, basically, an individual could become an expert in small cap stocks, and that they didn't know nobody kind of knew, officially that small cap stocks tend to outperform large cap stocks. And therefore that person could claim that they're producing on the overall amount of money that they have, that their stock selection strategy, if you didn't know what they were doing. Even their stock selection strategy was superior to just owning all the stocks in the market or the index. And so they appeared to be that outperforming. Now what the academic research says, Wait a minute, wait a minute. Wait. There's there's a persistent outperformance or risk adjusted return outperformance for small cap stocks was the premium
Larry Swedroe 31:13
for taking either for most of the time he would certainly say small stocks are riskier just like stocks are risky than T bills. No one would say you're generating alpha by buying stocks and you beat treasury bills. That's a premium starkly about a percent or so on an annual basis. But 7% on a compound basis. That's a premium for taking risks. And the outperformance of small stocks is a premium for taking risks. Now, unless you be an index of small stocks, that's not Alpha anymore. And that
Andrew Stotz 31:52
the point is, is that now that there is all the innovation in the financial world over the past 20 years or so, basically, anybody can invest in small cap stocks in mass, and therefore anybody can capture that alpha, or they may actually cause the alpha to disappear.
Larry Swedroe 32:12
Yep. Well, that's an interesting question, I will diverge for a minute and come back to the other three points. If there's risk, and everyone, the sky discovers that small outperforms that premium might shrink, because more money is chasing small stocks. But it should never become a negative premium. In a logical world, in the same way that stocks should never logically have lower expected returns in T bills, because they're riskier, and no one should buy them, that doesn't rule out the possibility of bubbles. And, you know, we get them on occasion. And because of what are called limits to arbitrage, sophisticated investors can't fully correct Miss pricings. The way you correct them as pricing is you go in and borrow a stock and sell it going short, hoping to buy it back later. The problem with that is there's unlimited loss potential. So you can be right in the long term. But if you're wrong in the short term, you get a margin call. And if you can't meet it, you have to put up more capital, then you get called and your app. So exactly what happened to a hedge fund when the Reddit crowd got them on this Gamestop episode. And game stock, which was vastly overvalued, when he shorted it at probably like 60. This short squeeze them in the stock went up to like 450, or 600 is somewhere before the Venturi collapsed again. It's Melvin guy, this hedge fund lost 4 billion even though he was right in the long term. So people have fearful because it's expensive to short, and you have the potential for unlimited losses. If you go long, you can only lose what you put in. When you show up, there's unlimited losses. And that's what prevents sophisticated investors from fully correcting prices. So we can have bubbles. From time to time. We had the.com bubble, we had another bubble appearing with all these disruptive, innovative companies like Cathy Woods bought and they eventually imploded. Eventually those things go away.
Andrew Stotz 34:37
Can we talk again about the small cat let's just focus on that for a second. Because when you talk about small cat, you mentioned about risk adjusted return versus just returned. And the question that I want to make clear so that the audience understands the difference here. If we talk about small cap stocks, and we look at the performance of them over a long period of time as a whole, they tended to outperform. However, are you saying that they also outperform when adjusting for risk or don't outperform when adjusting for risk? Oh,
Larry Swedroe 35:14
here's the way to think about this. A smaller cap stocks have higher returns, but a lot more volatility and they suffer bigger crashes. They're illiquid, they cost more to trade, you should demand a premium for that type of risk. And they become even more illiquid in crises. And when you go to try to sell, there may be no bids. And you may have to take a big market impact to sell. And so all risk.
Andrew Stotz 35:41
Yep. And so as an as a as let's say, I'm an asset owner, I go to that fund manager that's managing a small cap, and he's going, Hey, I'm outperforming the market. I've been doing that for years with my small cap strategy. And what I should be asking him is, wait a minute, are you exposing me to a lot more risk in order to get access to that higher return? Or is that higher return coming at market risk?
