Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was head of Research at buckinghamwalt partners. You can learn more about his story in Episode 645, now, Larry stands out because he bridges both the academic research world and practical investing. And today, we are wrapping up our series on the book, enrich your future, the keys to successful investing. And specifically we're going to talk about how to put some of this in action, how to think about some frameworks. Are you a conservative? Are you aggressive? What types of frameworks you should be looking at, as well as talking about some instruments. Now, none of what we're going to talk about today is investment advice. It's basically for educational purposes to start thinking about these types of things. So I just want you to use this as a foundational way of kind of thinking about the way you're investing. So Larry, take it away.

Larry Swedroe 01:05
So one of the things that investors have to decide is, do they want to invest in a total market fund, which is a perfectly good weight certainly could be a starting point for discussion, because anything that deviates for that says, To at least some degree, maybe I'm smarter than the market, and I can choose which assets are better. That's one way to think about it, and it's a very low cost, very tax efficient way to do it, however.

Andrew Stotz 01:40
And just to talk about that briefly, when you say total market. Now normally, when we're talking in America, a lot of times when we're talking total market, we're talking about the total US market. So there's total market, as in the total US market, and then there's total global market. Maybe we could just talk briefly about those two steps, because let's just say you absolutely don't have any time, you don't have any knowledge, you don't have any interests, you know, all the stuff that we talk about not that interesting. And therefore, you just need the simplest way. Would it be total US market, total global market. How would you think about those

Larry Swedroe 02:14
two I believe that the right way to think about these things is to start with core principles of investing, and I think that there is just a small handful of them. That's the good news. And the first is you should believe, because the academic evidence, as we have discussed, is overwhelming, that the markets, while not perfectly efficient, they're highly efficient, which means it's very, very difficult to outperform on a risk adjusted basis. Okay, it doesn't mean that there aren't inefficiencies. It doesn't mean that some investors won't outperform. It just means that the odds of your identifying those investors or doing it yourself are so poor you shouldn't try. So if you believe that markets are efficient, then the right way to think about that is the market's price is the best estimate we have of the right price, okay? And that means also, if markets are efficient, that all risk assets right should have similar risk adjusted returns, okay, so one, if markets are efficient, we don't want to engage in individual security selection or market timing, okay? And it means that US stocks have to have the same expected return as Thailand stocks or or emerging markets in general, or

Andrew Stotz 03:55
the same risk adjusted return. Risk adjusted Okay, yep. So

Larry Swedroe 03:59
for example, let's keep it simple. We know that junk bonds should have higher returns than AAA rated corporate bonds. That doesn't make them better investments. It makes them higher expected return, because risk and return should be related once you adjust for risk, and that could be the duration risk or credit risk we talk about bonds, then they should be similar. So let's take an example. If Thai stocks, right, had lower expected returns, as many people think, than US stocks, and if markets are efficient, what would happen? People would sell Thai stocks, driving their valuations down doesn't change the earnings of the Thai companies, so it drives their expected return up, and money would then be flowing into US stocks because they think they. Their higher risk adjusted returns and driving us valuations up, which means expected returns are now lower because you didn't change the earnings until we're in an equilibrium,

Andrew Stotz 05:12
which is exactly what's happened the time Thai stock market has devalued de rated over the last, let's say, five years till we're getting very close to book value. Let's say we're at one to 1.5 times price to book. I was just looking at a company. I went to visit a company yesterday, and they're trading at 0.8 times price to book, whereas you see the US is at four and a half five times price to book for the overall market. So that exact thing you're saying is what's happened, just looking at Thailand versus us,

Larry Swedroe 05:43
should happen over time. Now that doesn't mean the market's always right. Obviously, for the last 1617, years, US stocks have outperformed international stocks, but that's now reversing, and there's no evidence that we know of that people can time flows between stocks. So number one is all risk assets. One, the market is efficient. Number two, all risk assets should have similar risk adjusted returns. So you want to avoid active management, etc, but invest in the assets based upon your ability, willingness and need to take risk. If you're willing to take more risk and have the ability and maybe the need to well, then you can load up on more risky, high expected returning assets. It doesn't mean that they're better assets and means that they have higher expected returns, but not when you adjust for risk. Are they any better? Okay? And then the last thing is, if all risk assets have similar risk, adjust the returns. This makes no sense to concentrate all of your risk in one basket, whether it's US stocks or Thai stocks, if you're live in Thailand and you have a home country bias, or even equities in general, and we've talked about maybe investing in other assets, not just international assets from equities, but Things possibly like reinsurance, infrastructure, funds, private credit, things like that, where you have low ex low correlation to assets. Okay, so, so let's get to your question about us versus International, emerging market. I think the only right way to think about this, at least as a starting point should be. Again, markets are efficient. Today, the US is maybe 65% of the global market cap, so therefore that's a good starting point. And then of the remaining piece, there's a ratio of about three to one between developed and emerging so if you had 35% maybe it's 27 and eight, or something like that, between developed and emerging markets, and you could just buy Vanguard, has a total global market fund where you could buy a total US and a total International and then if you decide that you have either the ability, willingness or need to take risk, or if you decide you're smarter than everybody else, and you think you know us, assets are now way too highly valued, I might use the word sin a Little and not own 65% us. Maybe I'll own 60 or 50, but I wouldn't own 10, right? I don't want to get too far away from the global market cap, because I don't think I'm much smarter than anyone else. It's interesting to point out, by the way, in 1989 Japan was something like 60% of global assets, and it was in a bubble, clearly in hindsight, and now the US is way up there, a much bigger percentage than its share of the world economy, and that's because us valuations have gone way up. So if somebody asked me today, what would your preference be? My own answer is, I'm 50% us and 50% because I think US assets may be, in general, too highly valued in the way Japanese stocks work, too highly

Andrew Stotz 09:36
valued. So 50% us, 50% non US.

Larry Swedroe 09:39
But notice I'm not that different from the rest of

Andrew Stotz 09:43
the world, right? So the rest of the world, right now, if we looked at the VT fund by Vanguard, which owns, let's say, about 10,000 stocks, and there's other ones, whether that's fidelity or Schwab or dimensional or others that have these types of other. Passive funds. But let's just take Vanguard for an example. They've got about 10,000 stocks, and their exposure to the US is about 60 to 65%

Larry Swedroe 10:10
right about the world cap, free float some you know, that's the way, typically, most fund managers do it, not the app, but what's called free float money, you know, shares that are available to be trading.

Andrew Stotz 10:24
Yeah. Okay, so now let's just stay on this topic. So right now, I want to look at kind of three types of people. Let's say someone in their 20s, and let's just say they're a typical person in their 20s. They're they're earning some good money, and there's there's they're spending, they're saving, but you know, they got many years ahead. And then you got someone in their 40s, and let's say that there's 20s and 40s. People want to retire when they're 60, let's say and then you've got someone in their 60s, right? So we've got three different general age groups, and we can say risk profiles, if we consider that they're like the average 20 year old, the average 40 year old and the average 60 year old. Should the, let's just take the global market exposure. Should these people only have global market exposure? Or should they say, I want global market equity exposure, and I should have some sort of fixed income or bond exposure?

Larry Swedroe 11:21
Yeah, so number one, one of the worst mistakes that you'll often see even professional advisers make, which anyone who's read my books on financial planning and retirement knows they they're making the mistake of only looking at one factor, and it's only a part of one factor, which I call the ability to take risk. The ability to take risk depends upon two things. One, your investment horizon. Obviously, if you're 65 or 75 you have a shorter horizon than a 25 year old, so you have less ability to take risk and wait out a bear market, and especially if you're retired, you have less ability to take risk because you're subject to this sequence risk that you can't recover from because you've withdrawn the money.

Andrew Stotz 12:17
And just, just to, just to clarify this, I think when you say the ability to take risk, I think what you really mean is the ability to bear

Larry Swedroe 12:24
risk. To bear risk. Well, the same, you know, same exact thing. Yeah. Okay, so that's number one. But there's a second thing that so many people totally ignore, never even ask. So I'll just ask you, Andrew, to give you a chance to show your audience how smart you are. So you've got two groups of investors, okay, and they're both the same age, okay? And everything about them is equal except their job, okay? So you got a group of investors that are auto mechanics, construction workers and stock brokers, and you got another group that are doctors, 10 years professors at university and government employees not subject to those so which group has more ability to take risk? So,

Andrew Stotz 13:25
but first idea that I had was that the first group seems like they're really exposed to the economic cycles, versus the second group is less exposed to economic cycles. Goes up and down, but doctors are going to get paid, yes. So the result of that is that, first of all, when the economy goes bad, a mechanic or that type of person in that type of job that you've described in the first group is going to be terrified that they're going to lose their job, their income could go down. They could lose their job. They have to switch, get a lower job. And so from that perspective, I would say that they've got some real serious exposure to the economic cycle, and therefore less ability to bear risk.

Larry Swedroe 14:03
That's exactly right. And not only that, it could get much worse for them, because the markets crash and they get laid off, and they have to sell stocks to put food on the table, and then eventually, when the markets recover, they can't, because that money has been spent. So that's one part of the equation that you must consider, but that's only one of a three legged stool, and like any stool, all three legs have to be firmly planted, or you could tip over. So we have the ability to take risk. Second thing is what I call the willingness to take risk, or the stomach acid or sleep well, test right? So some people, if the markets crash, can't sleep and life's too short not to enjoy it, and they're going to worry. So. They shouldn't take a lot of equity risk, and some people just will panic and sell, right? So in the first group, they don't panic and sell, but they worry so much they can't enjoy their life. That group should clearly be taking less equity risk, and the other group, and then you have this need to take risk. And so what I talk to people about is something called the utility of wealth curve. So when you're don't have a lot of money, let's say you're homeless and someone gives you $20 I mean, that's enough for maybe get a shower and, you know, a meal at a, you know, and stuff. And that's makes a huge difference in your life. If you have $10 million and there's a $20 bill on the floor, you might not even stop down to pick it up, because it's not going to change your life in any meaningful way. So what the academic research shows is, once you have a sufficient income, assuming you have your health food on the enough money to put food on the table, you're not worried about paying the rent, those kinds of things you're there is no difference in happiness between people who have more or less this done all these studies on places like Easter Island and New York City and, you know, jungles in Africa and Peru being, you know, the small towns and stuff. And they find this is true, that the utility of wealth curve goes like this. More money early can mean a lot, but once you have a lot, then more money, of course, is better than less, but the incremental value becomes much less. So in the US, a study was done about a decade ago, and it found that that level of happiness where it didn't matter, was about 75,000 So today, let's call it 90,000 now, maybe in New York City, it's 200,000 and in Hope, Arkansas at 60. But there's a level. And if once you have enough, right, it's, you know, yeah, it's nicer to play golf around the golf at Pebble Beach than it is maybe a local, municipal golf course, but you still got a beautiful walk in the sun. Maybe you're playing around the golf with your best friends or your wife. You can have a beautiful day and enjoy it. Pebble Beach is nicer, but it really doesn't change the quality of your life very much. To me, I get the greatest joy of walking around the local park here, around a beautiful lake with my wife reading books or playing a game of Monopoly deal with my grandkids like I did this afternoon. That doesn't cost anything, right? And so what I try to teach wealthy people is, once you have enough, and let's say, in the US fairly wealthy. If you can't be happy on, say, 200,000 a year, something is wrong. Okay, well, you know, if you use a 4% withdrawal rate, multiply then by 25 200,000 5 million, why are you sitting with 50, 6070, 80% equities? It doesn't make a lot of sense, okay, so at least as one starting point is I don't need to take risk. And when I tell people, once you're at that level, I can't see a need to own more than 20 or 30% equities. That greatly reduces your tail risk. And you know, if you miss out on a bull market, who cares? You're going to be happy anyway.

Andrew Stotz 18:46
Okay, so let's tie that into the question I asked you, which was your 20s, 40s, 60s. We now you've talked about three factors to consider, the ability to bear risk, the willingness to bear risk, and the need to bear risk or take risk and now we've got a good understanding of that.

Larry Swedroe 19:04
Let me say this. Add this before you ask your question, because all three legs have to be stable. In general, the answer should be whichever is the lowest number. So if you have a big willingness to take risk and a big ability, but no need, I recommend that that should dominate your answer, okay, but there are mitigating circumstances. I think we may have talked about this in a prior podcast, but I had a friend named Philip was a senior executive, top marketing guy at a company I worked at, and he was the epitome of somebody who couldn't stand risk. I mean, he'd go crazy if the market dropped a few percent, which of course, it could do often on a daily basis throughout a month or a year. It. But he was about at the time, about 45 and he hated working in the pressurized world of corporate Corporation. He wanted to quit and become a photographer, and that was his passion. So I said to Philip, and I wrote this story up in the book, okay? And this was in the early 90s. I said to him, Oh, yeah. I said to him, here's your choice. You can have a low equity allocation, sleep well, and you'll have to stay as an executive in this world, and, but you'll make a lot of money and but you're going to have to work another 20 years to get to your number. Or you could take a lot of equity risk, buy a 20 year supply of Maalox and hope we get a bull market, and then maybe you can de risk later and then quit and whatever. Well, this was early 90s, and the next several years, of course, we had spectacular returns, and he benefited from that, because he made the decision that his life priority was more important and he was going to live with the risk. And he then retired and became a photographer. So sometimes you have to, there's not a free lunch there, but if you have a choice, it's the lowest number that should dominate.

Andrew Stotz 21:31
Okay, so let's go then to the person who's in their 60s, and say they, they do. They don't need to have 100% exposure. Let's say to global equity market is the way that they're going to reduce that exposure through fixed income. The primary way of doing that,

Larry Swedroe 21:52
I would say, No, I would say that again, it comes down to diversifying in a world where all risk assets have similar risk adjusted returns, and here it somewhat depends in the US. We're lucky. We are in the last really, only about the last five, maybe 10 years have seen alternative assets come to market with much lower fees than they used to do you wanted to invest in reassurance or private equity or private credit or private real estate, you were typically paying at least 2% annual fees and 20% carry or share of the profits. Today, those numbers that come way down. So 10 years ago, I didn't own any of these alternatives, and now my portfolio is half because I believe in diversifying those assets, of course, as many as I can. So it may depend upon what you have available to you. And since that book was written, there have now been a few others added to the portfolio. I recently made an investment, for example, in an infrastructure fund run by Hamilton lane, which is a huge company advises on something like a trillion dollars of pension plan assets and infrastructure in this fund happens to be what's called the tender offer fund. Their fees are only 1.4% now that's not cheap relative to index funds, but it's a far call from two and 20 and the expected returns today are in the 10 to 12% range, and the volatility is low single digits, so much lower than equities, and there's very little inflation risk, because they typically have long term contracts that things like dams and roads and utilities or Amazon's got a facility that there's a 15 year contract and it's got escalator clauses with triple net leases. So I now own things like a reinsurance fund. I don't have to pay two and 22 for private credit. I'm paying much less than two and 20 something like effectively about 115 so I'm now able to capture that. So it depends on what's available to you. I think we're much luckier in the US than the investors overseas are, where fees are much higher.

Andrew Stotz 24:39
Yeah, that's for sure, and so it's what you're saying. And I just want to try to get this as simple as possible. Is what you're saying is that fixed income should not be the primary way to reduce risk. It

Larry Swedroe 24:53
depends upon what assets you have as alternatives if you have access to go. The relatively lower cost alternatives, I think the typical investor should have an absolute minimum of 15 to 20% alternatives. Then you might have 30 or 40% inequities, not too much, and then the rest, and you could have in, say, fixed income, if you're a little more aggressive and willing to put in the time to get educated, you might have more like 1/3 in equities, 1/3 and also 1/3 in safe bonds. And if you're more like me, you can look more like the Yale's of the world. And maybe you only have 20% in equities, maybe 50% in or 20 to 30% equities, 50% in these alternatives, and then the remainder, and say, fixed income. Now I think you should never own less than 20% equities, because there are periods when stocks or when do well and bonds do poorly, and so you want to have at least that 20 to 30% but make sure you're globally diversified and use low cost vehicles, okay? And so it's just going to depend on your willingness to deal with a lot of the psychological issues, which we've talked about often, this tracking variance and recency bias, which are the fatal enemies of most investors.

Andrew Stotz 26:27
And when we think about first of all, for international investors, a lot of times, these private these alternative investments, end up being funds that they can't necessarily access as easily as they can ETFs. So that's the reason why, for some people, even though there's lots of different credit private credit instruments available, they are generally funds and harder for, let's say, an international person to buy. And hopefully that will change, but we'll see more of that in ETFs, and I know there are ETFs on them, and so now, basically, one of the questions that I have then, okay, so it always makes me think when I think about asset classes, because in the end, equity is exposure to Companies and fixed income, unless it's government fixed income is exposure to those same companies, but with a different mechanism, a different risk structure, and the like and private credit is maybe exposure to companies, but maybe companies that you wouldn't necessarily get access to, that are smaller or that type of thing. So although it's still exposure to companies, it's, you know, different, and that's different from something like a commodity as an example, that's not necessarily tied to a company. So I want you to help us think about asset class, and just to add in a little more complication, some people will, let's say all the I'm exposed to all these asset classes because I have small cap, I have large cap, I have high quality, I have low quality, I have all of these different stocks. But to me, they're really explaining maybe exposure to factors. They're not explaining exposure to asset class. So how should we think about asset classes?

Larry Swedroe 28:19
Well, so what you want to think about is what types of risks you're exposed to. Forget even the words factors or asset classes. What are the risks? Okay, that you're exposed and what you want to do is diversify across unique sources of risk. So for example, all equities are exposed to economic cycle risk, so they have a market beta, typically on average of one. So you look like the risk of the market. So the market goes up 10% you'd expect to go up 10. If the market goes down 10, you'd expect to lose 10. Now, there are certain stocks that we call high quality, defensive stocks. You might think of them as supermarkets and drugstore chains. You know, high quality companies that have low financial leverage, very stable earnings, they might have a beta of something like point seven or point eight. So much less economic cycle risk. Okay, so when markets are up 10% you might only be up eight because you don't participate as much. But when markets are down 10% you may only be down eight on average. Okay, so these stocks have clearly some unique risk to them, okay? And this happens to be called the quality or profitability factor. We know small cap companies look different than large cap companies. They tend to both. Depends on the. See, you're in to some degree, and your finances be have higher betas than the market. So market goes up 10% small cap stocks may go up 11 and the reverse is true in the downside, just specifically in private credit. We could spend an hour alone on that subject, but credit is has a broad spectrum of risk in it. You could be US government, which has no credit risk, for at least US investors, you have AAA companies which almost have no default risk. I think there's only been one AAA company that's ever defaulted Penn Central Railroad. So it's non zero, but very low. And then you have double A, single a, double B, you know, etcetera, all the way down to high yield bonds. And I yield bonds have much more risk in 2008 when government bonds went up in value, and Triple A bonds also did well. High yield bonds lost 50 or 60% because of their exposure to that and private credit covers that whole spectrum. Could be highly risky, or is a fund that I invest in and run by a firm called Cliff water that only invest in private credit that is senior to all other debt. It is secured by assets, not, you know, paper promises, and it's backed by private equity. So if the private equity firm thinks that the lenders will take over the company and declare a default. They'll get wiped out, or could get wiped out, and so they are more likely to step in. They're not going to throw good money after bad. But the evidence is, if there's a chance and they think they can salvage it, they will and this and the average loan to value is currently about 40% so the historical default losses on this type of loan is 0.25% so I also invest in a little more sophisticated product. It's called the double B tranche of a pro of a clo or collateralized loan, and its yield as the private credit fund I'm in has cranked out about 10 or 11% for the last several years, okay, with very low volatility. Okay, this double B fund is at even higher returns, and in the 20 year history of double BS, there's virtually never been a default loss. But most people aren't aware. They don't it's esoteric, but And very few people play in it. Fact, there's only one fun that even focuses only on that. So there is a big spread available, because there's no supply to that marketplace. So there's a very wide spectrum, and you have to do your homework or work with an advisor who has access to these products and has done their homework. And I would recommend, as we discussed in our last session, ask to see their financial statement if they're invested in those funds they're recommending, and if not, been run, so you really have to do your homework here, or have somebody you can fully trust because they're a fiduciary, puts the money where their mouth is, invests in the same way they're recommending, and is willing to educate you about all of the risks of these investments. So

Andrew Stotz 34:00
for the next thing I'm going to I'm going to preface the next question with a couple little stories. You know. The first story is, if a tree falls in the woods, you know, and we didn't hear it, did it actually fall another in another concept related to this is the tin can portfolio. Some people say, Oh, my uncle just put, you know, his family bought stocks, and they put the shares in a, you know, in a drawer. And 30 years later, he won't, you know, he found them. And he's a multi billionaire, right? Because he didn't look at prices and all that. And Warren Buffett, you know, goes on about that as an example. And then my third thing I would look at is a bank. Now, banks generally trade close to book value. They trade at a premium to book value most of the time, but it's pretty close, and that's because banks are marking their portfolios to market on a pretty regular basis, where they're making an estimate of. Of potential losses, and then setting aside a provision, and that is trying to get somewhat close to market price, and that's why banks tend to not trade it four or five times price to book. Now, when we look at and so therefore, when you buy a bank, you're buying a portfolio of lending. Ultimately, if it's a typical bank, a portfolio of lending that's not priced as daily, let's say, as the market price for assets. But when you look at private credit, to what extent are we just buying things that are not priced often, and we're still exposed to underlying risk, but because we don't see those risk changes, we don't, we don't recognize that in the same way and which, which could be good. I'm not saying it's bad, but I just want to understand this concept of, you know, pricing versus, you know, other risks. Well, just