Larry Swedroe 36:05
Well, here's an easy solution for all your listeners, you don't have to ask any questions. There's a wonderful free website called portfolio visualizer.com. And you just enter the name of that fund, you run, have it run a regression, to tell you what risk factors it was exposed to. And it will spit out whether they're once you adjusted for their exposure to these factors, like size, value, momentum, quality. And then it will show you whether there was any alpha there or not. And when you'll find this, in the vast majority of cases, there is negative alpha.
Andrew Stotz 36:49
And I'll include that in the show notes. I'm just looking at the site right now, so people can check it out. But let me ask you, if you saw that somebody did outperform, according to portfolio visualizer, to say, in other words, that let's just keep it simple by seeing small caps that they were overexposed to small caps. And they did better than the small on a risk adjusted basis, they did better than the small cap index. Right. The next question is, was that because of luck? Or was that because of skill?
Larry Swedroe 37:20
That's right. That's a very difficult question. And it's hard to know, without having like 50 or 75 or 100 years of data. And here's one, think about, let's imagine were in a room with 100 fat, or let's take it as a stadium for a World Cup soccer match. So you got 100,000 people, right? And let's well have a coin flip contest. And we're gonna say heads wins and tails loses. So they flipped, and we would expect the will we know the number won't be exact that 50,000 will be we'll have we'll win. So that's round one, round 220 5000 have flipped heads twice in a row, round 312 1500, round four, six to four, you're down 10. And maybe you've got two or four people left, whatever, right. Would you attribute that to skill that people want? Would you bet your retirement account? on that?
Andrew Stotz 38:28
Well, let me let me answer that by talking about I had a group of 2000 people I spoke to in the Philippines young people, and I got them to do that exercise, except in this case, I said, if you get a heads, you're a winner. If you get tails, you're a loser. And then I had them do it until we did 10 flips, you know, and we got through it. And then I had them the winners and the losers get up on stage. And then I asked them how they did it. And we were laughing because some of them said I you know, I rubbed the coin. I said a prayer. And so they were even attributing their, what we can obviously say was luck. They're attributing it to some kind of impact that they had on it. But yes, we would attribute that whole need to lock.
Larry Swedroe 39:16
Right. And that's so that's the problem. Today, you have over 10,000 There are more funds than there are stocks by a huge margin. Right? And you have not only 10,000 or so mutual funds and ETFs, but more than 10,000 hedge funds, right? And so when you have so many people playing, the odds are purely randomly somebody will beat the market 10 years in a row, and it might just be luck, and people can't accept that, but that's the reality. And that's why you do statistical tests, and fama and French I mentioned this luck versus skill paper. When you run the test that way, they found in less than 2% of active managers were generating statistically significant alpha. So the Alpha was big enough to say with, let's say, 95% confidence that it was skill, but there was still some chance that might have been locked. Now, if you had 100 years of data, you might be 99%. Confident.
Andrew Stotz 40:26
And also, it's not enough. If somebody's looking at the stock market and they see that person statistically show outperformance it's not enough to tell me. And they've done it for five years? No, we need to see much more data. That's what you're saying. I know, you'll be able to get much
Larry Swedroe 40:46
more. Let me give you some examples. So in the 70s, if I had to ask you to guess who is the best mutual fund manager, one name should pop up?