Larry Swedroe 35:58
one comment for you. I like that story, of course, the guy who found shares of IBM or whatever, okay, but you never hear the story of the guy who looked and found the shares of Polaroid or Enron, right? So that's true. One comment also, banks, on average, may trade around book, but they all they also run other businesses that are growing Asset Management and stuff that you know that is not, you know, an asset per se, it's services provided trust companies and other things. And JP Morgan, for example, I think trades well over two times book today, and there are other banks that trade below book because they're not growing well, and maybe their assets are worried about overvalued. What we do know in general about these illiquid assets is the following. There are plenty of academic papers on this. So private equity as well known to have a lag in their valuations and a fair degree of freedom on how they mark and that leads to stale pricing. And the stale pricing, on average, tends to run between three and six months, depending upon the firm. So that's going to make volatility look a lot lower, because if things go up and down and you know, Mark, you're marking it maybe in the middle of both times, right? So that's a real problem. And however, the private equity fund that I invest in run by Cliff water, the symbol happens to be CPE FX. They actually do where they can a daily mark, and they do that by putting a beta adjustment factor to their portfolio. And let's just, I'm going to make this up. I don't know exactly what it is, but let's say it's point three. So if the market goes up 1% they'll only mark it up one you know, point 3% they also mark daily any new information they get from the hundreds of investments they have. So they invest across, let's say, 300 different investments across maybe 20 private equity providers. So they're partnering with these firms. And each one of them, maybe one of them, does their quarterly marks in January, April, July, etc, and the others do it in February and on, and the other ones doing them on. And they're getting these coming in every month. They're getting some and whatever they get that month, they're marking it immediately, not waiting, so you have much less of a lag there. But you're still going to get a lad on their private credit fund. They're marking it daily with a, again, a beta adjustment to what's happening in the public markets. And there you have a much better read, because you have no duration risk here, because it's all floating rate credit and private credit, almost all of it, and everything this fund does is so you don't have to worry about that not being marked properly. And a recent paper I got a hold of looked at that and found, because of these adjustments, the lag was only about a month. So where private equity may show volatility because of this phony counting, if you will, of only 10 or 12, it's going to be more like 15 or 20, more like equities. But private credit, instead of being two, might be four, and still way below, because. Plus, again, at least the private credit that I'm talking about, senior secured backed by private equity. Low LTV, strong covenants has an incredibly low default rate, and its lag is no more than a month. So again, you really have to do your due diligence, understand the fund, what they're accounting, how they're marking, etc, and that's one of the risks of investing in this space. It's not for amateurs,

Andrew Stotz 40:35
right? Just I just have a file where I keep the price to book of companies and SEC by sector. And just you know, there's two sectors. One is called financials, which is a more all encompassing, versus banks, which is what I was talking about. And banks trading at about 1.3 times price to book globally. And if we look at us right now, the price to book of banks is about, let's say about 1.5 so a little bit better. And JP Morgan's at about 2.5 as you said, you know they're the best. So you know, the best in the industry gets the highest amount.

Larry Swedroe 41:18
We have a lot of earnings coming from services, not assets, correct, Wealth Management, etc,

Andrew Stotz 41:26
yeah, and banks in emerging markets are much more pure lenders, because there's just less of that service industry, you know, income. Okay, so, so the question then becomes, let's go back to a person in their 20s versus a person in their 60s. One of the questions that I have for you is, if you're in your 20s and you've got a good you've got the ability to bear risk, you've got the willingness and you've got you got some need, like, you know you do want to build wealth, is there any point in owning these instruments besides equity,

Larry Swedroe 42:05
yeah, exactly, for example. Today, I'm not saying this is long term, but the expected return to the reinsurance vehicle I invest in is about 20% and the volatility compared to stocks is about half or 60% and it's totally uncorrelated risk, because bear markets don't cause earthquakes or hurricanes and vice versa. So it's the perfect asset. Why people don't own more? I have no clue. It may be because they're scared of climate change, and I tell people, Gene the scientists are Warren Buffett's, you know, general reinsurance. They never heard of climate change, and they haven't built their best estimates. And now could turn out that the risks are greater than they think, but also could turn out to be they're less than they actually think. And the last two years, this fund has returned 92% cumulative. And it's up again this year despite the largest fire in California history, with the largest loss ever done. Okay, so there I you know, if you look at private credit 10 to 10, 11% for the least risky part of that. Well, what's the expected return to us? Stocks today, Vanguard, JP, Morgan, all saying six to seven, and the volatility is four to five times that, at least that of high quality private credit.

Andrew Stotz 43:40
Okay, so for the 20 year old, there's, there's, there's other options. You need access to these vehicles at the appropriate cost. That's

Larry Swedroe 43:50
the problem for foreign investors,

Andrew Stotz 43:53
yeah, but for the 20 year old in the US, basically, what you're saying is that look beyond equity,

Larry Swedroe 43:58
yep. Okay, I don't care if your need to take risk is high and your ability to take risk is high and your need to take risk is high, you should still diversify, because equities can get killed for the next especially us, equities could turn out to be another lost decade as the 30s were as basically 66 to 82 was and the 2000 decade, those were lost decades you got no real return. Basically,

Andrew Stotz 44:34
okay, so one thing that I think people find hard to understand, and I think it was either Yogi Berra or Albert Einstein. Both of them are very smart. He said, in theory, there's no difference between theory and practice. In practice, there is

Larry Swedroe 44:53
yes, but partly because of human behavior. So if you're going to be subject to re. Decency, bias or tracking error, regret you shouldn't own anything but the s and p5 100 or a US total market fund, because there will be periods. I'll give two examples. Reinsurance fund that I just told you made 92% the last two year, calendar years from 17 through 19, I think it lost about 35% and people said, Ah, you know, going on it? I point out that US stocks have gone down a lot more than 35% in any year you they've gone down as much as 90% in the Great Depression. They went down more than that in a weight, right? They went down more than that, or about that much or more than that, actually, in 2000 Oh, two that's a reason to diversify, not have all your rights and what, but not avoid an asset class.

Andrew Stotz 45:58
The question then becomes, it's hard for people to understand the statement that you made, which is that you know that we should have equal risk adjusted return in a, in a in a efficient market, and we have an efficient market. We've talked about that many times. So if let's just take for a moment, that theory was always in practice, and share prices and prices of assets are adjusting constantly, perfectly for their risk level. Does that mean that any asset will do?

Larry Swedroe 46:36
No, we talked about this before, right? That just means, for example, the US expected return. Okay, you could one way to do it is to look at the Cape 10 or the sickly adjusted chiller, and it's close to 40. I'll just round it to 40. And if you invert that to get an earnings yield, you get two and a half percent. If you look at expected inflation, maybe, let's say it's two and a half percent. Look at the Philadelphia Federal Reserve estimate. They publish a quarterly that's like 60 top economists at the leading banks in the country. That gives you a pretty good collective wisdom of the market, so that together is five. Now, does that mean we're going to get five? Of course not. That means there's a 50% chance we think it'll be more than five, and a 50% chance it'll be less than five, and maybe if returns are normally distributed, you might say there's a 40% chance you'll get more than six, and a 40% chance you'll get less than three, and there's a 20% chance you'll get more than eight, and a 20% chance you'll get less than zero, and a 10% chance you'll get more than 10 and a 10% chance, you'll lose 10% a year like, I mean, Japan for 36 years has had a nominal return of less than, I think it's around one and a half percent for the last 36 years. That's nominal. So real returns are probably about zero. Nobody knew that in 1999 right? Well, you have that's why

Andrew Stotz 48:29
hold on for just a second there, because we're, let's say we're in somewhat of a situation now in the US, particularly in a group of stocks, where valuations are very high. And people did know that the Japanese valuations were extremely high. Everybody felt it. Everybody saw it. They enjoyed it for the 10 years prior,

Larry Swedroe 48:46
but they thought the earnings would continue to grow because Japan was dominating the world in electronics and everything else. There was one semiconductor plant left in the US. So high valuations could, in theory, be justified now, I think most economists would have said it was a bubble and it would eventually burst, which it did. But, you know, people were saying the same thing in 85 and they kept, prices kept going up, and they Greenspan said the same thing in the US in 96 and prices went up for three and a half more years almost.

Andrew Stotz 49:22
Well, wouldn't you say that buying something on 40 times PE the risk is extremely high?

Larry Swedroe 49:28
Yeah, yeah. Why is it trading? See, here's the way you have to think about it. Why is it trading at that level? Why, if you assume markets are logical, which are not always perfectly so that means that people expect the earnings growth to be spectacular. So now that can be true of any one company, like Nvidia has been but it cannot be true of every company in the semiconductor space, growing earnings. Is high enough to justify 40 PES because within 10 years, they'd be the whole economy. So we're not saying that the market's rational. We're saying that it's efficiently pricing in what people are expecting. Whether that expectation is right or wrong is another thing, and we have talked about this, that there are what are called limits to arbitrage, which prevents sophisticated investors from correcting over valuation because of the risk of shorting, is unlimited losses. You rarely see markets undervalued, except in panics, maybe for a short term, because that's easily corrected. You could just buy and your losses are limited. So what?

Andrew Stotz 50:44
So, just to wrap up this concept of risk adjusted return, let's go back to theory and imagine that at the moment, let's just say all different alternatives are priced perfectly, and on a risk adjusted return basis. Does that mean that in that case, the only thing that really matters when constructing a portfolio is correlation between these different

Larry Swedroe 51:15
No, I would say this. I would say, you want to find assets with the lowest correlation and good returns are expected, but you have to have confidence in them. So if someone's worried about climate change, and if we have three bad years, they'll fire their advisor and fire the firm, then I would say, don't buy it in the first place. Another example there's a firm called AQR, which runs a style premium fund. So based on the historical evidence, they have some of the best finance people in the world working there, rocket scientists, PhDs, best databases, best trading execution of anybody in the world, probably or at least as good as anybody. And when they do so they go long value, short, growth or short, they go along what's cheap and short what's expensive. They go long things that have high yields. It's called the carry trade. And short things with low carry. Okay, so you might own you Australian dollars assets and short German assets, and earn that carry on average. And they have go long things with positive momentum and go short things with negative momentum. And they go the fourth is they go long quality stocks and short jump. When that fund came out, I think in 2013 or 14, they expected a return of four to 5% above t bills, and that's virtually what it's done, something reasonably close to that. That's amazing, right? That 12 years later, you got pretty much close right to what the returns were. And yet, the first four years or so, it had great returns. Getting very close to that. T bills were about two, so it got seven, totally uncorrelated to anything that's a great asset, right? Volatility, about half of the equity market the next three years have lost about 35% people fled billions, fled the Fund, and the next several years, it earned over 25% a year, and it's up nicely again. Your only way you get the good returns is if you can stay the course and not panic and sell so you have to have a belief and understanding, a willingness to absorb bad periods and what you should think, okay, it's down 35% but I only own five or 10% of it. My portfolio is doing okay, and I hope that there'll be periods like in 2022 that fund was up 25% or something like that, when the S and P was down double digits, and so was US bond funds, right? That's what you want. In fact, someone once said, If there isn't a part of your portfolio that's doing poorly, you're not diversified enough.

Andrew Stotz 54:27
Okay? I think the

Larry Swedroe 54:28
behavior determines outcomes more than assets in some cases. So what I tell people is, there is no one right portfolio. The models in my book are good starting points for you to think about. Maybe, okay, but the right portfolio for you is the one you're most likely to stick with, assuming you didn't take more risk than you had the ability, willingness or need to take.

Andrew Stotz 54:58
Well, um. I think we should probably wrap it up. I mean, we've covered so many things in

Larry Swedroe 55:05
let's cover one more quick thing. Let's do it one you can read about this in my column at sub stack this week, on the virtue of single factor funds, so it invests in value or small cap or quality stocks or integrated funds so dimensional and Avantis, for example, build funds that might be small value, screen out negative momentum and buy high profitability. It. Many people think the best way to do it is just buy the fact that you want. That's the absolutely wrong way to do it. I explained in my paper, why, in my article, why. And a simple explanation might be this, so you have a company that stock is crashing, and now it becomes a value stock, right? The PE is falling. It's gotten cheap, so you're buying it, and over here you own a momentum fund, and it's turned negative momentum, and you're selling it. So you have paid two transactions costs, maybe even realize the gain in a fund, and you end up with exactly the same position because you undid the trade that you did, right? It makes no sense. What the research shows is ensemble funds are much better structures, because what you're doing is avoiding buying something that's cheap but junk, so that's a value fund only, and you didn't screen for value. Or you could own a high quality fund, but it's expensive, too expensive, maybe, so you're better off Owning a fund that screens for both. So it's got maybe second quartile in both, rather than top quartile on one and bottom quartile on the other, and you get better returns, lower draw downs, lower trading costs, more tax efficiency. So you want, instead of owning a small value and a quality fund, own a small value quality fund like Avantis or dimension

Andrew Stotz 57:21
so where the fund manager is bringing together the various factors to then make a final decision on each

Larry Swedroe 57:31
stock. Yeah, of using systematic rules, not their judgment.

Andrew Stotz 57:37
Okay, and okay, so that I, you know, I did, I did read that when you, when you, when you sent it on sub, now that you mentioned it, and I did that, this integrated approach and all that. So, yeah, that's interesting. And that's, it's a good reminder for all of us to keep up on Larry sub stack. But maybe as a, as a wrap up, I'll give the last word to you. You know, what do you want people to take away? We spent a lot of time talking about what you've written about in your book. We've talked about a lot of things outside of that. We've talked about theory, we've talked about practice, we've talked about stories. You know, what would be the last thing you would want people to take away from all of this discussion and what you've written in our talks.

Larry Swedroe 58:21
Yeah, the first thing I would say is, my son in law is really handy. Anything goes wrong in the house, he can somehow fix it. I'm exactly the opposite. I will not try to do anything more than screw in a light bulb or bang a nail to hang a picture, because I will end up creating a problem that will cost twice as much to fix if I hired a Handyman in the first place to fix it. The same thing is true of investors. There are people, maybe, who have all of the skills and all of the behavioral traits needed to do it themselves, I would suggest that that's less than 1% of the population. Based on my 30 years of experience. People are far too over confident of this skills. They don't have the time to do all the research, read the book, all the books that I've written on people like Bill Bernstein and others to get the knowledge, but then to do it right, you have to integrate that into a well thought out estate plan risk management, meaning insurance of all kinds. So I think the vast majority of people are better off finding a an advisor who is truly a fiduciary who fought who makes investment decisions based all only on the empirical evidence, and puts their money where their mouth is and accepts payment only from you, no commissions or anything else, and is willing to show you that their investment. Investing their own money in exactly the same vehicles, although it could be a different asset allocation, because their ability, willingness and need to take risks. Get yourself educated. You don't have to read all, for example, 18 books I've written, but read three or four of them to get that deeper understanding of the basics of finance. You know, education may be expensive, in this case, is pretty cheap. You can go to library, pick up any of my books or buy them on Amazon. But ignorance is much more expensive in investing than education will ever be. Last thing, make sure you build this integrated plan. I'd recommend reading my book, Your complete guide to a successful and secure retirement addressing all kinds of issues, including things like elder abuse, fraud committed against older people, women's issues and stuff, has seven chapters on investing, and the rest upon how to build a life in retirement and make sure you enjoy it. Have that well thought out plan, and make sure one you don't overestimate your ability, willingness or need to take risk, don't own assets that you're not willing to stick with at an absolute minimum of, say, 10 or 15 years and survive and say, Well, I just had bad luck and risk showed up, and I'm going to stick with it, and I'm going to actually have to keep buying more, because my asset allocation is targeted 5% now I'm down to Three. If you aren't willing to do that, then you shouldn't own that asset in the first place. And keep in mind that every single risk asset, including US stocks, goes through very long periods of horrible performance. We've talked about the three periods in the US of at least 13 years where they under perform T bills, and there's no guarantee that the US is in the next Japan, where for 36 years they earned less than a 2% nominal return, which means probably close to zero there. So that's the best advice I could give other than pick up, enrich your future and get a good education on a lot of these issues. Well,

Andrew Stotz 1:02:28
I want to thank you for this discussion, and it's been great to learn from you, but also to get to know you and the way you think about things. It's definitely added a lot of value in my life and in my thinking. So I appreciate that. And in closing out this session, I'm not going to say what I normally say, which is I'm looking forward to the next chapter, but I think we can look forward to some next discussions on interesting topics. And for listeners out there who want to keep up with all that Larry's doing, you can find him on X Twitter at Larry swedrow. Can also find him on LinkedIn, but most importantly, subscribe to his substat, where he is sharing stuff that's fantastic value, as we've just talked about, integrated versus ensemble type of factor investing. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside and.

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy com, continuing my discussion with Larry swedrow, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in Episode 645, now Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically we're going to be talking about chapter 41 A Tale of Two strategies and the final chapter, chapter 42 how to identify an advisor you can trust, Larry. Take it away,

Larry Swedroe 00:37
right? So it was the best of times. It was the worst of times. Probably the most famous words in all of literature. They're the opening lines of Charles Dickens, A Tale of Two Cities, which is all about, of course, the French Revolution. However, these words apply, I thought when I wrote this book just as much to the world of investing. For active investors, it's kind of the worst of times, because 20 years ago or now, it's 27 years ago when I wrote my first book. At the same time, Charles Ellis published his famous book, which is something like in its eighth edition. Now I've only had second editions of books, not eight. But he found in 1998 that about 20% of active managers were generating statistically significant alphas or out performance on a risk adjusted basis, before taxes, some for most people are taxable investors, unless you're endowment or a pension plan. Then, since taxes are the largest expense active investors face, if you're taxable, it's probably with something like 10% and as we discussed here, it certainly meant that you could outperform but Ellis called it the losers game because the odds were greatly against you, in the same way you can win in the casinos in Las Vegas or Macau, but the odds are also greatly against you, so it's okay to have a small entertainment account, take a trip for A weekend, and then maybe for some people, losing 500 or 1000 bucks, that's fine, and they had a good time. For other people, maybe 100 bucks might be the limit. And unfortunately, it wasn't that long, just 13 years later, which is now 14 years ago, faume and French famously wrote a paper showing that only 2% of active managers were now outperforming on a statistically significant basis. You know, that's 49 to one odds against you, and that was before taxes.

Andrew Stotz 02:59
How like were those studies? Were they pretty similar? I noticed that you mentioned before taxes is that they're both basically done on the same four

Larry Swedroe 03:07
taxes. And subsequent studies have pretty much confirmed that there was another study I forgot. Who did it? It's something like 2% also. And as Andrew Birkin and I explained in our book The Incredible Shrinking alpha, we explain why the trend was getting worse for active managers and why it was likely to continue to persist in getting worse, because the people who are quitting active management were the people likely who didn't have the skills or were unlucky. Either way, they leave. And if you have, if you are less skilled, there's less victims for the active investors to exploit. And they need victims because it's a zero sum game, even before expenses. So people are leaving, the competition is much tough. 30 years ago, you got out of school, maybe you had a Literature degree, and you went to work for Goldman Sachs, and they trained you to be a security house. Today, you need a PhD in Nuclear Physics, let alone and finance to go work for some hedge fund that's who's managing money today, so their competition is and the databases are much tougher, and you have artificial intelligence helping everybody, but clearly it's going to get harder and harder for active management to win, the more people leave the game and keep switching. Now we really want to keep this a secret, that it's a loser's game, because we do need some naive investors to continue to be the suckers at the poker table, because that we need active managers their price discovery efforts to keep the markets efficient and pricing. Now what's important to understand is. This in the 1950s the markets were still pretty efficient. The research showed active managers were not outperforming generally, and there wasn't persistence of out performance. And there was only about 100 mutual funds today, there are 10,000 more than twice as many as there are stocks, when you count the all the ETFs. So you know, the industry could shrink 90% and we'd still would find, I think, the markets highly efficient, especially because the remaining people would be the Warren Buffett's, Peter Lynch's citadels, Renaissance technologies. And they would keep markets highly efficient. So these are the worst of times, I think, for active managers. On the other hand, it's the best of time for the passive or systematic investors, is the term I like to use. So using quant strategies that are systematic, replicable and transparent, like those of dimensional fund advisors, Avantis BlackRock, even Vanguard uses systematic strategies, not just pure index funds, which we've pointed out, are perfectly okay vehicles, but they do have some negatives that can be either minimized or eliminated by intelligent design, including patient trading and the cost of literally gone to zero. Who can own an S and p5 100 found or a total for virtually or either zero expense ratio? And you have many vehicles. You know, when I started investing with dimensional, if my memory is right, in 1995 their small value fund, which is a systematic strategy, was like 92 basis points. I think it's in the 20s. Now, caught you've got better vehicles, more sophisticated, updated using new research, better trading strategies, and the costs have come way down. So for active managers, it's the worst of times, and for passive or systematic strategies, it's actually the best of times.

Andrew Stotz 07:17
And I was just looking online, and the ICI data shows that actively managed funds were about 49% of total funds as of April of 2025 versus passive at 51 so I think it was two years ago, or a year and a half or so that active actually exceeded passive for the first time, which is one of The other way around. Passive exceeded, yeah,

Larry Swedroe 07:42
that's roughly 5050, now from studies.

Andrew Stotz 07:45
And you know, I'm reminded of when I was a broker. We that the EU came up with something called method two, and it was a way of trying to deal with the costs of funds and ETFs, and they came up with all these regulations to try and what it ended up happening is that they they pretty much increased the cost through those rules and regulations, and they destroyed the independent research providers that they thought they were propping up. So the unintended consequences were incredibly destructive, in my opinion, for the industry in Europe. But what fascinating is, you just take one crazy man, John Bogle, yeah, with one very counterintuitive against an American idea, yep. Yeah. Very different, you know, I am very different from what was happening. He challenged the convention. He overturned it, and he basically by just that movement of one man in a capitalist society that allows you to bring any product, any service, in any way, into the market, single handedly, that man probably reduced fees that people paid from when he started till today, by at least 50% on average that people pay

Larry Swedroe 09:06
Andrew. You know what's amazing? I mentioned that Ned Johnson, who was the chairman of fidelity, when Bogle introduced Vanguard's first S and p5 100 fund, he called it unAmerican. Why would anyone want to accept average returns? Well, Johnson was the fool because he was confusing market returns with average returns. If you get market returns by definition, you have outperformed the average active investor, because you've got lower costs than they do. And if you own the market, they collectively have so they have the same gross returns, but much lower net return. And today, fidelity is one of the world's biggest provider of low cost index funds.

Andrew Stotz 09:55
Yeah, there's two things I want to mention just before we leave this topic in. The first one is. About tax, and the second one is about the factors. So, you know, a person can own, as you mentioned in this chapter, a fidelity as an example, fund that's zero, you know, and there's others that are, you know, the fees are so close to zero for just a total market fund. But then, as you've mentioned in here, there's also factors within that there's factors like value, size, momentum, profitability, quality, low volatility, these types of factors. So that's, you know, one thing I just wanted to mention. But the other thing I just want to understand is, when we talk about taxes, what do you when you say, not considering the negative impact of taxes, are you talking about the impact of taxes within the fund as they're buying and selling? Are you talking about the tax impact when the person who owns it is selling

Larry Swedroe 10:47
it? You're talking about both, because actively managed funds have much higher turnover, so they realize more short term gains, more long term gains. Now that has been mitigated to a great degree by the introduction of ETFs. So I always tell people, if you're going to invest, at least in the US, in taxable accounts and equities, no question you should own ETFs. Now, ETFs are often, but not always, a bit cheaper than a mutual fund. Avantis, for example, charges the same, but others are a bit cheaper. Vanguard, I think, is the same, but at any rate, you do have a bit more expenses, because when you trade a mutual fund, it's at the nav so there are no trading costs there. You may pay some small commission, but with ETFs, you do have the bid offer spread, but that's, you know, it is an expense that you can avoid by owning a mutual fund. Well, you would

Andrew Stotz 11:56
have had that bid offer spread if you were building a portfolio of 10 or 20 stocks, you would have had that bid offer spreads with those different 10 or 20 stocks. Times,

Larry Swedroe 12:04
10 times, not once, yep, but in an IRA, you should never own an ETF. You should only own a mutual fund because you don't have the trading cost that bid offer spread.

Andrew Stotz 12:16
So let me go back to this for a second, just because many people don't understand how an active Fund Manager works. And let's talk about an active fund for a moment. When they're buying and selling, I'm assuming that they're paying, you know, people would assume, when they look at it like, okay, they bought a stock for 100 they sold it for 20, 120 they made a 20% return. They did that in three months because they're a good trader. Are they paying a tax on that 20 game?

Larry Swedroe 12:45
Yep, absolutely. So that, because they have to pass through the net gains at by the end, you know, during their fiscal year, which typically might run from October to October.

Andrew Stotz 12:58
So let's say for the fiscal year, they've done all of this trading, and they ended up with a 20% average capital gain. And they ended up with, you know, a certain amount of tax of that capital gain. How does the investor does that come in? What part of that comes in the nav versus what's, you know, fed

Larry Swedroe 13:19
through to us? You would get a 1099, it's called, it's a statement from your custodian, and it would show how much of your return was in the form of dividends, some of which can be qualified, and they're treated like, more, like capital gains. Some are non qualified, and that's treated as ordinary income. You have short term capital gains, which are treated as ordinary income. And if you live in California and you're a high bracket investor, you're paying 43% or so federal tax and maybe 13 or more percent California tax. So you're and then there's long over 50% of your return, if, on the short term gains have disappeared, and for the longer term gains, you're paying 23% roughly, plus the state tax. So you're going to give up a large percentage of your returns. Now, as I mentioned, ETFs, through some technical mechanisms, basically avoid most distributions. Most ETFs don't distribute any capital gains or very, very minor here's the thing, Andrew, most people don't know if, let's assume the average fund actively manages expense ratio 1% but because they're active, they have to sit on some cash. Let's for argument's sake, that's 10% of the portfolio as they're waiting looking for good ideas and stuff, right? Half? Have liquidity to meet demands of people redeem, etc. Well, today, cash is yielding. You say 4% and stocks, let's say have an expected return of 10 so you're giving away 6% on over the long term. Now, in a bear market, cash would help you, but on average, markets go up. That's one cost cash. Second costs you have are, of course, any bid offer spreads that are called market impact costs. When you want to move a large amount of stock, that's increased because there's much less liquidity today, as we have discussed. And so you not only have the bid offer spread, say it's 10, bid 10 and a quarter, ask for 1000 shares, but you want to sell 100,000 you may end up with an average price 10 and three quarters, and then the price drops right back to to 10, and you just paid away 7% in market impact costs. You know, market impact costs are significant. And then, of course, you have taxes, and those easily, collectively, could be three, 4%

Andrew Stotz 16:15
and can we go back to the tax for a second? So let's say that you get it. You get your 1099, statement. It shows what's portion is, you know, dividend qualified, unqualified, short term, long term, you have these components now that also means that that fund manager, through their activity has generated that either the dividend income from what they own or the short term and the long term capital gains, when they actually execute those trades throughout the year they're incurring and building that up. Are they paying tax on those trades?

Larry Swedroe 16:49
No, the mutual fund doesn't pay the tax. They allocate out the taxes to the ownership. Pro rata there. I may not remember this exactly, but Russ warmers did a study, pretty famous one in the early 2000s looked at this, and he found, as you would expect, because we, as we discussed, the average retail investor, the stocks they buy go on to underperform, and the stocks they sell go on to outperform? Well, somebody's got to be on the other side of that trade. Turns out it's professional investors, institutions, mutual funds. They are good stock pickers. The problem is they gain, let's say, 60 basis points a year from their active stock selection skills, they charge you 1% your cost of cash, he estimated at about 70, and your transactions costs were another 1% or so. So the average fund underperformed by one and a half percent or something like that, even though that was pre tax, even though the stocks they picked out perform.

Andrew Stotz 18:02
Was this the concept of active share? No,

Larry Swedroe 18:05
not active share. Okay, if you pick up my original book, you'll find rust formers, and you could dig up the stuff.

Andrew Stotz 18:12
Okay, fantastic. Well, let's move on. Let's move on. Before we do that,

Larry Swedroe 18:17
I want to end with the moral of the tail. Okay, do that one thing we haven't really covered. Sorry about that. By tales, not only has an analogy, but has a moral. So this one I write, when Dickens wrote those famous opening words, perhaps he knew that. Would it be applicable to all times. They certainly are applicable to investors today for the majority of those who continue to place their faith in the practice of active management, it has been the age of foolishness, the season of darkness and the winter of despair. However, for those who have adopted a passive investment strategy, that has been the age of wisdom, the season of light and the spring of hope. Wow, that's the moral of that tale.

Andrew Stotz 19:07
So what do you want? We want light and hope, yeah, all right. So chapter 42 how to identify an advisor you can trust,

Larry Swedroe 19:21
yeah? Well, when it comes to like home repairs, there are individuals like my son in law, he can fix anything. I can screw a light bulb in and screw a turn a screw in or bang a nail to hang a picture, anything beyond that, I know I will end up paying twice as much to undo the damage than if I paid a repayment in the first place. Right? So there are people have the skills, and they should try to do it themselves, and it obviously, then is likely true of investing the problem. Is that so many investors are overconfident of their skills and being able to pick stocks time the market, identify the best investment vehicles. And on top of that, you not only have to have all those skills, you have to have the behavioral skills to be able to set up your plan and then stay the course, avoid all of the biases we've discussed, like recency bias, tracking variance, or get regret because your portfolio underperformed the s p5 100, even though you decided you didn't want the s p5 100 because it's all in one risk, and it's had three periods of at least 13 years where it underperformed T bills. So you wanted to diversify, right? But even that's not enough, because a good wealth advisor, not just an investment advisor, not only helps you build a plan and choose the best investment vehicles that'll give you the best chance of achieving your life and financial goals, but you integrate that plan into a well thought out estate tax, insurance of all kinds plan and then helps you adopt over time as life events happen, changing those plans adopts to the latest research. 10 years ago, I wasn't investing in any alternatives. Now half my portfolio is alternatives, and having the knowledge and ability to do the due diligence understand how the world has changed is important. So those are all things investors should know. But I created a list here in the book of 11 commitments that advise investors should demand of an investment advisor. So when you go meet with them here, here we go. So number one, the firm should be able to demonstrate that it's guiding principles is to provide investment advisor services that are in the best interest of the client. In order to do that, principle number two is you should demand in writing that you that the firm is providing you with a fiduciary standard of care which is fitted the highest legal duty. It differentiates itself from the suitability standard which all people generally who work for investment firms like Merrill Lynch and Morgan Stanley their fiduciary responsibilities generally not to you, but to their firm. So let me just give a simple example of the difference. I worked at a registered investment advisor in the US all RIAs are required to be fiduciaries if I want to invest in an S and p5 100 fund, I'm required, say, to offer them Fidelity's fund, or Charles swaps Fund, which costs a few basis points. If I worked in Merrill Lynch, they may have or some insurance company, they can have an S and p5 100 fund that costs 75 basis points, and it's suitable, but clearly not in your best interest. I have talked to hundreds, if not 1000s of investors who work with those kinds of advisers, and none of them know the difference between the suitability of fiduciary sin, they all think they're required to give advice that's in their interest. So that's number two. Number three is the firm should put in writing that they're a fee only advisor, meaning the only one compensating them in monetary ways, is someone meaning their client. So you can't get a commission from anybody else because that commission could bias you. Obviously, I could tell a quick story. I was invited to be a guest speaker on this investment advisor here in towns radio show. I had to be very careful what I said, because he was work for insurance company, and his big thing was selling annuities. So I had to be very careful as a guest, I didn't want to, you know, be too impolite. But after the show, I said to him, said, Look, we're offering our clients the same investment product, without all these bells and whistles, which are just big expenses you're you know, and we charge 1% a year, and we're providing estate planning, insurance, all these other advices, and we act as a fiduciary. It. And the guy said, Well, why should I do that when I get an 8% commission upfront? And I said to him, how do you look yourself in the mirror? And that ended that conversation. I was never invited back as a guest, right? It's required of all registered investment advisors. They're fee only. Can't be anything else. You must disclose. The SEC requires them what's called the ADV, or investment advisory agreement, that all potential conflicts of interest are disclosed the firm, very importantly, should be client centric, okay, meaning they deliver sound advice that's only in the client's interest. It's unique to them. Okay, most importantly, or one of the key things, is their advice. They must be able to demonstrate to you that their advice is based on empirical, academic research, not their opinions, like, I think the market's going up, or this stock is going up. We've gone through the evidence on active management. So why would you choose someone who's doing that, you know, and stuff. Everyone people ask me, What do you base that recommendation on? I can show them. Here are the academic papers in my book with Andy Birkin, your complete guide to factor based investing 110 academic papers decided. As you know, in all my books, I cite the literature. These aren't my opinions. They're based upon what the research says. You want to make sure they deliver a high level of service. So they're working with a small number of clients, not 250 or whatever, that they have a team of experts who no one's an expert in all fields. Some are more knowledgeable about investing, some about taxes, some about insurance, some estate planning. And you want people who are giving you advice to have the professional certifications that say they are an expert in this. You know, in that advice, you want to make sure they develop a plan that's integrated, because investment decisions have tax consequences. They have estate planning tax consequences, things like that. You want to everything should be integrated, and how one investment impacts the rest of the investments and the whole estate plan, their plan should be goal oriented. Every investment should increase the chances of achieving your goal, and they should be required to show you why that's the case. So those are all things. If you can't get all of them, just walk away, because there are 1000s of good advisors who can provide those services. Oh, one other thing demand in writing to see that they are investing their personal money in the very same vehicles they're recommending. Now I wouldn't expect it to be the same asset allocation because they're a different person, different age, different job stability, different ability, willingness, and need to take risk, but I was always happy to pull out my Schwab statement and show them. Here's my investments. Now some people might not want to show them the dollar. Them the dollars. That's fine. Blank out the dollars, but you could see what the vehicles are if they won't show you what they're investing in. Wave goodbye.

Andrew Stotz 28:53
And is this a tough standard, a normal standard? You know what? I think it's

Larry Swedroe 28:59
very simple. If someone's not prepared to do it, why should you trust them? Yep, every one of those things should be there. Now it doesn't mean, for example, you may have an investment advisor who outsources the tax expertise to some attorney they work with. You know, that's fine, but I think it's best if all those resources are in house, because every decision, or many decisions, are integrated, and you have to make sure you're reviewing everything with each decision.

Andrew Stotz 29:32
You know, there was a time where this, all that you've just talked about, was not very commonplace and not regulated in the way that it is in the US and in fact, in markets around the world, particularly in Asia, that's not common. And in fact, you'll see that they really, not only has the regulator not gone where the US has gone on it, but you also have investors who say, I'll never pay for financial advice, you know? And. So it's the same thing, a little bit like trying to get independent research, where you do try to sell independent research to fund managers. Say, why? Why should I pay for that? I get it for free from a broker, right? Yeah, and it's a similar type of thing. It's very interesting. And you know, I'm wondering,

Larry Swedroe 30:15
the broker charges you the 8% commission product that was, you know what I pointed out to a friend of mine? You

Larry Swedroe 30:56
i He loved his broker because and then I looked at his returns and showed him he'd underperform for years. I said to him, those are the most expensive suit. I don't know what happened. Well, I think

Andrew Stotz 31:09
we caught most of that, but just you can wrap up that final point you were saying,

Larry Swedroe 31:13
yeah, let me get I'm trying to shut down some things, so let me see if I can shut this. Okay, alright, oh, wait, I can shut one more thing down because I was working on something else. Okay,

Andrew Stotz 31:35
so maybe go back to that, the that story, yeah,

Larry Swedroe 31:39
okay, oh, here we go. I'm

Larry Swedroe 32:12
all right, just up in the corner here. Now, weird? Yeah, you're not hearing me, huh? I

Andrew Stotz 32:18
hear you, and you're a little bit sketchy on the video side. Here we go. Let's see.

Larry Swedroe 32:40
Okay, we're back on. We are back all right, so you

Larry Swedroe 33:18
so, this is one of my favorite stories. I don't know what the story is, Andrew, let me try one other thing I'm going to sign off you.

Larry Swedroe 34:19
Uh, okay, I think that should do it. All right, yeah, all right, so I'll start, and I'll tell that story. So one last story to round this last chapter out. One of my favorite stories is this one. I had a friend who had a broker, and every year, I mean, he would rave about this guy, because he'd get tickets to the Super Bowl to you. Golf Championships, whatever. And I would ask him to say statements and stuff, because that boy I get to

Larry Swedroe 35:20
the expensive tickets he had ever gotten for free, he could have bought tickets online at StubHub or something for 1000s of dollars less than he actually paid for his free tickets because his performance was so bad and there was so much tax inefficiency,

Andrew Stotz 35:46
right? Yes, well, it's, it's incredible how easily people can be manipulated on that. And I see that. I see that in Asia a lot too, where private bankers and others are losing people a lot of money, and then they take them out for nice dinners, and they take, you know, get them all kinds of perks, and they Love it. And so they

Larry Swedroe 36:08
ask, what kinds of you

Larry Swedroe 36:32
perks, they are in Thailand, right? All right,

Andrew Stotz 36:37
I'm going to wrap this up so Larry, I want to thank you again for this great discussion, not only of this chapter, but of all, all 42 chapters, which has been incredible. I want to do a wrap up later on this, but I look forward to that final wrap up. But for listeners out there who want to keep up with what Larry's doing, you can follow him on x, and you can also follow him on his sub stack and on LinkedIn. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside.

Andrew Stotz 00:01
Fellow risk takers, this is your worst podcast host. In fact, I just saw some person, or a couple of people, published an episode of the show called the worst, and so I had to somewhat one of my friends and former guests, Frank, basically put a note. Wait a minute. You can't be the worst. Andrew is the worst. So the fight didn't last long. I triumphed. I'm still the worst. Andrew Stotz, from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in Episode 645, Larry stands out because he bridges both the academic research world and practical investing. Now today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically we're talking about chapter 40 the big rocks, Larry, take it away.

Larry Swedroe 00:58
Yeah, thank you, Andrew, good to be back. So like all the other chapters in the book, this one begins with a story that we use to as an analogy to help understand a financial issue in this one, it's a story I read about where a professor in time management talked to a bunch of doctoral students, and she brings out a beaker and fills it up with some big rocks. And then when she couldn't get any more big rocks in, she asked the class, is the jar filled? And some couple of people shout out, yes. And she says, Oh, really. She pulls out from under the desk a bunch of smaller rocks, and starts to fill in the spaces between the big rocks until no more small rocks could fit in. And she then asks the class, is the jar now fill? And the class kind of says, not really. And so she says, That's right. She pulls out a box of sand and pours the sand in and sprinkles it until no more sand could fill and then she asked one more time, is the jar now filled? And the class says no, and says, that's good. And she pulls out a glass of water, fills it up until no more water would fill in. She then asked the class, so what's the moral of the story? And one bright, eager student jumps up and says, no matter how busy your calendar is, you can always fit in one more meeting after the laughter dies down. Says, that's not really the message, of course, the message is, if you don't put the big rocks in first, you could never put them in right and so she said, the question then is, what are the big rocks in your life? And is it trying to outperform the market or spending time with your family, et cetera. And we looked at all of the evidence. And if you put in all this time trying to beat the market, trying to outperform, professionals who are spending all of their time have a lot more access to data, as well as all of the training, et cetera, the odds are your app perform them are asymptotically close to zero. They're not zero. But especially after taxes, it's so low that it's not prudent to try. And as my Bucha co published, or co authored with Andrew burkin, The Incredible Shrinking Alpha shows it's getting harder and harder to outperform over time, it was about 20% of professionals. Professionals were outperforming back in 1998 when I wrote my first book about 13 years later, it was down to 2% even before taxes and 1% after, and it's gotten even harder ever since. So that raises the question, you know, what are the big rocks? What's important? And so I told the story in the book, which is a true story happened with me. It happened a bit after my first book was published in 98 I got a call from a doctor who relayed this story to me. It was in the late 90s, of course, and a lot of his friends doctors and doctors, as it turns out, if you ask most investment advisors, they will tell you that doctors are the worst investors because they confuse intelligence with wisdom, and because they're obviously a highly intelligent individuals. You can't get through med school and not be intelligent, then you could apply that intelligence and make you know, outperform the market. Whenever I'm I hear that. From a doctor, I always tell them, Well, I graduated number one from my MBA program. Would you let me operate on your patients? And they laugh, and I said, Well, why do you think you can use your intelligence to outperform when you have no training and investment I bet you haven't even take a single course in capital markets theory, and you get a duh kind of answer, right? So the doctor went on to tell me the story that a bunch of his friends had been making a lot of money, outperforming the market, buying these stocks that related to medicine they were researching. So he decided he ought to do it. So after coming in, after putting in maybe an 80 hour week, he'd come home go to his computer instead of sitting down to a dinner with his wife, read a book to his new baby, you know, it's new child, and spend hours researching, looking at the charts, listen to videos and all this stuff, reading blogs. And very quickly, it turned a small investment, he said, into 100 grand. The problem was he no longer had a wife, no longer was a father to his child. You know, no one got divorced at this point, but he was spending no time with his family, and his family was not happy about it. The good news was he actually, over the next several months, lost the entire 100 grand. And if someone who had read my book recommended he read my first book, the only God you'll ever need to winning investment strategy, he read it and figured out why he was playing the losers game, not the winners game, and he was one of those losers, both in investing and in the game of life, because he was focusing on the little rocks, the sand, the water and the pebbles, not the important things, his wife, his family, etc. So he after reading my book, he gave all that up, and now we had much more time to spend with the family, so now he said he was playing the winners game in life and investing. And of course, that made my day. No authors generally get rich from writing books on investing, unless you're Warren Buffett, he's already rich, or John Bogle or somebody like that. And then there was one other story I added, because it really resonated. I was introduced to a fellow who was the assistant treasurer of Anheuser Busch and in charge of their pension investments, and they were actively picking money managers in each asset class, reviewing performance and shifting every few years based on past performance. And I went and explained to him our strategy and showed him the evidence that that strategy didn't work. Past performance is not a good predictor, and it all resonated with him, and he decided to become a client of my firm. Months later, I met with him, and we're talking about how things are going. His wife was with him. Said, never mind how things are going from the investment side. Rick was his name is now spending. We count. She counted. It was 50 hours a week that, you know, he was spending, you know, sorry, 10 hours a week he was spending, previously on investing. Now, when he came home, couple hours a night during the week and stuff that he no longer was doing, he was now spending with his wife. So you multiply that I was 500 hours a year he had recaptured to spend on big rocks instead of reading barons and watching Wall Street week and reading the journal or whatever, which is really nothing more than the sand the gravel and no small pebble. So that, again, made my day, because helping somebody improve the quality of life is much more important. I think that's really the big rocks in our lives.