Andrew Stotz 40:57
Peter Lynch, who
Larry Swedroe 40:58
was he's alleged, but that's the wrong answer. He was only the second best fund manager forgot the guy's name, but the fund was called 44. Wall Street. In my book, I talk about this, you might find that just name escapes me for the moment, the next 10 years, Lynch went on to become famous, right as a great manager. And while the market saw it in the 80s 44, Wall Street lost 73%. So you wait 10 years, okay, it can't be locked. This guy's better than Peter Lynch meant to give him all my money you missed out on the great returns. And then you got horrible returns. So it's likely that he wasn't a genius, who suddenly took a stupid pill, he was just locking down on locking. And it's very hard to differentiate between Lench and M. Let me give you another great example of Bill Miller is the name many people will read. He beat the s&p, I think it was like 15 years in a row, the first guy to ever doing now, randomly, we should expect somebody to do it. But he was the first to do it. So money flows in, right, everyone, you gotta get intimate. And then the next decade, wherever his returns were very poor. In fact, he got fired as a fund manager left, you know. And so this is very common. And a problem is this, as we talked about in The Incredible Shrinking alpha, one of the problems is successful active management contains the seeds of self destruction. Because to beat the market, you have to look very different than the market. And when you get a lot of cash, you either have to diversify, you get a lot more assets, or your trading costs go through the roof, because you're buying large blocks of a small number of stocks, which is,
Andrew Stotz 43:03
which is just dealing with an issue that some people will say is that, oh, I've got a straight a trading strategy that's outperforming right. But can it be done at scale?
Larry Swedroe 43:13
That's right. And that's the problem scale is a negatively correlating figure relating to asset management.
Andrew Stotz 43:22
And I think you're talking about David Baker, by the way, David Baker.
Larry Swedroe 43:25
Yes. That's the name. Thank you. Alright, so
Andrew Stotz 43:29
that's number one, was not much
Larry Swedroe 43:31
number one. Number two, the competition's much tougher when I got out of my MBA program was one of the first MBA programs in finance, because there was no financial theory until the late 60s with the cap M. That if you were taking finance courses, or was probably in an accounting, or economics degree, I went through one of the first in the late 60s, early 70s. finance programs in my undergraduate and graduate school today, so people who were managing money were not finance majors, they didn't know financial theory didn't have the knowledge we have today. Today, everyone managing money knows all of this stuff. And they are a lot smarter. As I mentioned, they hire world class scientists. The competition's tougher. Yep. And there's something called the paradox of skill. When the tougher the competition, the harder it is to differentiate yourself. So what I talk about is that fact that in baseball, the kind of the standard, the toughest thing to do today, is to be a 400 hitter. Now, no one has done it since 1941. That's 80 plus years, but it was done 11 times in the prior 40 years. But the problem is today, why are they no 400 hitters, when today's athletes are bigger, stronger, faster, better regimens, better diets, better playing against
Andrew Stotz 45:12
better players performance. Sorry, they're playing against those better players.
Larry Swedroe 45:17
Yeah, that just as the batter's have gotten better, pitchers have gotten better, the fielders have gotten better, the gloves have gotten better. But in 1900, and throw around 1940. These standard deviation batters averaged about 250 to 260. But the standard deviation was over 40. So there were big differences. So it didn't take a huge, you know, amount of this, you know, you wouldn't be three or four standard deviations away, and you would be a 400 hitter, one standard deviation got you to 300 200 to about 343 got to 390, our 380. And then the fourth year up there, right? Today, the batter's still average that same 250 to 60. But the standard deviation is under 25.
Andrew Stotz 46:16
And that's math information that people know that if some someone's swinging in a certain way they see it and then or they're practicing in a certain way, and then the next club just picks it up and starts doing it or what well, the
Larry Swedroe 46:29
competition's just tougher. It's like I said, it's tougher for Roger Federer as he walks through a tournament and wins matches. By the time you get the championship. He knows the win was in about 55 60% of the time.
Andrew Stotz 46:45
Okay, so you could say over time, you know, if you go back 50 years ago, there was a small number of people that collectively had been trading markets. But as time goes on, their record is shown and people see the public information about it. More and more people are entering the game. And now information is beginning to be more narrow and understood and knocked up
Larry Swedroe 47:07
more people are playing the game. It's that smarter people are playing the game, more informed people. As I said, When I graduated, no one running money had a PhD in finance, or very few. They didn't have high speed computers. Today. The head of Research at dimensional fund advisors is an ordinary trickle engineer. The head of Research at a Montes is a nuclear, you know, as a rocket scientist. Yeah, I mentioned in the Birkin at Bridgeway. These are much smarter people who also have better training in finance than the people who ran money in the 50s. So they're competing against each other, making it harder to be a 400 hitter, making it harder to outperform by a wide margin. And that's why you don't see people doing what Buffett did a year three. Yeah. So just very quickly, in my book on the Incredible Shrinking alpha, we showed the dispersion of returns of active managers over time, and the dispersion is going like this. So when that's how you can tell that skill is getting better, because it's hotter than if the worst dummies get booted out. Right? They fail and no one will give them money. Right. And so smarter people remain, and that's like Roger Federer are going through the tournament, the four traders, for managers are leaving, leaving the remaining players being tougher skill and harder to win.
Andrew Stotz 48:47
Some competition is not as tougher as number two and the dispersion of returns. Reducing overtime is great evidence to support that what's number three?
Larry Swedroe 48:56
Exactly three is you need victims to outperform right? Because outperforming even before expenses, a zero sum game, but trading and fund expenses aren't free. So you it's a negative sum game. So they've got to have dummies to exploit. Who are the dummies? Are they the institutions are retail money?
Andrew Stotz 49:24
In theory, it's supposed to be retail.
Larry Swedroe 49:27
Well, it's not theory. It's fact. Okay, now that we already talked about individuals, the stocks they buy go on to an average underperform. Right and the stocks they sell out before in 1945. Coming out of World War Two 90% of all stocks were held by individual investors in their brokerage accounts. That means they were doing most of the trading. There was only 100 mutual funds in the US in the 1950s. Today those numbers are completely reversed. Most of the trading is done by institutions. So that means when you're trading, you're likely trading in the today against Renaissance technology or Citadel, or Morgan Stanley, where in the 40s and 50s, you were trading against some other naive investor.
Andrew Stotz 50:21
So retail have been channeled, retail investors have been channeled into the funds that are managed by the smartest people in the
Larry Swedroe 50:31
NBA. Even among the professional managed funds, the ones who have poor performance, money leaves, they fall, and they disappear, they go to the mutual fund graveyard in the sky, and the remaining smarter players get more money. So now as we get back to the second point, you know, who are the people who are going to drop out, not the ones who were winning the game, the most skillful the dummies, the losers drop out. So now the competition keeps getting tougher and tougher and tougher. It's like Roger Federer was going through a ton of winning his odds of winning get tougher. The last point is this, this supply of dollars shrinking those, sorry, chasing those shrinking pool of, or sources of alpha has grown dramatically. When I wrote my first book, in the late 90s, there was 300 billion in hedge funds, the most sophisticated in theory investors, today, there's over 5,000,000,000,017 times the amount of money when the sources of alpha are shrinking, because the academics have converted into beta, it's no wonder it's becoming hotter and hotter, is this port number four. That's number four, the supply of capital chasing it. Now, that's the only one of the factors that could change. Because people could say, hey, the returns to hedge funds have been god awful for the last 20 years, as the supply increase, and the sources of alpha shrunk. And the competition got tougher, hedge funds had great returns in the 80s and 90s. But then these forces changed the game. And they'd been awful for 20 years.
Andrew Stotz 52:22
And they tell you that you're mentioning is hedge funds or fund management in general, in general,
Larry Swedroe 52:27
but I use hedge funds as an example. Yeah, but today, you have 10,000 mutual funds, and we had 170 years ago, amount of money chasing those shrinking sources about all the other things, those first three trends, I don't think are going to change, they're gonna get more difficult for creating higher hurdles, the last one could change, as investors decide if we should give up this game more than give it up. And the supply shrinks, creating less of a supply issue. The problem is the other things continue to get tougher and tough.