Andrew Stotz 09:08
There's that. There's a couple things you mentioned it where you said one line, luckily he lost all his profits within a few months, which, on the face of it, you would say, is not lucky, but it woke him up that he got back his family and his relationships.

Larry Swedroe 09:22
I have another story related to that, which is worth repeating, because this fellow eventually came to work for Buckingham, I'll tell you the story, and then he left and formed his own firm. And now the firm is called Hill investment groups, or anyone wants to go look it up. It's a large RIA on its own. And Rick Hill, someone had given him my book. He was working at some brokerage firm or something like that, and he read my book and said, Hey, this is the right way to invest. He came and applied. For a job we had just started out. We gave him a really low level job. That's all we had open at the time. But he would take anything just to get and to play the right game. And over lunch one day, he told me he had bought some high tech stock. Now this is like 99 All right, maybe it might have been early, 2000 somewhere around there. And I said to him, the worst thing that can happen to you is you'll make money on this, because then you'll confuse luck and skill. The best thing that can happen to you is it'll crash and you'll stop doing that. So I said, at the very least, set a stop loss, so if it does crash, you don't lose all of your money. Sure enough, as it turned out, lucky for him, the stock crashed. That may have been around March 2000 or somewhere around there, stock crashed, and he stopped picking stocks. Never bought another individual one, as far as I know, and then went on to a career as an advisor and formed his own firm, etc. So he found the winners game in both life and investing for his clients.

Andrew Stotz 11:12
There's another quote which is great in this, which is you quote from Paul Samuelson, and he said you shouldn't spend much time on your investments. They will that will just tempt you to pull up your plants and see how the roots are doing, and that's bad for the roots.

11:30
I love that. One

Andrew Stotz 11:32
of my favorite for sure. And then final pieces of advice out of this, I think really, really can help people who really are inclined to trade, and that is, you say, if you find that you need excitement from your investments, you should set up a special entertainment account. The assets inside that account should not exceed more than a few percent of your total portfolio. Invest the rest of your money in what I believe to be the winner's game. And I think that that is actually a very good solution for people who do feel like I got a trade,

Larry Swedroe 12:04
yeah. So you know, there are people who know they shouldn't take their IRA count to the racetrack or the casinos in Las Vegas or Macau, wherever they are, right? So, but they're willing to go and take $100 or 500 or 1000 consider an entertainment. If they blow it, they blow it, and the odds are they'll likely will blow it, because the odds are stacked against them, and they make the mistake when they're ahead, they keep playing, because it's playing with the house's money when it's their money. And you could quit at any time, but the house counts on it, and when they're behind, even though the odds, you know they'll lose more money if they play, they're trying to break even, so they just playing whether they're ahead or behind, and the more you play, the more the odds favor the house, right, right? So, but they go to the racetrack anyway, even though the house takes 17% or so in the US, and they buy lottery tickets where the house, the state and US takes 50% of the money. But that's okay. They understand the entertainment. They go to Casino. Maybe they enjoy watching people. They get the thrill of drawing to an inside street or whatever. But they don't lose their investment retirement money.

Andrew Stotz 13:25
Yeah, as we speak, my best friend Dale, who runs our coffee business, is in Cleveland, Ohio, in the one hotel that is right next to or has a casino in it, and he's there, he took a limited amount of money, and he's having a blast and but he takes a limited amount of money and he he's pretty convinced that he leaves a winner. You know, most of the time I

Larry Swedroe 13:47
should make sure he keeps a diary and actually write it down. I used to go to the casinos in Lake Tahoe. This is now 50 years ago, and when you had $2 tables at blackjack, and I would play. And those days, you were often facing like two or three deck hands so you could count cards, and I would knew which hands to draw on which, and knew when to double down, because the deck was stacked with more high cards, and I could, usually my rule was the 20 bucks or two hours. So if I was up at two hours, I was walking away. And, you know, sometimes I'd lose in 20 minutes, and sometimes I'd last two hours. But I had a little bit of fun testing my skill and stuff. And you could see the dealer laughing and smiling because he knew what, and he would let me do it because, you know, I wasn't betting 1000s that, you know, yeah, in which they would have kicked me off the tables then, or broken my leg.

Andrew Stotz 14:56
And just one last thing is, you mentioned about Doctor you had restored. Worry about Doctor. And for those people who are doctors, go to Episode 746, and you can listen to me talk to James Donnelly, who wrote the book The white coat investor. And that. There it is. And

Larry Swedroe 15:11
you see, this is how I learned how you could beat the deal. So by Ed Thorpe, yeah, he's the guy who broke the bank in Las Vegas, beat

Andrew Stotz 15:21
the dealer, a winning strategy. Man, that's amazing. So

Larry Swedroe 15:26
read his book and learned how to, you know, play blackjack at least put now, of course, you got five deck hands, and they shuffle it halfway through, and, you know, it's much harder to win. And they've got spy glasses, are looking down and all this

Andrew Stotz 15:42
stuff. Um, there's a great interview by Tim Ferriss on the Tim Ferriss show of Ed Thorpe. And I really, really enjoyed that. Just hearing,

Larry Swedroe 15:49
hearing a great movie about that, what was the name of that? I can't remember. I can't remember, but it was a great story.

Andrew Stotz 15:57
Speaking of that, you gave a great recommendation to me, and I'll mention it, which was, what was it? Department? Q, yeah. And as you said, the first few Are you enjoying it? Yeah, the first few episodes, you said, it starts a little slow, and it certainly makes you think that boy, Scottish people are just mad, angry, mean people, but maybe it was just the people who are in the but, yeah. But it did take a while. But

Larry Swedroe 16:22
the story is very clever, and the lead is really good,

Andrew Stotz 16:26
yeah, and you can see that they got a lot of room to bring new episodes of that, you know, a new series like that. So that was a good one, exactly. So anyways, let's now talk about we're going to wrap up. So I appreciate you know this story. I think it was great, and this chapter helps us, and we are now next going to discuss Chapter 41 in our next episode, not right now. And that is a tale of two strategies for listeners out there who want to keep up with all that Larry is doing, follow them on Twitter or x at Larry swedroe. Follow him also on LinkedIn, but most importantly, get his sub stack. In fact, you'll get book recommendations and what was the latest one I just saw and I went, I read. I read through it. I can't remember what it was, but my I'm a senior moment, but I read every one of yours that come in on sub stacks. So I highly recommend that people do that. So this is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from AE Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Bucha and wealth partners. You can learn more about his story at episode 645, now, Larry stands out because he bridges both the academic and research world and as well as practical investing. Today we're diving into a chapter from his recent book, enrich your future the keys to successful investing. Specifically, we're going to be talking about chapter 39 enough. Larry, take it away.

Larry Swedroe 00:31
Yeah. So this story begins like all the chapters in my book, with a story about an incident, and then I relate it to investing. And the story is one that I read about where Kurt Vonnegut is meeting with his friend Joe Heller, who had invited him to some party of some billionaire out on Long Island, Shelter Island, I think it was. And he's they're walking around in this magnificent estate with tennis courts and pools everything and Heller says to Vonnegut. He says, Kurt, Doesn't it bother you that this guy just, you know, trading on Wall Street doesn't contribute anything to society. You Yeah, so much more than you'll ever make from your best selling, award winning books. And Vonnegut says, No, because I have something he doesn't have and will never have. And hella says, What could that be? Says the knowledge that I have enough, that's an issue that I've always talked to investors about about separating desires from needs. And the interesting story is there's a whole body of research several years ago that looked at happiness factors around the globe. And it turns out that no matter where you live, could be on vanitu Island or Fairbanks Alaska or, you know, out of Mongolia, there's a level of income at which above there people are not any happier. Okay, so the utility of wealth curve looks sort of like an elephant from the side. It goes way up quickly, because when you have nothing, a little bit really improves your life. If you're homeless and someone gives you 25 bucks to go take a shower, get a meal and stuff, boy, that really made you much better off. But once you get to some level of net worth, call it 2 million or 3 million, or whatever the number is for you, you're really, you know, the extra wealth is better than less, but what it does to your incremental level of happiness, just like the elephant's back, flattens out, there's really virtually little or no improvement in your state of well being and happiness. And it turns out that, of course, the number or of income level is different. In Hope, Arkansas, it might be 60,000 a year. In Manhattan, it might be 160,000 a year. And in Thailand, might be 30,000 a year. But once you're above that level, and assuming you have your health right and you know and stuff, it doesn't matter how much your income is. And so the problem is people keep trying to get more, and they take on lots of risk when it may not improve their level of happiness. And therefore they don't need to take so much risk. They can dial down the risk in their portfolio and be much happier, sleep better and not worry about markets and enjoy their life.

Andrew Stotz 04:00
You know, I do. First thing I took out of this is something that I always say to people, because a lot of young people say, I want to get rich in the stock market. And I say, look at the richest people in the world. They're business owners. You know, it's not like, you know, the 500 you know, 500 people on the Forbes 500 list are all stock traders. And I say, Well, they say, Well, look at Warren Buffett, or, you know, George Soros. And I say, Well, you know, they definitely there. There's an angle of that. In the case of Warren Buffett, he's, he's really an investor in businesses. So Warren Berkshire Hathaway is a collection of businesses. If you look at some of these other guys, they've started hedge funds, which are some of the most profitable businesses in the world. And that's a big part. Now, sure they had some good trades and that gave them the money to start those businesses, but that's the first thing I was thinking about when I was reading it. What are your thoughts on that, as far as people thinking that they could get rich in the stock

Larry Swedroe 04:50
market? Well, first of all, I would say there are a far bigger list of people who have built businesses, et cetera. The second thing and more important. Certainly, perhaps, is, I would tell them to look in the mirror and see if they see Warren Buffett or George Soros. That'll answer that question pretty quick. But the most important thing, I think, is that you have to understand that the strategy to get rich, which is to take rich, in some cases, whether it's running a business or investing in the market, but once you have enough, whatever that level is, the strategy to stay rich is entirely different. It's to minimize the risks you need to take while still allowing yourself enough risk in the portfolio to maintain a lifestyle that meets your needs, not your desires. And when you turn needs into our desires into needs, like a woman needs 200 pairs of shoes, or the guy needs a Rolex watch, well now you have to take more risk, and now you may end up eating cat food when you were perfectly well off in the first place.

Andrew Stotz 06:01
And another, another sentence that I read that I just, you know, it made me think a lot was a great irony, is that the very people who have the most ability and willingness to take risks have the least need to take it. And so what you see in that is that the reason why they're taking it, you know, is, is a couple of reasons. Obviously, you talk about their confidence, you know. And when you're successful in business, you build up a confidence level that you can sometimes take in, you will take in pretty much every other area. And so that's one thing I see. It's like a confidence spillover, that you think you should be confident in another area just because you've been successful in one. And I've seen many business owners that sold their businesses, had money and then lost a huge proportion of it because they applied their same level of confidence to investing, and they thought that this is that, you know, their time has come. They got the cash now it's time to really beat the markets, and then all of a sudden they destroy themselves. So that's the one thing I wonder, you know, and you mentioned about having a couple that you met or advised that had went down to 3 million. Maybe you could tell that story, and that would be interesting.

Larry Swedroe 07:07
I was just going to tell that story and wrap this up. I thought so. In 2003 I was consultant to a large investment management firm up in Rochester, Minnesota, where the Mayo Clinic is. Of course, lots of doctors and stuff are there. And I was asked to meet with this couple individually the morning before I was going to give my talk, because they were in what they felt was a desperate situation. And I sat down with them, and here was a couple. We started off trying to get to know them. The guy was, my memory serves, 71 years old at the time, and he had bragged to me that he had worked for 50 years running some business, I think it was a dental practice, manufacturing devices or something, or medical devices anyway, and he had never taken more than like one week vacation in a year, which, you know, I thought was not a good way to live a life when you had made all this money and they Were still sitting with $3 million which I asked them, how much they spent a year, if you work 51 weeks a year, probably not spending a lot of money on vacations and stuff. And they said they never spent more than 100 grand a year. I said, Well, you're in perfectly good shape with a well diversified portfolio. You counting your Social Security, you're going to take out less than 3% a year, and that's you know, you could sit in totally safe treasury bonds and meet that requirement. The problem was, I knew that just three years before, they had had 13 million, and I said to them, if you're only spending 100 grand a year, you clearly didn't need to take any risk. You could have put all your money, or most of it, in a safe portfolio. Why did you take all that risk? Because you had to understand that while you had the opportunity, let's say, to double your money to 26 million, there was the risk it could go down. Right? Would your life have changed in any meaningful way if you had doubled your money instead of losing and he said, No. And I said, you know, well, the obvious answer is you shouldn't have taken the risk. And what was really sad. Their broker had had them all in high tech stocks, which is how he could have collapsed 70% the market is 6040, portfolio was probably down like 30 something like that, which would have meant he still would have had maybe nine or 10 million, not just three. You. Uh so. And I said to him, said, if you knew that could happen, why did you take the risk? And the wife turned to him, punched him hard in the arm and said, I told you. So. You know, I felt bad for this couple. But what better lesson than to understand that when you have enough it's time to take the chips off the table, and

Andrew Stotz 10:20
they are so lucky to be at 3 million. You know, I have a friend of mine who is a businessman, and he sold his business. Made good money from the sale of his business, but he started investing through somebody that basically lost almost all of his money. And he's now, you know, 75 and I just talked to him yesterday, and he's basically living off of his girlfriend. At

Larry Swedroe 10:48
least he's got a girlfriend he can live. He's

Andrew Stotz 10:50
lucky, very, very lucky. I mean, he is a good and sincere man, and, you know, he made a huge mistake, and he didn't end up with 3 million and so I think the lesson that I want to, you know, take away from this too, is this idea that it's not easy if you're a businessman or woman who's used to taking risk and and used to seeing it through those risks and building something great in your business and all that, it's not easy to to think, how Do I reduce the risk in my investment portfolio because you want to. You're naturally a risk taker, and that's the hardest part, you know? Yeah,

Larry Swedroe 11:27
well, the real problem is his lack of financial literacy. If he had financial literacy and read, for example, my books, that situation never would have happened. He would not have allowed some stock broker to exploit him and put him in highly risky assets. He would have known better if he'd read my book. You're a complete guide to a successful and secure retirement. Wouldn't be in that that's the sad reality that people spend far more time watching reality TV shows than they do investing in their own financial

Andrew Stotz 12:02
education. I mean, I would just push back on that, because I do agree that you know education and the key is, you know, and you what you've been teaching through your writing is fantastic. But there's I would tell you, my friend probably read all those books, and he still did it.

Larry Swedroe 12:17
I'll take that bet. I bet he hasn't read a single one of those books. Okay, so let's find out on our next call. We'll see who won the

Andrew Stotz 12:26
bet. Let's do that. Fantastic. All right, you can still be

Larry Swedroe 12:30
right. I know people who have read my books who still go on to make dumb mistakes because they think they're smarter. Yeah,

Andrew Stotz 12:39
I got my homework now I'm, I'm after digging. He may not like it if I ask him a lot of that question, because it's so painful. It is very painful, you know. And it's a reason why this episode is so important, you know? I'd say, So, yep. Um, well, that's why

Larry Swedroe 12:53
we're here, is to help other people and prevent them from making those mistakes, yeah. And

Andrew Stotz 12:58
that's what I when. I always say, when I open up my worst investment in ever podcast, I always say, you know that I'm on a mission to help a million people reduce risk in their lives, and this is one of those discussions. So I want to thank you for this great discussion. And also, I'm looking forward to the next chapter, which is chapter 40, the big rocks, not the big rock and roll, the big rocks. And for listeners out there, we want to keep up with all that Larry's doing, first subscribe to his sub stack and otherwise go to Twitter at Larry swedroe, or you can see him on LinkedIn, and this is your worst podcast host, Andrew Stotz saying, I'll see you on the upside you.

Larry Swedroe 00:00
You know what the definition of a broker is, someone whose objective is to transfer money from your account to his account?

Andrew Stotz 00:07
There you go. And fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe who for three decades was the head of Research at Buckingham wealth partners. And you can learn more about his story in Episode 645, now, Larry stands out because he bridges both the academic research world and practical investing. Today, we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And we're going to be talking about chapter 37 Sell in May and go away. And chapter 38 chasing spectacular fun performance, Larry, don't go away in May. Take it away.

Larry Swedroe 00:45
Thank you. Good to be back. Andrew, well, this is one of the things you hear every April, right at the end of the month, that there's this advice that investors should sell in May and go away like many of these axioms, bits of advice, they're legends without actual facts or logic even behind them, but there's usually a hint of truth somewhere in them to cause people to believe it. So let's look at the actual evidence. It is true that stocks have performed much better from November through April than they have from May through September. The stocks in the last roughly 100 years, we have data for the annualized premium from November to April was about 10 and a half percent, and the annualized premium from May to October was about 3.8% okay, so stocks got almost 14% from November to April, when T bills were about three and a quarter, and stocks got about 7.1% from May through October, when T bills were a little bit more than three and a quarter, so there's clearly evidence that stocks do much have done much better for whatever the reason, from November through April and hence, maybe people say you should sell in May and go away. But here's the facts, without even considering the taxes you would have to pay, and in the US, you'd be creating all short term gains, equities returned 7.1% per annum from May through October of 20 for the period through 2024 And outperformed T bills, which returned 3.32% by 3.8% now Gee, that seems like a pretty good equity risk premium to me. And so clearly, there's no logic, no facts. And here's what's really stupid in my mind about it. For you to believe in a strategy, there should be some economically logical reason for it to persist, so you could be confident it isn't just some random outcome. Maybe, for example, it could be a few outliers that causes this, like the crash in September of 29 right? We also had the famous crash in October of 87 when the market dropped 23% and then we had March of 2000 when the internet bubble burst, right, and 911 was September event. But here's the thing, in order for you to believe that stocks are going to underperform totally riskless treasury bills in that period, you must logically believe that stocks are less risky than riskless T bills, because the higher risk asset should, in the long term, provide a higher return. And I think there's nobody who would say stocks are less risky and therefore have lower expected returns in that period. So it's just another one of this bit of nonsense that gets repeated. I heard it again this April, and God help the poor fools who listen to it, at least so far as the month of May, had a huge rally so

Andrew Stotz 04:53
far. Yeah, and why? Why is it that you always talk about the stock? Returns in relation to the risk free rate. You know, other people talk about the absolute stock returns. Why is it you always go back to that?

Larry Swedroe 05:08
Yeah, because you should get a risk premium for taking the risk. And so the benchmark for any asset that has risk should always be the T bill rate. And then you can decide, Is there a large enough risk premium for you to justify taking the risk based upon your own individual situation? I will point out that 2022 was a year that seller may really work well, but it was the last time before that was 2011 went a decade of underperforming every year, and yet still it persists. So you're saying there's a chance, yeah, there's all Yeah, and then people claim at work around anyway. Look what I tell people is the thing you don't know about investing is the investment history you don't know.

Andrew Stotz 06:05
Let me ask you one other thing about this, which is that in your discussions, in your book, and other areas, your discussions about factor investing, you say, one of the things that's important about factor investing is that there should be some logical underlying, you know, relationship you know as to what you're saying. And reason I wanted to ask about that, because some people may say, no, no, but I found that relation between the price of butter in Bangladesh and s, p5 100 and it's, it's, it's a lasting relationship and, and let's say that there's something out there. But why is it so important that it makes sense,

Larry Swedroe 06:43
right? Because you have to be careful to not confuse correlation and causation. If you test, for example, a correlation, and there's a standard test you call the T stat, and the standard had been to test for a T stat of at least two that meant there was a 95% chance. You could be confident it was not a random outcome. Still, it was a 5% chance. But that's reasonable odds. Now, when I was going to college and in order to program a computer, going to date myself here, we had to go in and program punch cards, hand it in overnight and pray you got it back a few days later. Right? So the problem, the benefit, if you will, of that is you really had to have done your work created a good hypothesis for why there was a logical explanation. Say, for example, consumer confidence could predict stock markets. Let's say you believe that that would seem to make sense. If people were confident they put money in the market and put prices up, they became less confident. People would go down. And so you would test that, but you wouldn't test butter production in Bangladesh against the US, because there's no logical reason for doing it today with high speed computers and much broader, better databases and how cheap it is to run data. You can just ask chatgpt to run a correlation, and three seconds later, you might get an answer. The problem is, if you tested 20 and it would take you seconds and cost nothing or virtually nothing, you would get one of them would likely be correct, and it would be purely random. If you just ran 20 samples created 20, you might find one, and that's a problem. So economists, or financial economists, have proposed raising the T stat standard to at least three today, which would mean a 1% chance. But still today, I just read a paper on volatility. Is it a good predictor of downside risk? And there are lots of measures of downside risk, maximum drawdown, semi deviation, which is only the downside, and a whole bunch of other things, Value at Risk, etc, and they tested 1500 now, if you test 1500 almost certainly you're going to find randomly, you know, correlations, but it doesn't mean there's a logical correlation. And today, with the access we have to computers and artificial intelligence, it is very easy to torture the data until it confesses.

Andrew Stotz 09:53
Yeah, and that's interesting, because what you're talking about is, in the old days, you had to structure your hypothesis before you started. Tinkering, whereas now we can tinker and then, and then, you know, create a hypothesis. Yeah. And one of the things that reminds me of my, one of my favorite guys in that influenced me a lot in my life is Dr W Edwards Deming of the quality movement. And what he said was, there is no learning without a hypothesis. Yeah, you know, if you don't set a point right that you're predicting, then any outcome will give you information, but it may not give you knowledge.

Larry Swedroe 10:37
Yeah, that's it. That's you. You always have to confuse information. You have to make sure you don't confuse information with value added information. Oh,

Andrew Stotz 10:50
your bar is always so high. Larry, before we go from selling, may you can go away. I started as a stock broker myself in Bangkok, Thailand in 1993 and I was a research analyst, and I work with a guy from London, and his name is Henry Woodruff, and he said, he he said to me that I love the idea of being a stockbroker in Thailand, because when people ask, what do you do? You say, I'm a stockbroker. They want to hear your views on things. He said, But when I was in London, nobody cares about a stock broker's opinion about anything. And that was, that was pretty funny. But also, you know, we buy from my coffee business. We buy machines, coffee espresso machines, from the largest producer in Italy, chimboli, and we always had to get our orders in early because they shut down in August. So over the whole month of August is shut down. And we know that in Europe, you know, in the UK, to some extent they take long, you know, breaks over the summer. So I always thought that selling May and go away was simply people saying, Please don't bother me, because I want to take the summer off. So,

Larry Swedroe 12:00
speaking of stock brokers, my favorite line is stealing from Woody Allen. The definition of a stock broker is someone who's objective it is to transfer money from your account to their account.

Andrew Stotz 12:13
Yeah, unfortunately, that's that. That can be true. All right, let's move on. So that's a good one. What about, uh, chasing chapter 38 chasing spectacular fun performance. What do you want to tell us

Larry Swedroe 12:24
about that? Yeah, so one of the things we've talked frequently about in our discussions is that investors are prone to all kinds of behavioral errors, and one of them is recency bias, so they project recent events into the future as if it's inevitable, and ignore all the historical evidence. Okay? And that's what actually leads to the phenomenon called momentum, which has no logical risk based explanation. It's that people tend to overweight, in some cases, recent data and project it, and that pushes prices up, and it can also cause prices to go down as well. So there was a we know that when a fund has spectacular performance, what is Morningstar? Do they raise their ratings. And we know the studies have shown that when Morningstar raises its ratings, guess what, funds flow to those funds. So performance itself leads to fund flows, and then ratings follow performance, and that leads to fund flows. And that can actually cause momentum because those funds buy the same stocks, okay, but people forget what often causes spectacular performance is valuations going way up. Okay, so it's interesting. Study was done by Morningstar and Jeffrey patak, he conducted a study that looked at all mutual funds that gained over 100% in the calendar year, which is, yeah, that's spectacular. No one would deny that he found 123 of them between 1990 and 2016 so a 27 year period, just 24% of them, or, you know, just 24 of them, not 24% that's about 20% of them, made money at all in the three years Following the big gain, and much worse than the average fund proceeded to lose 17% a year. That's pretty bad, because if you make 100% and then lose 17% every year, you've given back. Maybe a huge chunk of those gains, maybe even all of them. So the doc also found that funds that had lost money in the years before the big gain were far likely to earn a positive return in the years after the big gain than funds that made money in the run up to the big game, he found 18 funds that earn more than 100% in 2020 and all of them were trading extremely expensive, three times the value of the NASDAQ. And we know the one of the certain things, although it doesn't predict short term returns, is valuations do or are the best predictor we have of longer term return. So you don't want to chase funds that had spectacular returns, because valuations have gone way up.

Andrew Stotz 15:58
And does it mean that you should if you happen to be the lucky one that's owning in a fund that has 100% return, should you exit it?

Larry Swedroe 16:09
Well, I would ask the question why you bought the fund in the first place, and what caused the gains, and how are the valuations? So for example, let's say you are an investor in a distress Value Fund coming out of 2000 and, you know, and the market and the spectacular returns and growth stocks in the 90s valued it poorly, and then you get the recession, you know, now, the PES are six, and the stock double in valuation to 12, leaving you about the historical valuation of value stocks. I don't see any reason to panic and sell there. Your basic reason for owning those that fund is you believe in value investing and prices were about their historical average. So why would you sell? Would you cause you to sell evaluations or stretch so that, let's say, historically, value stocks traded at 12 and growth stocks traded at 20. If value stocks had a run and that led to cash flows and value stocks were now trading at 18, and growth was still trading at 20. Well, now maybe I want to get it. Consider getting out or at least rebalancing, reducing my exposure, because the premium isn't likely. Their premiums are regime dependent, dependent on the spread in valuation.

Andrew Stotz 17:44
So the important part about that is that you state your intention, you write your intention in your investment plan, so that when you go into it, you understand what you're expecting. So in fact, in a turnaround fund, you may expect it's going to do poorly for a bunch of years, and then one or two years, it's going to have a huge return, as opposed to getting to the point where you're sitting on a huge return, and you're rewriting history because you never really wrote it, and then you you end up getting caught in this situation where you're coming up with reasons and excuses as to, you know, why am I owning this? Well, because, you know, I saw that there was a big tech boom, and, you know, therefore such and

Larry Swedroe 18:27
such, or fear of missing out another behavioral mistake, yeah, deadly disease.

Andrew Stotz 18:35
Bomo, well, I think that's a great discussion. And ladies and gentlemen, the sad news is you can't take June, July and August off. You got to stay in the market. So Larry, I want to thank you for another great discussion about creating, growing and protecting our wealth. And I'm looking forward to chapter 39 and has just one word as a title, and it's called enough. There's many ways to interpret that one word. And for listeners out there want to keep up with all that Larry's doing, find him on X Twitter at Larry swedroe, as well as LinkedIn, and follow him on sub stack, and you will get a notification in your email every few days of what he's doing. So keep up that great work. And this is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, and continuing my discussion with Larry swedrow, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in Episode 645, Larry stands out because he bridges both the academic research world and practical investing today we're diving into a chapter from his recent book, enrich your future the keys to successful investing. Specifically, we're going to be talking about chapter 36 fashions and investment folly. Larry. Take it away. Yeah,

Larry Swedroe 00:34
well, psychologists have long known that individuals allow themselves to be influenced by a herd mentality, right? And, you know, this was known back even in 1841 Charles McKay wrote a great book. I'd highly recommend it for those who are interested in history and finance and economics and markets really had a big impact on me to see history repeating itself often and again, right into the 1990s when I read the book and again with AI, all kinds of bubbles happen because of fear of missing out and this herd mentality. He wrote a book called extraordinary Delusions and the Madness of crowds, right? And Isaac Newton said he could predict the movement of stars, but not the madness of crowds, right?

Andrew Stotz 01:33
Crazy quote, you know, it just shows that intellect, you know, it's hard to win with intellect, you know, in a crazy market,

Larry Swedroe 01:42
yeah, exactly. Markets can remain irrational longer than you can remain solvent. It is another famous line, which is a warning not to bet against bubbles, because they can get bigger and bigger, totally irrational eventually, like a rubber band that gets stretched too far, it snaps back, and all those fake gains that weren't fundamentally based get erased and investors get wiped out. That's happened over and over again. South Seas bubble, for example, the Mississippi River bubble, there were railroad bubbles. There were even in the US bowling alley bubbles and.com bubbles, and maybe there's an AI bubble around. And I gave it this title because we know that there's a herd mentality in fashion. You know, you saw in the 60s, Twiggy wear this really short skirt, a mini skirt, and that became the immediate fashion, whether women should have been wearing those appropriately or not, and fat ties or skinny ties, whatever's in, everybody follows that fashion. So there really should be no surprise that we would see, or at least expect to see this madness or crowds, and what I would call recency bias, where people forget all of the economic history that they may have learned if they have knowledge of history, and focus on whatever is the current madness, whether it's Bitcoin or whatever it might be. And one of the to me, one of the great anomalies, if you think about it from a rational perspective, in finance, I don't think we've even talked about this one, Andrew, there are about 10,000 mutual funds and about 10,000 hedge funds and Lots of SMA or separately managed accounts, and there are only about 3600 stocks today. Why do we need so many funds? And what we know Wall Street's marketing machines are great at creating product. So whenever a fad comes about, and there was a.com era, so there were dozens of funds immediately that had the name.com somewhere in the mutual fund. Now there'll be artificial intelligence fund and crypto funds, and whatever it'll be, there'll be hundreds, if not 1000s, of them. What most people don't know is 7% of all mutual funds disappear every single year, and that's mostly because most of these funds shouldn't exist in the first place. It's the advertising machines of Wall Street that create these in the 1960s and 70s and into the early 80s, small cap stocks dominated, you know, far outperformed large and guess what? Mutual funds came out with lots of small cap funds to try to take advantage of it. And then growth stocks outperformed in the 90s, and then you got all that. And so investors really need to be careful and not get caught up in these fashions. And the follies and fear are missing out. Have a well thought out plan that's based on empirical evidence, long term results, and avoid the concern about, hey, my neighbor made all this money. I gotta make sure I don't miss out on what he's doing.

Andrew Stotz 05:20
This chapter was particularly interesting because it kind of shadowed my life in some ways, because in the final second, second to last page of this chapter, you said, A perfect example is the asset class of emerging markets, when the asset class was providing great returns in the period of 1987 through 1993 and then you highlight 35% per year. There was a tremendous proliferation of emerging market funds. Now, before I go on to your main point, the after that, the point, from my perspective, was that I became an analyst in an emerging market in September of 1993 the first four months of my job, the stock market doubled. And by January of 1994 the Thai stock market had hit its peak. And we still haven't reached that peak

Speaker 1 06:15
yet. And 32 years later, now it's

Andrew Stotz 06:19
incredible, yeah. I mean, how, how long? I mean, I'm pretty much convinced that that's just generational. You know, you just got a huge generation. A generation gets wiped out, and then it takes so long they never get back in the market. At least, I think that's happened

Larry Swedroe 06:31
in Japan, of course, right? 35 years now of no real return. Well, it

Andrew Stotz 06:36
happened in the US too, after the Great Depression that it took many decades to get the US market back up. So that was just a little personal. The beginning of my career was right at the end of that bubble. Luckily, I was able to, you know, ride the wave down and survive. But yes, our stock market fell from 1994 it fell 90 90% roughly. And in US dollar terms, it fell about 95% so if you had put $100 in, you would have gotten $5 out if you if you bought at the peak and you sold at the bottom, which was about 2021

Larry Swedroe 07:13
I think it was Wow, and it's Oh. And I'm sure a big part of the crash was 98 when long term capital went under, took the emerging markets with them, yeah.

Andrew Stotz 07:23
So that was just more like that was Russia and other things that were happening at that time, all at the same time, yeah, yeah. But you know, the big question I had in my head when I was reading this chapter is, how do we reconcile the efficient market hypothesis with these kinds of madness. And I thought I wanted to ask you a question, which is, you know, normally, when we talk about the efficient market hypothesis, we talk about what it is, you know, in other words, it's semi strong form, or it's weak form, or it's strong form, or, you know, those technical terms. But I would like to ask you what, what is an efficient market? Not so, for instance, just be is efficient market? We know is assimilating information extremely quickly. But what is it that we should don't ascribe to an efficient market? For instance, if you say, well, there's bubbles, therefore the market can't be efficient. Can you tell us, like, what the efficient market does not mean?

Larry Swedroe 08:27
Yeah, so the first thing is there. It's called, for a very good reason, the efficient market hypothesis. It's a theory or hypothesis. It's not a law like we have in physics, and it's basically a model to help you think about how the world works. That's number one. Number two, what the efficient market hypothesis says. Really, it never says if the current price is the right price. It says the current price is the best estimate of the right price. Okay? And the way you test whether markets are then efficient is whether you have evidence that there are more investors who outperform than would be randomly expected to do so. So a good example, we've used this before. I think a few times. You put 1000 people in a stadium and ask them to flip coins, and they flip ahead, they win. If the tails, they are eliminated. At the end of 10 flips, maybe have 10 people left, Andrew, are you going to bet that they will be successful in the next coin flipping contest? Nope, nope, right? And because, in a world of investing today, 2011 farm and French published the. Paper, and they found that about 2% of active managers were outperforming, on a statistically significant basis, beyond the randomly expected, which was less than what you would have expected randomly Okay, SPIVA S and P publishes what they call the SPIVA, which is active versus passive scorecard. And again, this year in the US, they showed that if you're a quartile one performer in the first year, there's a 25% chance randomly you would expect to repeat that performance, and then there is a, say, a 6% chance you'd repeat that again, okay? And the answer is, then do more than 6% or whatever the right number is, repeat for three years in a row, and in every asset class, they found that less than that did so so you can't tell. It's hard to at least then there's no one has found a way to do it yet. How do you differentiate between skill and luck? And if you can't, then it's hard to say the market's not efficient because people can't exploit persistently mispricing. Now, why do anomalies exist? If the market is efficient, anomalies are for example, I've talked about this before, lottery stocks. So stocks that have a distribution of returns that is far from normal. Most of the time. Like lotteries, the return is zero. The mean return, if the state is taking 50 cents on the dollar, of course, is minus 50 cents. So if you buy $1 ticket a million times, you'd expect to end up with a half a million dollars. But of course, your distribution. If a million people are playing, you know, a few people will hit big home runs, and the most will lose 100% right or close to it. So it looks like a lottery ticket. Stocks that have that kind of distribution, which means they have God, awful returns. They actually this group, which I'll mention in a moment, have returns that underperform treasury bills which are totally riskless, right, at least for US investors. So they are stocks in bankruptcy, penny stocks, large cap growth stocks with high investment and low profitability. Well, a lot of.com stocks, for example, you know, fit that definition, but people get enamored by the fashion of the day, or some, you know, Reddit post that tells them you should buy GameStop or whatever. And so these prices get overvalued. But the problem is the risk and the cost of shorting are so great that it's the sophisticated investors can't risk betting against it to drive the price down, to drive the price down, you have to go short. So Melvin capital, a highly successful hedge fund for decades, noticed that Gamestop had been rising, rising, and this company had horrible financials, and it shorted it. And the way you short it, you borrow the stock, sell it. Say the stock was 35 and they thought it was worth 10, okay? And now you hope to buy it back at 10, and then there's your profit. The problem was people on Reddit ganged up on them and able to do it, and drove the price up, I think, to like 400 and Melvin capital lost four or 5 billion, and basically lost all of its assets and returned the capital shut down after decades of strong performance and and ever since that incident where the markets learned that these retail investors had figured out how to game the system, and I'll touch on that for A moment, very few people are willing to go short stocks, which means I think you'll have more in, you know, inefficient pricing on these smaller stocks. It's hard to do that on Microsoft, because you can't squeeze an investor in those stocks. The market cap is too large. But in these small companies, these people in gang up. And the way they did it is they figured out you didn't have to buy the stock itself. What you did was to buy an option, probably even an out of the money option. So if Gamestop is trading at 35 you could buy a call, say. 40 or even 45 and the more out of the money, the less you have to pay. So you don't have to put up a lot of money. The people who write there and sell you that option have to hedge that risk. So will they go in and let's say they sold the option on 1000 shares, they may go out and buy 50 shares, and if the stock starts to rise towards the exercise price, they are doing what's called delta hedging, increasing their exposure so or at their holdings, so they can't get killed. And so these people come in and start buying calls, and they tell everybody else to buy calls, and then the hedgers have to go in and buy the stock, and it's dropped, and there's little liquidity. And that's how Melvin capital got squeezed. And they figured out they can gang up. They look for low capitalization stocks with large short positions by some institutional investor, and they can gang up. Institutions can't do that. It's illegal. Individuals can and you know, so that game, sadly, has been played, and they're all cheering, but it's made the markets more inefficient, and it will lead to people losing fortunes, likely because they'll engage in this stuff. And eventually, Melvin capital went from 400 think last time I looked, it was trading at 35 again. So how

Andrew Stotz 16:31
would you describe let's say, take the.com bubble, where we were at the peak of the bubble, and market optimism was super high. Number one, we could easily say that, you know, information was getting into the market very, very quickly. That's, you know, part of the efficiency. You could also say it was the best estimate, you know, of the price based upon the feeling of the time or the expectations of the time. Could you say that? And then I wouldn't say that and say that, in the end, was the price wrong?

Larry Swedroe 17:04
Yeah, I think Gene farmer has argued you can't tell a bubble till after the fact. And in general, I would agree with that. However, to me, there that particular bubble, which burst in March of 2000 was easy to tell and known before. The only problem is you can't bet against it, because bubbles could get bigger and bigger, and you don't have enough capital to last until it burst. And the reason I can say it was irrational Was this the best predictor we have of long term stock returns is valuations, and a good one is the cape 10, or the sickly adjusted price earner. And almost as good ratio as the current P E ratio, okay, not quite as good the P E ratio of the Q, Q, which was the high flying tech stocks, the NASDAQ, you know, 100 was over 100 that meant the expected real return was 1% when tips were yielding 4% no credit risk, no inflation risk, to me, that could be resolved one of two ways. Tip yields, how to collapse, or P E ratios, how to collapse, because there is no way that these 100 companies could ever justify their earnings and get them to grow so fast to justify 100 P E, they would have been more than 100% of the whole economy. It was someone did some math and showed you can't make the earnings. Maybe one company could, and Google, maybe, you know, became that one company and the other 99 you know, like Intel and Cisco, you know, they still, in some cases, haven't passed their high price of that period and have been horrible investments. So I think again, it comes back to you can have bubbles because of what is called these limits to arbitrage. And the key to investors is don't get caught up with these fashions and folly and just have a broadly diversified portfolio that you can stick with, you know, and ignore the noise of the market, and don't care what your friends are doing. So

Andrew Stotz 19:31
I want to go back to my question about, you know, what efficient market isn't? Let's say someone doesn't know anything about the market, and they hear people saying, Oh, the market's efficient. Blah, blah, and then they look at that, and they see it go up to this huge bubble, and then they see it collapse. And they say, I don't understand how that's efficient, but I want you to answer what is. What is not? What are we not saying efficiency is?

Larry Swedroe 19:52
Yeah, one was saying it's not impossible to outperform by spotting bubbles or finding. Individual stocks and trying to time the market. However the overwhelming body of evidence is that playing that game, we can call it, active management, is gives you about the same odds of winning as playing at the casinos in Las Vegas. You can win, but the odds of doing so are so low. And if the vast majority of institutional investors, who are run by people with PhDs in physics and you know, mathematics and finance and their rocket science, the best databases, and you know, they are spending 100% of their time on this stuff. What odds if you look yourself in the mirror and say that I can outsmart these guys when they fail most of the time to outperform? And Warren Buffett, the greatest investor maybe of all time, hasn't outperformed for the last almost 20 years. The market efficiency caught up with you know, with Buffett, he was able to exploit inefficiencies over time, and as my book The Incredible Shrinking Alpha showed, Buffett was able to exploit things that people didn't know, and once those papers get published, those anomalies disappear, and Buffett couldn't outperform anymore.

Andrew Stotz 21:28
Yeah, it doesn't mean he didn't end up with a huge amount of money, but Right? And in fact, you know, out performance in your early years is extremely valuable, because generating the capital that's compounding at, let's say, a market rate for the past 20 years, exactly. So, okay, well, interesting discussion. And I know I for a lot of people out there, you know, we think about the efficient market hypothesis, and we think about what it means, what it is, and what it isn't. I think what we can clearly say is that when there is a narrow, real focus of the efficient market hypothesis, and that is the dissemination of information into the market, and also the efficiency of the market is proven by the fact that very tiny number of people, even less than would be predicted through simple statistics, managed to outperform.

Larry Swedroe 22:26
Well, let's add to this one other thing. If you doubt the markets are efficient, all you have to do is look what happens when a company announces an earnings surprise just the other day, maybe it was today, even aber Combi and Fitch announced better than expected earnings. Now the price didn't go up, like, from, say, 30 to 30 and an eighth to 30 and a quarter. It went from 30 to 40 like instantly on like the first two trade in one of my books, I cited a study that the vast majority of the performance after news is on the first trade that tells you how quickly the market incorporates new information.

Andrew Stotz 23:14
Yeah. And the funny thing is, that may not be a very profitable trade. Their next quarter could be terrible.