Andrew Stotz 53:08
And what one last question I have about this, and we're gonna wrap up in just a second. But what does it imply about let's take Renaissance as an example, let's take dimensional as an example. Does this mean that they end up accumulating all the assets over time? Or does the same thing happen to them that it's happened in everybody else in five or 10 years? They're not going to be as fancy and as big anymore? And another, you know, no other group is going to rise? Or what's the prediction there?
Larry Swedroe 53:41
Well, let's see if we can answer it in the best way here. So Renaissance, for example, had the greatest track record of any hedge fund in the world, when they were managing a small pool of the founders money and stuff. And then they started taking outside capital. And they was so successful using quantitative strategy. They were not hiring PhDs and finance but world class mathematicians. And they paid super amounts of dollars for the fastest computers with the quickest pipes to the exchanges. So they could get a head of and trade one millisecond faster than your eye. And that gave them a big advantage. So they could make pennies on billions of trades and full profits out of the market. They then were charging as much as like five and 50%. So 5% fees 50% of the return. They brought in so much money, the returns to investors were actually poor, and they gave it back and now they I think managed pretty much only their own smaller pool of money that shows the problem. I think what you're likely to see is the shops that are purely systematic meaning They go after unique sources of risk. And then by all the securities in that universe, they will continue to gain share the way Vanguard has gained share the way BlackRock and their iShares have gained shares, market share, and that's going to be the trend, they will continue to get bigger and bigger as more people go into the systematic passive strategies. And a few active managers who are continuing to be successful, will likely continue to gain market share. And that will create a problem for them, because the only way they'll be able to continue to generate alpha is the stop taking assets, because otherwise, they get too big, they have to either diversify or their market impact costs go up. And how many managers do you know that will turn down the chance to earn higher AUM fees? That's a That's why many swipe Peter Lynch knew the game was up, he had gotten so big, it was going to be very hard to generate alpha, none of the successors he hired to replace him who all train none of them, were able to replicate Lynch's performance. Its successful active management contains the seeds of its own destruction.
Andrew Stotz 56:22
And I think what you are explaining is maybe we could call it exposure investing, where if it's a small cap attribute that you want, you're going to buy a particular strategy that's getting exposure to that rather than trying to outperform that little narrow thing.
Larry Swedroe 56:41
So instead, the simple way to say it is you might buy the s&p 600 value index. So you're buying small value stocks, you own all 600 In a market cap weighted way, where an active manager would say we're gonna pick the 100 best stocks from that 600 list. And we're going to outperform we don't want to get average returns. And that's the myth act. Indexing does not get you average returns, it gets you market returns, which by definition gets you better than the average returns, because it's a negative sum game, to all of the active small value investors in aggregate. So if somebody outperforms, even before expenses, someone must underperform even before expenses, and you're guaranteed to be a winner if you're a passive, systematic investing.
Andrew Stotz 57:41
And ladies and gentlemen, that wraps up mistake number one, are you overconfident of your skill? As you can see, Larry has a wealth of knowledge and experience anything you would leave the audience with in relation to this mistake in our discussion today.
Larry Swedroe 57:57
Yeah, well, I think the one thing I would mention is, of course, you shouldn't be overconfident. And related to that is don't make the mistake of confusing information, which is something everybody knows with value added information, which is something either nobody else knows, or somehow you are able to interpret it better. And if you don't ask that question, you are likely to be overconfident. And you think you can outperform when the odds say you're not likely to be able to do this.
Andrew Stotz 58:33
Boom. And that's a wrap on another great discussion about how to create grow and protect your wealth. This is your worst podcast host Andrew Stotz saying, I'll see you on the upside.
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Further reading mentioned
- Larry Swedroe and RC Balaban, Investment Mistakes Even Smart Investors Make and How to Avoid Them
- Philip E. Tetlock, Expert Political Judgment: How Good Is It? How Can We Know?
- Carol Tavris and Elliot Aronson, Mistakes Were Made (But Not by Me): Third Edition: Why We Justify Foolish Beliefs, Bad Decisions, and Hurtful Acts