Larry Swedroe 23:20
Well, in the long term, that's so the market incorporates this new information. It moves when you get surprises, which by definition, is what unpredictable? Yep. Well, Larry,

Andrew Stotz 23:34
I want to thank you again for this great discussion, and I'm looking forward to the next chapter, which is chapter 37 Sell in May. Wait a minute, it's May, and go away a great old saying in the market. And for listeners out there who want to keep up with all that Larry's doing, find him on X or Twitter at Larry swedroe, you can find him on LinkedIn and also follow him on sub stack. He's relentless. They just keep coming into my email box. It's hard to keep up with all that you're writing. You got two of them today. Incredible. You know that's, that's, this is wonderful. I've enjoyed it. So this is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in Episode 645, Larry stands out because he bridges both the academic research world and practical investing. And today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically we're talking about chapter 35 man money Larry, take it

Larry Swedroe 00:32
away. Yeah, you gotta ring the bell there for this one. I wish I used to have a bell. I don't

Andrew Stotz 00:40
know if there used to be a bell on my little thing here, but I'm ringing stuff right now, but I don't think it's coming up. We'll

Larry Swedroe 00:46
see anyway. So Jim Cramer, for those who don't know him, he was an ex hedge fund manager. He worked at Goldman Sachs, and clearly he's become one of the most recognizable faces in the world of, you know, finance, he actually rang the bell, I think it was today, on the 20th anniversary. So good timing of his show on CNBC. So he's clearly been a success in terms of entertaining. That's

Andrew Stotz 01:19
20 years would be, I would say that's pretty, you know, amazing to be that. Yeah, march

Larry Swedroe 01:23
2025, march 25 205, was the introduction of his show, and the audience numbers went up 140% in the next quarter. So clearly, has been a success as as an entertainer, the question that we really want to know the answer to is, is advice have any value, or is it just entertainment, and you're best off ignoring it, unless you like people banging bells and blowing whistles and, you know, and clowns And you know, it's my opinion, it's sad, a very smart guy has turned himself into a caricature in order to get good ratings. And I backing that statement up with the academic research that actually looked into what happens if people followed his advice. So the first study that I cite in the book is a 2018 study on the performance of his charitable trust and what those recommendations did and he had established that trust. So from its inception, the portfolio through the period they looked at, which was through December 31 2017 the fund returned a total of 97% during that same period, an investment in the s and p would have returned 204% and that, of course, doesn't even take into account Any trading costs or taxes from all of the the trading. There was another study that was done that was published in the journal investing in 2012 it looked at his buy and sell recommendations over the period July 28 oh five through December 31 2008 now, of course, this was a period of not very good returns, right? But what the researchers found was three key conclusions, one, investors were clearly paying attentions as the stocks that he recommended had abnormal returns of almost 2% on the day, uh, following his recommendations. So his show appears at night. People come in in the morning, and the stock jumps. Now, of course, that doesn't mean you made any money. Let's say the stock was at 10, and the first price, because you get all these people trying to buy is 11. Well, the stock went up 10% but you didn't make anything right? Nobody got that. That's called market impact cost, right? The returns for the recommended stocks were both positive and significant for the day of the show and the 30 days actually prior to the show. So it seems he was actually recommending stocks with short term momentum, which there is evidence of, right? However, the returns were negative and significant in the two to three days through day 30, following his recommendations. So now you have to ask who actually made money. Well, the naive retail money comes in, pushes the price up and pays their market impact cost. The sophisticated, high frequency hedge funds know the Kramer knows nothing really. The investors are naive. They drive the stock up. They come. In and go short it, and the price goes right back down. And there's a third study that basically done in 2005 is the market mad evidence for Mad Money. And it found exactly the same thing, that the prices rise overnight and very quickly they get corrected, meaning that Kramer added actually negative value for the people who try, you know, to implement, because they drove the price up when they're in their, you know, when they're buying frenzy. And then the smart money comes in. Knowing Kramer knows nothing of any real value, price reverts back to basically where it was before he made the recommendation. So that's showing really two things, investors are naive. Kramer is an entertainer, not a financial advisor who adds value. And the third thing, and maybe the most important lesson for investors, is the market is really highly efficient, and that it's very hard to beat it, because clearly, Kramer is a very smart guy. I just think his talents are wasted. Except I'm sure he's making a lot of money being paid for an entertainer, but not really for his stock skills. The last thing I'll mention in the chapter is there's a major study on this whole issue of gurus. It was done by the CXO advisory group. They covered 68 gurus, including Kramer. They looked at forecasts over the seven year period from oh five through 1260, 584 forecasts. Basically they found there are no real experts. The distribution of their accuracy looks virtually identical to a bell curve, but slightly to the left, meaning, on average, they do worse. The average accuracy was 47% which happened to be the same score as Kramer's. So of all the experts who are non expert, Kramer was average at being a non expert.

Andrew Stotz 07:15
You know, there's so much to unpack in that one too. Like, you know, one of the things that's really important about, you know, how to construct these types of studies. Because, as you said, if you don't take into consideration, for instance, the fact that, okay, let's just say that Kramer is a great entertainer. He gets people really excited at night. And all the buy orders compiling up before market open. And now you've got, you know, a huge amount of buy orders for this thing, instantly the stock is going to gap up. And when it gaps up, the gain is gone, yep. Now

Larry Swedroe 07:51
and then it reverts back, yeah,

Andrew Stotz 07:54
and then it comes right back to where it was. Or worse, there's

Larry Swedroe 07:59
another study, a famous one. You know, Value Line used to boast that they had these great returns, and then a group of academics took a look at it, and here's what they found. Value Line published their results Friday night, the letters went out. The investors got the information over the weekend, and the prices jump Monday morning. And guess what happens?

Andrew Stotz 08:26
You can't buy that. So the way that we can't buy it,

Larry Swedroe 08:29
if the stock closed at 10, and they're recommending at 10, you can't buy it there, but they calculated their gain from the closing price of 10. But it doesn't work that way, and maybe it persists for a few days, maybe even a bit longer, but eventually it mean reverse. So what

Andrew Stotz 08:47
we've I've done this type of testing in my own company, and the way we've solved that is a couple of ways. One way is to take five day average price after the recommendation, another way is to just take the second day or the third day and say it's going to take now, it's going to take some time for people to get into this stock. But when you look at institutional investors, there's very rarely are they going to be able to move a sizable amount of money into an idea in, you know, two or three days. So they may need two weeks or a month to go through their investment committee, if it's, if it's an active fund, and they are looking for ideas and it's a new idea for them, you know, it isn't going to happen like that. And so that's the reason why, you know, it's important to understand, you know, how people are actually measuring these types of returns? Well,

Larry Swedroe 09:43
I would add this. I don't think you even have to do any work on this, because no institutional investor is going to make investment decisions based on Cramer's recommendations, because they're aware of the literature almost. Certainly as a professional investor, and they know it has no value, right? Here's the thing, especially, and we're living through that kind of period now, while it's markets are always uncertain, nobody knows what the future is going to be and but there are times when things become or feel more uncertain, and this is certainly one of them, self imposed uncertainty because of President Trump's policies on tariffs and the tax bills and other things. So when times become more uncertain, people look to somebody. You can tell them what's going to happen. Some expert, sadly, there's only one person who knows where the market's going, and neither you or I nor anyone else on this planet will get to speak to him or her, at least while we're on this planet. So you're best off just ignoring these forecasts, because the research shows there aren't such, you know, super human beings who are great forecasters, right? Yeah,

Andrew Stotz 11:11
yeah. And, and also, the guru statistics are interesting, as you say. It's a normal distribution, but, but shifted to the left, meaning that's before trading costs. Remember, and but what I would add besides trading costs, not all of them have a promotion machine like Kramer does. So Kramer has the advantage in these numbers, if you look at it, you know in this way is that he can at least get enough people behind it to pump it up on day one, many of these gurus can't even get that kick. You know that would, you know, in theory, show that makes it look good, but isn't real. Yeah. So that's the guru statistics fascinating. And, yeah, I found this really interesting. And the question is, has any I wonder if anybody's ever measured the performance of his compensation, because I suspect the performance of his compensation has been incredible. Ryan, well, yeah,

Larry Swedroe 12:11
it's one of the most popular shows. People seem to love the entertainment. I just hope they're not listening to the advice they definitely are when he's ringing bells and slamming hammers and, you know, I just find it sad that he's turned himself, a very bright man, obviously, into a caricature. Yeah,

Andrew Stotz 12:31
There's two other things I would say before we wrap up in. The first one is that his show is showing 250 times a year, I guess, or Daily Show. So, you know, you got to think, Okay, wait, so he's going to come up with 250 outperforming idea. You know, that's impossible. So already, just logically thinking about it doesn't make sense. But the other one I was going to share is that in Thailand, as well as most of these emerging markets, brokers and the analysts and the gurus at the brokers are, all they're doing is pumping and pushing, you know, let's say one stock a day, and getting all the power of their broker behind that and pushing that stock and then saying, you know, I move the market, and that's why you need to follow me. And people see that, and they feel as though that person really moves the market. But they really unless they take an honest look at what's happening, they people gather around that type of stuff.

Larry Swedroe 13:31
Yeah, what you might suggest to them is going to chat GBT and look up the terms pump and dump.

Andrew Stotz 13:41
That's a good one. All right, so Well, Larry, that was a great discussion, and it helps us to stay away from the TV. I shut the TV off many years ago. I sold my TV when I was young, and I never

Larry Swedroe 13:53
that's got to improve your investment outcome, because you can't make mistakes listening to basically, what's investment pornography? It's meant to titillate and excite you, but, you know, it doesn't have any real value. You know,

Andrew Stotz 14:09
I started as an analyst in 93 and in that time, really, market was very immature. In Thailand, it was extremely volatile, you know, and the way that we got news was the newspaper which arrived on our, you know, on our doorstep at five in the morning. So each morning I had, like an architect drawing table at my house at 5am I'd wait for that newspaper to come, make a cup of coffee, sit down, and what I would do in those days is I would cut out stories and I'd paste them into my little book, and then I'd take notes, because also I was learning at that time, it was 93 I was 28 years old, or whatever, and I was learning about the market. So I was learning about the ticker codes and the companies and what they were saying. And then I would go in, and then we would write up, you know, here's the news of the day. We weren't necessarily saying that certain stocks were going to, you know, fly that day as much as. Kramer is, but we would, you know, put together, this is what we think is interesting. Now 10 years later, let's say in 19, in 2003 I was head of Research at Citibank at the time, and I remember walking in my office at about 630 I had already been through all the papers, and as I walked in, I saw my analysts with their feet up on the desk reading the paper. I went to the sales room, and I saw the sales people all reading the paper, and then I saw the sales traders reading the paper, and I thought to myself, How the hell am I ever going to get a competitive advantage in reading the paper? And I immediately, on that day, called the Bangkok Post, and said, cancel my subscription. And I never received papers ever again after that, because I thought I got to think different. You know, I got to think, you know, I got to get away, and it's not so much. And I always tell people that don't worry too much about where you're going to go, what you're going to think, worry about getting detached from what everybody's digesting first.

Larry Swedroe 15:59
Here's the big lesson I've written about this and my books, including my investment mistake book, what you learned is to not confuse information with value added information. In other words, if you know something because it was in the newspaper, right, everyone else knows it as well. So it has no value. It's in the price, which is why, to me, one of the most ridiculous ads of all is by Barron's, which popular publication, and their ad is Barron's before the market knows you're reading a newspaper, but get the news before everyone else knows. I mean, I mean, how ridiculous is on the face of it, it's absurd. Yeah,

Andrew Stotz 16:49
I think that was an interesting thing. And then, you know, I'm sure at times you've heard podcasts, or you listen to something, and you've listened to a guy, and you try to follow what the guy's saying, and really, he's not saying he's he's presenting a lot of news, a lot of history. He definitely has a depth of knowledge of this, but he's not actually bringing any value in the conversation. Value about the judgment of, let's say, what could happen to margins going forward, what could happen in this and that, you know. And so I listened to one of these guys one morning on podcasts, and it was so clear, it was so good in the sense, that he was such a master bullshitter that made him sound so smart about the topic. But it was all about the past and this and that. And then I stopped it. And I got out of the shower. I stopped it. I sent it to my team. I said, Cut these three minutes out as an audio file, a video file, put it in my valuation master class boot camp. And then the next night, I had my students listen to and I told them, write down your notes of what you learned from this. And so I do this every single time with the students, where I asked them to write down and by the end of three minutes, they're totally confused, but they're trying to extract value. Because I'm telling them, as a teacher, listen to this because this is valuable. I don't tell them it's valuable. I just listen and get your takeaways. But in the end, I go, the whole reason why I'm showing that is that this is an example of talking aloud but not saying anything. You know well,

Larry Swedroe 18:17
what I try to do when I try and write, when I write my columns on sub stack and other places, and people want to I get asked, what's going on? I got asked the question often in the last several months now, is this the end of us exceptionalism, right with the change in policies and de globalization and tariff wars and all this other stuff. But so instead of making forecasts, because I learned long ago, you have to be very humble about making a forecast, right, all I tried to do was point out, here are the facts, here are the risks. Here's what could happen, here's the impact on your portfolio, and what are the things you might want to think about, right? So in my article is this, you know, a new era is the great rotation begun. I pointed out that here are, these are the facts, it's possible, you know, the US could end up causing recessions, right? We could see all kinds of issues. I list them, and then I said, and by the way, US stocks, which have outperformed for the last 17 years, which is why we have this issue of us exceptionalism, and I pointed out the reasons why people believe US stocks have outperformed, including better labor laws for businesses, easy to hire and fire people as one simple example, more freedom of capital. It's easier. You know? To get businesses started much the world's deepest capital markets. Entrepreneurs find it much easier to raise capital than, say, in Thailand, right? But I also pointed out that in that 17 year period, the vast majority of us outperformance came not from earnings growing faster they did, but not that much faster. It was mostly because PES of US stocks went way up, and which means future expected returns are now lower, and PES of foreign stocks actually went down. And if that just ended, foreign stocks should outperform. But what if? Now people believe the US was no longer this exceptional place and capital started to flow out. People were worried about, you know, trade restrictions and capital, you know, being confiscated even right? So it could reverse. So you want to think about, are you willing to live with those risks, or should you build a more diversified portfolio? So I'm not making any forecast, because I know I write this off, and my crystal ball is always cloudy. So want to just think about the risk and what risks you're willing to bear,

Andrew Stotz 21:21
yeah, and, you know, 17 years ago, emerging markets were like a little baby coming out of the crib, and now they have, you know, consumer, you know, consumption is is much higher, and wealth levels are higher in the middle class and, you know, and there's a lot of intra Asian trade, you know, that's significant, you know, so it's, it's a different world. It's going to be interesting to see on the next, you know, five or 10 years ago in that,

Larry Swedroe 21:48
yeah, we're looking at emerging markets and international developed markets trading, you know, like at 30, 40% discounts. In fact, two recent studies have found if you take, I'll just make this example pop so it'll be directionally correct. You take, say, General Motors. Let's take a different one. Let's take a Pfizer, a US multinational, global pharmaceutical company, and Hoffman La Roche, a global, international pharmaceutical company, but one is listed on the New York Stock Exchange, and the other is listed on some international stock exchange. If you did studies and found hundreds of companies that look the same, except for their listing. So they're both global, so they might have both say 40% of their sales internationally, right? The US stocks traded something like a 40% or more premium, even though their sales around the globe are the same. It doesn't make sense, really. So that's why, in particular, I think you're likely to see us companies. I just wrote this up the other day, buying up international stocks because you're taking your stock with trading at 25 PE and you're buying the same company basically at a 15 PE. So you're using your cheap capital to buy an expensive company that's got much higher cost of capital. So there are, your returns are going to be higher when you buy it, you immediately convert their earnings from a 15 PE to yours at 25 simply because of the listing.

Andrew Stotz 23:45
Yeah. And one of the reasons why Asia and particularly emerging markets, are trading at a discount is their profitability is at a discount. But one of the things that's interesting about Asia is that, like America, the markets are dominated by large companies, yeah. But unlike America, those large companies are not trading at massive multiples. No, they're not. So what that means is that the whole the mid cap space in Asia is exposed. It shows, you know, that they're not hidden, they're low PES and stuff like that. But if you look at America, I think the last statistic I saw, I don't know if you've seen this, but it's like 30% of mid size or small size listed companies in America were losing money.

Larry Swedroe 24:34
It's certainly I don't think that's true of mid size, but it is certainly true of the stocks in the Russell 2000 which is the smaller part

Andrew Stotz 24:43
of so it's something like, is that? Is it 30% what was it like? It may be higher. It may even be 40, yeah. And so the result is that actually a huge part of the US market is in very serious trouble, not doing that well. But when you look at the overall profitable. The

Larry Swedroe 25:00
companies are staying private, or were taken private,

Andrew Stotz 25:03
yeah. And so my point is that, though the US market looks like really, you know, high PE and in earnings have risen quite a bit at these large companies, there is a nasty underbelly that if those seven, you know, 10 largest companies, pe started to come down and became less sensational all of a sudden. What would be exposed is, Whoa, there is a lot of companies in the mid and particularly small case, small cap space, that are struggling,

Larry Swedroe 25:33
and I'll point out that they are trading at lower valuations. But let's we could dig a little bit deeper, having a little fun here on this so US stocks have performed well, but a big chunk of their earnings increase was that they were able to extend the duration of their debt at much lower interest rates Up until 2022 and which they did, unlike our US government, which foolishly kept funding short, unlike Austria, for example, who issued 100 year debt at under 1% Janet Yellen has to go down as the dumbest Secretary of State in history,

Andrew Stotz 26:16
in my opinion. Yeah, she missed a huge opportunity on that one? Yes,

Larry Swedroe 26:21
a huge opportunity was missed there for political reasons. So shame on her. That's not her job, right? Is to get someone elected or whatever, at any rate. So a lot of the margin increase was because interest expenses came down. Now you've got tariffs. Someone's going to eat that tax. Could be foreign companies, but there's only a limit to that, depending on competition, right? It could be consumers having to eat it, or it could be companies having to eat well, the odds are it's probably going to be spread among them. No one knows exactly where, so there is at least a reasonable chance that corporate margins will come down in the US, if we're at an all time high in margins, which historically run between about six and 10% of GDP corporate profits. And so when we're in a boom time and corporations profits tend to grow, we're in recessions, they come down, and then things reverse, right? We get this reversion. We are way above the historical average, and now those margins come down. Interest costs are going to go up because the interest rates are now higher when loans roll over. You know, it seems likely to me, at least there's the risk that US profit margins could come under pressure, and when you're trading at such high multiples, you're trading almost as if you will, that the news is price for perfection is, I point out there is that risk. You don't have as much risk in the international stocks because they're trading at about their historical averages, right? These in the roughly 15 for developed and emerging markets may be a bit lower, and value stocks internationally are trading much lower, more like 10. So maybe we'll get a rotation to value, or maybe we get a continuation the last 17, where growth continues to outperform. So

Andrew Stotz 28:40
and that's interesting, because if you get a falling margin and a D rating in multiples, that's the double whammy that causes, you know, a fast crash, yeah,

Larry Swedroe 28:57
you know, just think, I think most people think there's at least a reasonable chance of a US recession, especially if they don't solve this tariff war situation fairly quickly. US corporate earnings on average, in the average recession, which is a GDP, fall of about 2% drop about 11% Yeah, well, if your profits drop 11% just from the recession, and then margins, I mean you, but profits drop 11% PES come down from, say, 20 to 15, which would still Be just average. PE, not like low like in 2008 we went into single digits. Well, you get a 25% drop from the PE multiple falling. You get another 10% or so drop from profits and margins falling. And you could see the market wouldn't shock me if you know. Well, we saw the market drop 30% or something, down to 4000 or some number like that. I'm not in any way predicting that, but if you get the trade situation continuing, or worse, we get problems with Russia or China decides to take advantage and invade or blockade Taiwan or who knows what, right? I mean, you know, 4000 wouldn't shock me at all. Yeah, and just

Andrew Stotz 30:27
to get that, to make that clear, let's say a company's profits start falling. What's going to happen is that, if nothing happens to their share price, then their PE is going to rise as the earnings fall. So when we talk about the actual fall in PE down, you know, to a more normal level, you're talking about a real serious fall in price.

Larry Swedroe 30:53
So that's what happens, because the PE, the higher PES, are built on the expectation of fairly rapid growth in earnings. The market was expecting going into this year, a 13% increase in earnings. Well, if you get it instead a 10% drop, well, that's a 24% difference, roughly, and that's just the earnings going down. And then you have to say people are certainly going to demand a bigger risk premium because things are more uncertain, and that's how you get big bear markets. Again. I really want to emphasize I am not predicting anything here. I'm just pointing out that your financial plan should include the possibility that that should happen, could happen, and if, if if you couldn't take that loss, or you panic and sell and you wouldn't sleep well at night, then you're taking too much equity risk in the first

Andrew Stotz 31:48
place. So to follow up and wrap up on the the data that we talked about, about the number of companies that had negative earnings according to data that I'm finding as of 2024 within the s and p5 106% of companies are have negative earnings, meaning they're losing money within the Russell mid cap, as you said, it's it's more than that. It's 14% but as you also said, within Russell 2000 the latest number is 42% which is up from 14% two decades ago. What's going on with the Russell 2000

Larry Swedroe 32:27
Yeah, it's a lot of these companies that are story stocks that you know have raised capital, spent a lot of money on investment and have not yet turned profitable. And investors seem to like, you know, these, what are called lottery stocks, but the more profitable ones, which were not trading at high multiples, the private equity firms have come in and bought them up and taken them private, or they've been acquired by big companies who were using their cheap, high priced equity to buy lower price, you know, profitable companies, yeah.

Andrew Stotz 33:05
Well, what a great discussion again. And I look forward to the next chapter. The next chapter is chapter 36 fashions and investment. Follow me for listeners out there who want to keep up with all that Larry's doing, you can find him on x at Larry swedrow, you can find him on LinkedIn, and you can also find him on sub stack. Now this is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.

Andrew Stotz 00:02
fellow risk takers. This is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story at episode 645, now Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future the keys to successful investing, and that is CHAPTER 34 bear markets and on unnecessary evil. And just to highlight Larry just wrote on his sub stack. If you're not subscribed, make sure you are Larry's sub stack, he wrote, with the sharp drop in US equities investors have experienced and the questions I've been getting about the drop, I thought I would update a piece I wrote back in 2008 explaining why bear markets are a necessary evil. Larry, take it away. Yeah.

Larry Swedroe 00:55
So we could define a necessary evil as something that maybe isn't pleasant, but is needed. And the most common thing I think people can relate to are taxes. You want to live in a country and have police and schools and, you know, Social Security and Medicare in the US? Well, we got to pay taxes to support that, as well as defense. So that's a good example of a necessary evil. And I wrote it that way because bear markets really are a necessary evil, or investors should think about it that way, because if stocks didn't experience the kind of bear markets that we have, investors would actually be very unhappy. So let's think about why that's the case. The most common, most important, the most basic principle of finance, is the relationship between risk and expected, but not, of course, guaranteed return. Right? So the more risk, the higher the expected return, which means, if risk is high, which means that there have been risk of big losses, then investors apply a bigger risk premium, which leads to the denominator in the formula of a Net Present Value. The numerator is the expected earnings. The denominator is the risk free rate plus the risk premium. Well, the bigger the losses have been, historically than that. People would think of equities as being more risky. So I point out in my article that the US has experienced, you know, four periods where the losses were greater than the 34% that we experienced in the US during the COVID crisis, which lasted just a month and four Days, from February 19 to march, 23 from January, 29 through December, 32 the market lost 64% from January, 73 through September, 74 it lost 43% from April, 2000 through September, 2002 it lost 44% and from november 2007 to February, 2009 it lost 51% now imagine for the moment that US equities The worst loss that ever had experienced was 10% clearly, investors would view equities as a lot less risky than it was even in the post war period. We've experienced nothing like the Great Depression, and so that's one of the reasons that the equity risk premium has come down, people are willing to pay more because they believe the Federal Reserve has learned from the mistakes of the 1930s when it tightened monetary policy in the middle of a Great Depression. We now have much better accounting regulations. We have an SEC which we didn't have before, and we have much better regulatory rules guiding the actions of corporate executives, much more severe penalties for breaking the law. So there's investors believe it's safer. So if you go back to the 1970s or so, the average PE may have been just 15, so maybe it gets to the 20 in a good period and goes much lower in a bad period. For the last 25 years in the US, the average PE has been over 20. And so people believing markets are less risky because the economic cycle risk has gone down. We haven't had a really severe recession, except for 2008 in the last, you know, 40 years. Okay, so think about if the worst recession caused the market to only drop 10% maybe investors would be willing to pay 30 times earnings instead of 20 times earnings. That would mean the discount rate would go down, the net present value would go up, so the price of equities would be higher. You don't change the earnings of those companies, just the discount rate. And therefore, instead of stocks returning, say, 10% historically, maybe they would have returned 5% and what if the worst loss had only been 5% well, maybe the price would have PE would go to 40 on average, right? So the point being that bear markets really are necessities to create the large equity risk premium that has been called the equity risk premium puzzle. Why have stock returns been so high when corporate earnings are nowhere near as volatile as stock prices. And the reason is, investors hate big losses. They don't like the risk that that creates, and therefore they demand the big risk premium. So the right way to think about bear markets is they're really good, especially when you're young and accumulating assets, and as long as you don't get fired from your job, you get to buy at much lower prices and get higher expected returns. They're bad when you're retired because you're withdrawing from your portfolio and you can't recover money that's already been spent, those assets are gone, okay? So the right way to think about bear markets is they are a necessary evil in order to create the large equity risk premium we have enjoyed in the last 100 years, okay? And therefore you have to make sure you don't take more risk than as we've discussed many times, you have the ability, willingness or need, to take risk, and as you age, your ability and willingness to take risk is probably going down, and therefore you should be lowering your exposure to the that economic cycle risk. And if you're young and you have a stable job, well, then you can take that risk. But if you're in an industry that is highly correlated with economic cycle risk, saying, home, building, construction, autos, etc, then maybe you should have a little lower equity allocation, or certainly a reserve of a significant number of maybe years two or three, at least, that you don't wouldn't be forced to sell equities at a time when they're in distress, and that's Actually the time you want to be a buyer, when everyone else is panic selling, because expected returns are now highest.

Andrew Stotz 08:27
Yeah. In fact, while you were speaking, I went on to Schiller's website to download his data and look at that. And I just, you know, went back to 1900 and made this chart. But here you can see, and of course, it gets a little meaningless when you look backwards, because the numbers were so small, maybe if I put on a logarithmic scale, it would look have a different meaning. But the point is here we can see in 2000 2000 the.com bubble crashed, and then we can see the 2008 bubble crashed, and then we saw the COVID crash, and now we're seeing a recent crash. So bear markets, ultimately, as you say, are a necessary evil.

Larry Swedroe 09:10
Yeah, they restore a larger equity risk premium. You know, the worst thing that happened to young investors was the bull market we really experienced from 2009 through 2024 because that drove the PE ratios way up and expected returns down just when you're investing. It was the best thing that happened to retirees, because their assets continued to grow, and as they withdrew, they weren't suffering because those assets kept appreciated. So you know, you really have to consider the stage you're in as well when you think about your asset allocation and

Andrew Stotz 09:54
the the although the economy in the stock market don't correlate. Um. So it is interesting to think about the bubble and the boom and the bust. I know Peter Schiff. I listened to him recently, and he said something that maybe came from someone else, but the point is that the recession is the cure. And what his point was, and I think it's very true is that when good times are here, all kinds of people enter every industry, until eventually very high returns get competed away, and then you have oversupply, and then you have the peak of a economic bubble. And then eventually what happens is the weak players get knocked out. And I would argue the reason why we haven't had a sustained recession for a long time is because the COVID period was like a flash recession that just instantly knocked out maybe 500,000 businesses in America and maybe 10 million businesses around the world boom, the weakest ones that may have had to die slowly were put to death. How do we think about the economy and the cycles in the economy versus the cycles in the bear markets, in the market?

Larry Swedroe 11:11
Well, yeah, you have to be careful about your comment that the economy and the stock market are uncorrelated. I think you would find that they are with a lag, because the stock market is forward looking. So it tends to go down before we get a recession, and it tends to recover when we get a recession right, maybe in the middle of it, because the market looks ahead and says, gee, the government is likely to enact fiscal stimulatory policies that will help recovery. The Federal Reserve is going to lower interest rates and ease monetary policy, and that will stimulate the economy. So the market actually tends to go up once we get through the early stages, possibly, of a recession. It tends to go down ahead of the recession because it's anticipating it, and anticipating, for example, that their excesses in the Federal Reserve is going to have to tighten monetary policy, etc. In this case, what we're seeing, just to discuss what's going on now, the market concerned about the uncertainty by a self imposed recession because of the uncertainty of Trump's war on, you know, on trade policy. In the other cases, all of the other instances were exogenous events. So we had the events of 73, four. We had an oil embargo. We had 2001 we had the terrorist attack. 2008 we had a global financial crisis. 2020, we had COVID. This is a policy induced one, which leads me to believe, if rational people, and I don't know how rational President Trump is, everyone will have to make their own decisions if the markets start to crash, that alone can induce a recession because of the wealth effect. All the uncertainty he's created has driven consumer confidence way down. That means they're likely to spend less. We don't see it right away. In fact, we're seeing the reverse, because people spent more in the fourth quarter, in the first quarter, to buy things before tariffs went into effect, and so they front loaded things. So the next quarters could be weak corporate executors, their confidence level is way down, so cap x is down. No one's going to build a plant in the US, because they don't know if the tariffs will be there or not. So until they know, right and the wealth effect with the market going down is another problem, because people will spend less and all the doge cuts, it's not just the jobs lost there, which is probably a very good thing get rid of bloated government, but there are probably two to three jobs in the private sector supporting every single job in the government sector. Just think about the hotels and the restaurants and the airfares, and, you know, the you know, cell phones that you know, and all that stuff, and the consultants and and everything else. So you're talking about hundreds of 1000s of jobs just seeing a bunch of the consulting firms, well known firms, have already agreed to slash billions of dollars, right? That's gotta slow the economy to some degree. Now, it may also help the budget deficits, which in the long term, would be a positive so

Andrew Stotz 14:50
in theory, the stock market is telling us we're in for, potentially in for a weaker economy. Well,

Larry Swedroe 14:58
the market is up more. Are uncertain, so the risk premium goes up. Whether we get the recession or not depends upon, you know, sort of read the tea leaves, and you can make your own judgment about this. My assumption is as follows, but I have to admit, I'm always humble, as you know, by making forecasts, I always tell people my crystal ball is cloudy. I don't change my investment policies strategies based on them, because I know I can't forecast any better than anyone else. And I tell people, despite how much you want to believe, that there's somebody out there who can predict the future, there's only one person who knows what will happen, and you and I will never get to talk to him or her while we're on this planet. Therefore, ignore forecast. But here's what I think is likely, or at least you know, better than a 5050 chance. I believe that the President watches the stock market as the gage of his performance, and he knows he's got a big election coming up, not that far in the future. And if you get a recession come the third or fourth quarters, that's going to run right into the election, the primaries and everything else. He's got such a thin majority he cannot risk it. So what he's likely to do is the following, I believe, announce very quickly major agreements on basic tariff trade policy, but he can't announce deals because it takes, historically, nine to 18 months to negotiate very complex deals which have much more to do than just tariffs but regulatory rules, safety rules and all kinds of barriers governments Throw up to protect domestic industries. But he could announce India and the US, or Taiwan and the US have announced a general agreement that we're going to go to zero tariffs on manufactured goods, and we're going to work on these five other things, and Taiwan has agreed to invest a trillion dollars in US manufacturing. And then when you get one deal, a lot of other people will rush, because they will want to not be excluded, and that'll set the stage. And people, then the market, will think ahead, and we will avoid the recession. If I'm wrong and Trump doesn't use the common sense that he should have, and this drags on, then you could see a recession, which means earnings in the average recession go down about 10% and PES could easily drop from 20 to 15. So you would get an earnings, maybe of 230 bucks or something like that for the S P, and put it just a 15 P, that's not a bear market even. And you're about 4000 on the S P, so I don't rule out at all a drop that could be another 20% from here or so. So a portfolio has to be able to withstand, you know, both the good and the bad outcomes, because we don't know which outcome is likely. I had

Andrew Stotz 18:35
a couple questions in the chapter. These are kind of, let's say quick ones, but you mentioned one thing where you said, from 1926 through 2022 the S P has provided an annual compound risk premium over one month treasury bills of 8.2% and an annualized premium of 6.9 so Let's say equity risk premium about 7% Yeah. Okay,

Larry Swedroe 19:02
that's because, by the way, the average PE over the 100 years was about 17, 1617, invert that, and guess what, you got an earnings yield of six to seven, which equates to about what the real return to stocks was. Andrew, you put up the current Cape 10. You want to show people what that is, and then we can invert that for them.

Andrew Stotz 19:29
Hold on, I let me get that second.

Larry Swedroe 19:37
It's come down some because the market has dropped, you know, close to 20% and it's rebounded a bit the last couple of days. Yep, I think peak to trop was down 20%

Andrew Stotz 19:55
give me a second, yeah,

Larry Swedroe 19:56
all I can tell you this while you're pulling it up the current. Forward estimate of earnings, which I think the earnings estimates are likely too high, especially if we get a recession, is about 20. So that would be an earnings yield of 5% so that would tell you the expected real return to stocks is 5% now not seven, but you still have a wide dispersion of possible outcomes around that cape 10 is not a good predictor of returns in the next 123, years. It's a reasonably good one over the longer term, like 10 years, right? It's about as good as we have.

Andrew Stotz 20:38
Okay, so let me pull that up one second. Put me to the test here. Larry had to calculate that one. Okay,

Larry Swedroe 20:51
there you go.

Andrew Stotz 20:53
So what we're seeing, for the people that are listening, we're seeing that the PE ratio looks like about 33 there. Maybe, yeah. So let's just say the recent peak was about 37 let's say and it's come down to about 33

Larry Swedroe 21:12
so 33 would be a 3% real return. You know that that's, I don't know how many people would take the risk of investing in stocks for a 3% real return when you can buy tips guaranteeing a 2% or so real return, right?

Andrew Stotz 21:30
Let's and let's just look at that from a, let's say, just a long term average, which we can see here?

Larry Swedroe 21:41
Yeah, I'd be careful. The long term average is about 17 now, but that's misleading, because of the reasons I mentioned earlier. In much of that period, there was no Federal Reserve, there was no sec, we didn't have gap accounting rules. We didn't have Sarbanes Oxley, all of these things which made equities less risky. So I think, you know, a more normal number might be the last, you know, 40 or 50 years, maybe, or last 25 and now you're looking at a cape 10, much lower. So I think, you know, still obviously 33 would be way above, say, 20 or or so. So we're still way above that. So

Andrew Stotz 22:35
let's just take

Larry Swedroe 22:36
P, the current P is much more in line with the last 25 years, or even a bit longer. So

Andrew Stotz 22:44
let's take the period of 1980 maybe, yeah, that's a reasonable one. Could say that with 1980 we definitely had the Fed, you know, being a much more active player. So now let's look at that chart again, and we can see that even, even if we did that, that's going to shift it up from about 17 times to about, what do we say 23 times, right? But still, yes, we're way above it, not as above as we were in the.com bubble. And one of the things about the.com boom or bubble was that we had a huge, you know, very small earnings and zero earnings for many of the largest tech companies. Whereas now those companies, even though they may suffer a bit, they're still super profitable. That's

Larry Swedroe 23:31
why you're not seeing the P the cape 10 at 45 you're seeing at 33 and if we got to remember, yep, you know, if you get that recession, which would be a self imposed one, because of President Trump's the uncertainties created, their earnings are going to come down, and then the risk premium will also go up, and that's how you get big bear markets. And so it wouldn't shock me. I'm not making that as a prediction at all, but wouldn't shock me if we sat here in six months and the S, P was 4200 because we had a recession induced by a failure to get trade deals done. And I would add, there are other things that are certainly possible. You know, there is tremendous geopolitical risk around the world, certainly Russia and Ukraine, certainly Iran. We could see the US, if US and Israel don't get Iran to agree to abandon nuclear weapons with a verifiable testing I believe there's a 98% chance or more that Israel and the US, or even Israel on their own, will launch a strike to destroy their nuclear facility. Who knows what that could trigger and Taiwan? On, given China's problems, if the US persists in this trade war, China could decide their economy could get into a serious recession, and they could be concerned even about being overthrown politically. They want to distract their population and launch an attack on to try to take over Taiwan. I mean, I'm not predicting any of these things, but I don't think anyone could say the chances of those things happening are zero. Yep,

Andrew Stotz 25:33
the last thing I want to ask you about what's in the chapter. It made me think about, when we talk about small cap, you know, we talk, sometimes we talk about small cap premium and small cap companies having a big loss relative to large cap companies and all that. I kind of realized that we need to differentiate when people, when we listen to people talking about small caps performance, we need to differentiate between just small cap return relative to, let's say, the overall market, or relative to large cap versus long, small cap short, large cap premium, right? That we're talking about the factor premium. How should we think about those two things, and what generally has been the difference. And can we really capture that long, short premium in small cap, or should we be thinking about just the premium of, you know, small cap performer? How do we think about that? Well,

Larry Swedroe 26:33
gee, we need a whole hour to answer that one, Andrew, but let's see if we can make it short. First of all, the small cap premium is really polluted, if you will, because of investor at the retail level behavior, retail investors have a weird preference. It's not financially rational. It may be psychologically rational to buy the stocks of small cap growth companies with high levels of investment and low profitability. They are hoping to hit the lottery, if you will, and find the next Microsoft. It turns out that stocks with those characteristics have underperformed treasury bills over the long term Cliff Asness and the team at AQR wrote a paper saving, I forgot the exact name, but saving the size premium by getting rid of junk. And once you do that, the size premium, all of a sudden is restored. We haven't seen a size premium basically since it was written about in the 1980s by Ralph bands. And it's polluted. Once you look at small companies that are more profitable, low their value stocks that are profitable, then there is a size premium, but you have to get rid of the junk stocks. Another example are stocks and bankruptcy. There have penny stocks. Do you know? Take a guess what percentage of these stocks, even though they trade, they are still in indices, you know, and stuff. So an index fund that's pure replicating would buy it. So a stock like hertz that declares bankruptcy, let's say it's traded. Take a guess what percentage of them ever return one penny to shareholders, is it 50% 80% 20%

Andrew Stotz 28:46
Yeah, I would say 40% return and

Larry Swedroe 28:51
60 times too high. It's 1% 1% and yet, people love this, right? Okay, so when you look at the small cap premium, people say there's no small cap premium. It's because you have this junk. And once you get rid of that, the small cap premium is restored, and it's been something on the order of two, two and a half percent per annum. And then you get a profitability premium on top of that, if you stick with the, you know, those companies, and you know, in general, there is that size, that profitability premium, so the it's very hard to capture it long short, because the worst performance guess what is in the short side. So you have to go short, and it's very expensive to borrow those stocks, because the risk of going short, like with hertz, who went way up, or GameStop, you know, the you can get squeezed by these crazy people at Reddit who want to go after hedge funds and stuff and so. That's what's called limits to arbitrage that allow these stocks to persist as overvalued. The way to access the premium, if you will, is to buy small cap stocks that are higher in quality, profitable and cheap, and go long them. And over the long term, you should have higher expected returns for very you know, because they are risky or smaller, less liquid, you know, companies right? And you'll outperform the junk as well.

Andrew Stotz 30:32
And just to show that, here's a chart I just made on let's see. This was something I did before, where I looked at a 10 year stock market moving average to smooth out the ups and downs and just to understand, but here you can see that the blue line is the small cap premium. That's the long, short premium

Larry Swedroe 30:56
ended right around 83 when Ralph bands published this paper, yeah.

Andrew Stotz 31:02
And so we had a underperformance, then outperformance and underperformance, which tells you, it's pretty much been destroyed and that

Larry Swedroe 31:11
Well, you gotta remember, much of this has occurred in the last 10 years, when the price what you have to analyze. Andrew, be very careful here you have to ask, Why did large caps outperform? Did they out earn? Which, in case, you could say, all right, that should persist. The small cap premium is gone, or did the PE ratios go way up? And much of that outperformance, perhaps all of it, is due to the spread widening. Small cap stocks are trading maybe 10 times earnings, and large cap trading at 30, so you get an average market of 20. I'm just making examples, and it's because the spreads have widened dramatically. That's certainly been the case in value stocks, and it's also been the case of US stocks outperforming international until this year, 80% almost of us outperformance over the last 17 years has been PE expansion, not earnings expansion, and much of the earnings expansion was due to interest expenses coming down when the Fed adopted a zerp policy. So that's going away now, yeah, and as those refinances come due, maybe people borrow 10 year money back in 2018, or 19, and you know, few more years, then they'll have to pay again market rates.

Andrew Stotz 32:44
Okay, so in wrapping up, let me just also mention that the paper you're talking about is called size matters, if you control your junk. Yeah, the latest green paper, yeah. Latest version came out in 2018 it's on SSRN, and as you said, Clifford Asness, Cliff so it and just to read the abstract, just briefly, the size premium has been challenged along many fronts. It has a weak historical records very significantly over time, in particular, weakening after its discovery in the early 80s, and it's concentrated among micro craft stocks predominantly resides in January and is not present for measures of size that do not rely on market prices, is weak internationally and is subsumed by proxies for illiquidity. We find, however, that these challenges are dismantled when controlling for the quality or the inverse of junk of a firm. Interesting, that's a great paper. Okay, I look forward to it. Well, let's wrap it up there. Larry, I want to thank you for this great discussion, and I'm looking forward to the next chapter. And the next chapter is chapter number 35 Mad Money. Now I don't watch TV, but I hear there's a guy named Jim Cramer we're going to talk about. So I'm looking forward to that.

Larry Swedroe 33:56
Yeah, it's an interesting discussion. It amazes me, given he's been exposed that he adds no value. He's been around for, I don't know, 30 years, and he can people still tune into his show when the academic research shows he knows nothing. Well.

Andrew Stotz 34:13
He may not add any value in his in our stock market performance, but apparently he adds some kind of entertainment

Larry Swedroe 34:18
value. Yeah, that he's certainly an entertainer, if you like, you know, clowns. Okay, well,

Andrew Stotz 34:25
we're looking forward. That's gonna be a fun one. So for listeners out there who want to keep up with all that Larry's doing, you can follow him on x and Larry swedro, you can follow him on LinkedIn, and maybe Larry you can tell us, what are you doing with sub stack,

Larry Swedroe 34:36
yeah. So I decided now that I have left Buckingham, I've semi retired, I still do some consulting to now eight firms part time, so I still want to write, and I have a lot more time to give back and help people learn about markets. So I write for. Four other websites, wealth management, financial advisor, Morningstar and alpha architect. So you could follow me there, or simply follow me on X Twitter or sub stack. So I'm writing more than the others are have the capacity to take so I decided, all right, I could publish on sub stack. It's free, you know, at least for now, and it allows me to add commentary like I added today about the bear markets are necessary evil. Rather than writing, most of my stuff is writing about the academic literature, reviewing what the researchers looked at, what they found, and the implications and takeaways for investors. This allows me to comment more on investor behavior and how they should be thinking about things in the marketplace. So I would urge all your listeners to check it out, and if you just subscribe and tell your friends, and hopefully that'll make you a better investor.

Andrew Stotz 36:04
Fantastic. And the great thing about sub stack is that you get a notification when a new piece comes out, where you may miss that on Twitter, you may miss that on LinkedIn, so that's great. Well, this is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now Larry stands out because he bridges both the academic research world and practical investing. And today we're diving into a chapter from his recent book, enrich your future the keys to successful investing. Specifically, we are talking about chapter 33 and investors worst enemy, Larry. Take it away. Yeah.

Larry Swedroe 00:35
Thank you, Andrew, good to be back as almost always. Each of my chapters begins with a story to help people understand the difficult concept. And this story begins with my background. As a kid, growing up in New York City, and like most kids who were athletically inclined, I practically had a basketball glued to my hand. I went to school in the morning, ran home, had a glass of milk and some cookies, and then ran back to the afternoon center to play basketball from like 330 to five o'clock. Run home, have dinner, and then run back to play at seven o'clock till 10 at night there. And I was a good enough athlete that I was able to actually make my colleges freshman basketball team, although I spent most of the season collecting splinters on the bench, and it was only a d3 school, so I wasn't saying much at age 25 I moved out to California, where everybody pretty much played tennis. In those days, that was a much more popular sport even than it is today. And because I was a good athlete, I fairly quickly became a competent player. What people would say would be a good weekend player in US rankings, it would be like a three, five player. So I could play with most people and be competitive, but I would often play against people. At the time, I was 35 and a good athlete could run around and stuff, and I was getting beat by 6065 year old men who I was much better athlete then. But of course, they were better tennis players. And this, of course, became very frustrating. And finally, I decided that maybe I ought to learn how to play the game of tennis and what the right strategy was. And I was out on the court with a tennis pro on a vacation, and we were doing drills. And of course, my weaker shot, like for most people, was my backhand, especially in those days, if you use a one hand backhand. And the Pro, and we were rallying, and he hit a ball deep to my backhand, and I cranked up and hit her, and he came to the net, and I hit this beautiful passing shot like, look like Roger Federer, I do, and went right past them, right down the line, landed dead in the corner. And I'm feeling great, and I've got a big smile on my face. And he calls me up to the net and said, Larry, I want you to know that shot is your worst enemy. So what are you talking I just made this great shot. Said, the problem is you're going to remember that you made the shot and try to replicate it. And while I could make it, he said, nine out of 10 times, you'll make it one out of 10 times, and you play what is called, at your level, a loser's game of tennis. What that means is most of the points are lost by somebody hitting a ball wide into the net or long they're not one because you hit a great shot. Obviously, the higher the level you go, the reverse is true. The great tennis player, if you watch a match with Roger Federer against Nadal, if you were lucky enough to see those events, the points were one because somebody just hit a great shot and the other person couldn't quite reach it. There aren't that many errors at that level. So he said the key to winning the losers game of tennis, which is what anybody but say a pro level at a club, you know, would be, is to just get the ball back with a decent amount of pace so someone can't just wind up and hit it deep. Okay, keep the person back and stop trying to hit winning shots. Just try to avoid hit losing shots by hitting some great shot. And I said, Boy, that sounds like good advice. Maybe I could do better against these people who are better tennis players, but I'm clearly the better athlete, and all of a sudden, I was beating people fairly easily who were beating me. So the key to understanding any game is what's the right strategy, and so how does this all relate to investing most? People think the key to investing is identifying the stocks that are going to outperform the market and avoid the ones that are going to underperform. Yet the vast body of evidence says that's playing the losers game. You're much more likely to hit the ball long wider into the net than find the next Google, and the evidence is overwhelming that the vast majority of professionals who have advanced degrees in finance and mathematics have access to the best databases, etc, spend 100% of their time doing this stuff, have huge advantages over individuals. Yet, as we discussed, something on the order of 98% of them failed to outperform in any statistically significant way on a risk adjusted basis, even before taxes. So the right strategy is to avoid the losers game. Don't try to pick individual stocks or time the market, just invest in a disciplined way so you can stay the cost through bear markets, and you will win simply by getting the markets returned. And so that's the winners game. The problem is we are all human beings, and as people who have observed the world of investing, investors are all just like I was on the tennis court, overconfident that I could make that great backhand passing shot. They all think that they could pick the next great stock. 90% of the people of the ass think they can outperform the market when we know that maybe 2% of them do. So the key is to avoid human biases such as overconfidence. Understand what the right strategy is, and it's because the markets are so highly efficient, not perfectly. So markets make mistakes, but it's hard to identify, especially after the cost and I would add the time and effort required to succeed, right and aren't you better off spending that time with your spouse or your children or grandchildren, taking a nice walk around the park or in the beach, reading a book or playing a game With your grandkids, then trying to outperform by picking the next school book. I leave that to your readers. I think that's a rhetorical question.

Andrew Stotz 07:27
Well, I think that also you could say, if you're a young person and your objective is to accumulate wealth, figure out how to add more value at your job. Figure out, you know, you know how to start a business that adds more value. These are great ways to build wealth, you know, over time. I just want to go back to something you've hit on many, many times, and I know we've even talked about it in relation to playing a tennis player versus playing the market, you know, just to help people understand, you know, what's the difference? So, for instance, I can play that great tennis coach that you just talked about, and he could even have a bad day, and I could even win it. Could. I could be a winner, you know, he could have a bad month and all that. But, you know, what I'm playing is one man or one woman, in this case, depending. And what I'm thinking about is, you know, can you just talk about, who are we playing when we're playing with the market? Okay, we had a fun, fun, you know, game match of tennis, and we played this one person. We're playing pickleball, we're playing this one person. But what happens when we're playing the market? Who are we trading with? Yeah.

Larry Swedroe 08:31
So actually, the way to think about it, I believe, is this, the research shows very clearly, and I think it's pretty simple to understand when you play games where you're playing one on one competition, it actually only takes small differences in skill to lead to huge differences as an outcome. As much as you might like to think you could play a tennis pro and maybe even win a game or a match, that's never going to happen. Literally never, right? Okay, because small differences in skill. Roger Federer, for example, one maybe the greatest player of all time, never lost the single first round match in a Grand Slam tournament. Yet he was always playing against one of the best 128 players in the world, always, and he never lost, ever. All right, so one on one, you could play against a very a master chess player, and if that master chess player plays against a grand master, they'll never win. Maybe they'll win one or two out of 100 matches, the odds are tremendously in favor, even with a small skill advantage. However, when you're competing in the market, you're not competing against one on one, you're competing against the collective wisdom of the entire market. Including their PhDs and rocket scientists at Renaissance technology and Citadel and Warren Buffett, and the research shows it's much harder to win that kind of game because of what's called the collective wisdom of the crowd, and that's why it's such a difficult game to win.

Andrew Stotz 10:22
You said small skill advantages can have major differences in outcomes in one

Larry Swedroe 10:27
on one? Yep, all right, so let me use this example hitting a baseball. Maybe the greatest hitter of all time was Babe Ruth or Ted Williams or whatever. Okay that they, however, were playing a game of one on one. Imagine now that they were facing a pitcher who had Sandy Colfax his curveball, Randy Johnson's fastball, call Hubble's screwball. Greg Maddox is control, etc. The best of each one of them, they probably would hit 200 not 350 or whatever their career averages were, and that's what you're competing against when you're playing the game against the market. But investors never think about it that way. You call

Andrew Stotz 11:24
it the collective wisdom of the market. I guess when I was thinking about what you just said on the baseball pitcher, I was thinking the collective skill of the market.

Larry Swedroe 11:32
Yeah, that's right, it is the collective skill in the same way that Roger Federer, as great as he was, as if he was playing a person who had John McEnroe's volleying skills, you know, Andrew Radox, serve, etc, picked the best the best forehand, the best backhand. He would never have won. He couldn't beat him ever, right? And that's the same thing that is true when you're trying to beat the skill of a market, it is a much, much more difficult competitor.

Andrew Stotz 12:10
Is there any other parallel? I mean, clearly this. The parallels that you talked about tennis really help us to, you know, differentiate. Is there any other game that we play in life, that we're playing a collective experience or a collective skill in the market?

Larry Swedroe 12:27
Well, any one on one game shows you that small differences in skill lead to big differences in outcome. The only one that I can think of, generally is the stock market where you're competing there. However, there are all kinds of other markets, foreign currency markets, betting markets. Now, right? We've got betting markets on almost anything like, will the US launch a strike against Iran in the next 90 days? You can bet on that, and very few people have the skill to outperform the market, especially after the trading costs, because the brokers in that trade, or the house Las Vegas, is taking what's called the vigorous maybe 5% so you have to win like 53% of the time, not 51% of the time. The

Andrew Stotz 13:24
vigor ish, I love that word. You've talked about that before,

Larry Swedroe 13:28
good Yiddish word that became an English word.

Andrew Stotz 13:31
Yeah, that's a good one. In the last section on page 210 you talk about the amount of money that the capital market is extracting. You talked about 150 billion. Maybe we can close with that discussion. Yeah.

Larry Swedroe 13:45
So Ken French did a paper on this and show that the average active fund underperforms by a certain amount every year after expenses, not taxes, even. And he then multiplied that number by the amount of money in actively managed mutual funds to come up with that figure. So the average investor in mutual funds that are actively managed is losing that amount of money. Just think about what the average person could do if they had that extra cash. And you know, it would be like a matching grant to their IRA every if they stopped just trying to beat the market and accepting market like returns. Yeah.

Andrew Stotz 14:28
I mean, that was a good chapter to help, help everybody to think about, who are we competing, about against, and how are we trying to compete the

Larry Swedroe 14:38
way I try to end these conversations and giving advice to people is so I ask them. So I'll just ask you, Andrew, you know, think of a stock that you want to buy. You give me the name. I ask you all the reasons why you want to buy it. You've done your research, or at least you think you've done research. Search. And you give me all these reasons, and then I agree with you that, let's assume you're 100% correct. Everything you say is true. And then I ask you, do you think that Warren Buffett, they're rocket scientists and Renaissance technology and Citadel they're unaware. And you know, you think the stock is at 30, but should be 40. If they thought it was worth 31 it would be there, because they've got billions of dollars that they can move the prices and move it there. It's obviously at 30, because they don't think it's worth 31 let alone 40. So what you have to think of is this, 90% of the trading today is done by the big institutions. That means, if you're buying a stock, you have to ask, who's the sucker I'm buying it from, who's selling it to me, 90% of the odds are it's Warren Buffett or Citadel or some other and then you have to ask, who's the sucker at this poker table? Is it me, if you're honest, the odds are highly likely it is, unless you have inside information, and Martha Stewart found out, what happens if you trade on that and get caught?

Andrew Stotz 16:15
Yeah, that could be your worst investment ever if you trade on that inside information. Yeah, I think the good question is, is it? It's not even a question, it's a statement. It's already in the price.

Larry Swedroe 16:27
That's that's real. What you should always assume is that everything you know is either in the price or illegal to trade on.

Andrew Stotz 16:39
And on that note, I want to thank you for another great discussion, and I'm looking forward to the next chapter, chapter 34 where we're going to talk about bear markets, unnecessary evil. And for listeners out there who want to keep up with what Larry's doing, find him on X Twitter, at Larry swedro, and also on LinkedIn. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. I.

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry Swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically we're going to be talking about chapter 32 the $20 bill Larry, take it away.

Larry Swedroe 00:33
Yeah. So there's an old story, Andrew. It's one of my personal favorites. It's a story about a passionate believer in the efficient markets hypothesis, which says it's extremely difficult to outperform the market by picking stocks or time in the market, because the market already incorporates all information, and you can't be smarter than the market, or it's extremely unlikely. And the story goes like this, that there he's walking down the street talking with a friend, and the friend says, look, there's a $20 bill there. And the economist says, can't be if there was a $20 bill, or someone would have already come by and picked it up. Of course, the person picks up the bill and, well, the people who tell that story may use it as a joke about clearly, the market is inefficient. Well, the right way to tell that story, my version of it anyway, is that there's a passionate defender of the efficient markets hypothesis walking down the street with a friend who spots the $20 bill and there, and the economist says, you better pick that up real fast, because it's going to be gone. You know, very quickly. $20 bills just don't sit around laying on the floor. The other guy, he does pick up the bill and decides he's going to spend his life trying to find these easy $20 bills. Well, a few years go by, and there's the financial economist. He's walking down the street, and he looks over, you know, he's down in New York City, and he looks in some doorway in an alley, and he sees his friend in ragged clothes drinking out of some brown paper bag, some bottle. Doesn't know exactly what it is, but the essence what happened to you says, Well, I went around trying to find $20 bills. I never found another one. And that's really a better example of the markets aren't perfectly efficient. There are occasionally $20 bills that someone can find, but if you can identify an easy way to find those $20 bills, well, the market will learn about it quickly and make those $20 disappear, as if, like somebody found bunch of gold rings on a beach. Well, all the people with metal detectors would be the next day, and within a day or two, there would be no more rings. That's how the efficient market works. There's always some anomalies. Somebody can discover some way to beat the market, but it gets reverse engineered very quickly, and that anomaly disappears.

Andrew Stotz 03:20
I was thinking to myself, does when we say that the market is efficiency, does that mean that there are no inefficiencies? Does are we technically saying, if it's efficient, there are zero inefficiencies?

Larry Swedroe 03:34
Well, there are several versions people have developed, and the efficient markets hypothesis one is the hardcore version, which would say there are no inefficiencies, which we know is wrong. There are plenty of behavioral anomalies. For example, the research shows that small cap growth stocks with high investment and low profitability have had returns below those of T bills, and yet people buy them. Why? Because they're hoping to hit the lottery and find the next Google or Microsoft or Nvidia. And there are limits to arbitrage, meaning the cost of trading and the cost of borrowing, because if you want to bet on a stock being overpriced, like these small cap growth stocks with high investment and low profitability tend to be you have to borrow the stock and go short it. You sell it and now you hopefully buy it back later, lower price. Well, the cost of borrowing can be very expensive and secondarily, unlike when you go longer stock, in which case you can only lose 100% of your money if you go short of stock. As people who shorted game stock correctly, knowing that the stock got way overvalued, but they got. You know, in a short squeeze, and the price went from like $10 to 300 or some crazy number, I forgot exactly, and they went bankrupt. Uh, Melvin capital lost like $4 billion betting on it. So the fear and the unlimited losses and the high cost create what are called limits to arbitrage, which prevents sophisticated investors from correcting mispricings. Momentum is another anomaly which clearly, there's no risk story to momentum. It's people buying things based upon recent performance. But let me give you a more common example, long time ago, there was a paper written on the accrual effect. What it said was, companies that have unusually large accruals tend to go on to unperform, underperform. Why they were tending to recognize revenue too early, and sometimes it never showed up. So counting irregularities, if you will, immediately after that paper was published, the anomaly disappeared because smart people read about it in the literature, and they started to buy, you know, go short the stocks, and that drove the prices down. The anomaly went away. Let me give you one other example to be helpful. So there used to be something known as the January effect, where small cap stocks tended to outperform in January. And that was so if you know that's going to happen? What would you do?

Andrew Stotz 06:43
Andrew, you're going to you're going to buy prior to January, yeah, so

Larry Swedroe 06:48
you're going to buy in December? Yeah, I'm a little smarter than you. I know Andrew is going to buy in December, so I'll buy in November. And high frequency traders, you know, like Citadel capital, they're smarter than me, and they'll buy in October, and then the anomaly is already gone, right? It never gets undervalued. And so once something is discovered, especially if a stock is undervalued, because there aren't the risk and the costs of shorting, these anomalies tend to disappear.

Andrew Stotz 07:22
I'm thinking about there's a word that I always find really strange. The definition of it, it just doesn't make sense to me, and that's altruism. And the definition is something like being, you know, a selfless concern for the well being of others. Well, that doesn't make any sense to me, because I know that nobody's going to go out and help other people in in ways that are going to harm them personally in the process of helping, unless, you know, okay, it's a parent saving a child, and parents going to hurt themselves in the process of saving, you know? And then I would say it's not altruism, it's instinct. And so I that word doesn't make a lot of sense to me. And in some ways, I was thinking about efficiency and thinking, you know, the actual act of correcting is what makes the market efficient. And so to expect that the market is perfectly efficient is actually rejecting the whole process by which the market becomes efficient. So therefore there should never be a something that we would expect that the market is perfectly efficient, you know, as opposed to, you know. So to say that the market is slow and at sometimes and fast at sometimes, at bringing in information into prices, does not tell me that the market is not perfectly efficient. You know, I don't know if I'm explaining it well, but, you know,

Larry Swedroe 08:45
let me see if I can be helpful in this. So if you go back to the early 1960s the field of finance didn't exist. You couldn't get a degree in finance. I graduated from college in 72 and I was one of the first people who actually had a degree in finance. Before that, you got some courses in finance in an accounting program or in an economics program, but William sharp and others came up with the capital asset pricing model to give us the first theory about asset pricing. And that theory said that beta, your amount of exposure, relative market risk relative to the market explained returns. Okay, well, it turned out that that model, which, like all models, are wrong, or we'd call them laws, like we have in physics. You know, gravity is not a theory, it's a law, right? So people went to work and they found all these anomalies. The first one discovered, if you will, or uncovered was a small cap effect. And so then we had this. Value effect that you know, Buffett became famous for, and in 92 farm and French summarized whole bunch of research, which they get credit for, but they never claimed that they didn't invent the small cap and vapor. And they just summarize the research and created a three factor model. Now the CAPM model explained about two thirds of the differences between diversified portfolios. So if you had a higher beta, you should have a higher return. So stocks that were more volatile had higher expected returns. Generally, that was the idea. Now you add size and value these anomalies, and now you're up to about 92% of the variance, so there's still room for anomalies, or, in theory, inefficiency. Right along comes Mark Carhart in 98 and he publishes a paper on momentum. And he's that when you added that you're up to, like, you know, mid 90s. Now, okay, so there's still some inefficiencies. Maybe that could be discovered, because there were 5% that was unexplained. Then comes Robert novery marks in 2012 took another, like 14 years for somebody could figure out the next anomaly, and he found that profitability was a factor, and companies that were more profitable tended to outperform, and then later came an investment factor, and we now have this Five factor model, and now you're up to like 98% of return. So let me just finish this. Take your question. So in 1974 you could claim that the markets were inefficient and you could generate alpha just by buying small and value stocks. By in 1993 you could no longer do that, because I could replicate that by just buying an index of small and value stocks. Then after 94 you could claim by adding momentum stocks or excluding negative momentum stocks, you could outperform, and that was an anomaly in the market was inefficient. Well, can't do that anymore, and then profitability and investment. It doesn't mean we can't uncover anomalies further, because we now have all these high speed computers and tremendously talented mathematicians trying to uncover some but there's not a lot more room. But to give an example. Harvey Campbell, Harvey, a well known professor, has written a lot of good work. He just published a paper talking about how factors are done. He thinks in a less efficient way by defining, let's say, value as the top 30% of stocks and cheapness and growth as the bottom 30% and you go long the cheap and short the expensive. Well, he says that ignores how value is impacted by other factors or impacts. So how does value play with a low volatility factor? How does it play with the profitability factor, and he's so he built a model that said you have to look at the pairs and score them, and the ones that have the best pairs gives you much higher returns. So that's saying there's some inefficiency. Well, I'd be willing to bet, within a reasonably short time, if not already, the high frequency traders and the DFAs and Avantis the world will start to incorporate, if they're not already, you know, doing this, just like they incorporated profitability, etc, Fauci and French just had size and value till 2003 and then they incorporated momentum, and in 2013 they incorporated profitability, and now the market is more efficient, meaning it will be harder and harder for active manage their value. It doesn't mean it can't still be some things found, but it means it's extremely hard to add more of our and find these inefficiencies. So

Andrew Stotz 14:25
let me try to explain one thing first, and that is the concept of what, what William Sharpe was doing, and that was basically he was saying, if you invest in the stock market, you're going to get a certain level of return above the risk free rate and return, yeah, and, and that that, let's, I want to think about that as a pizza, and this is a whole pizza that you're going to get from that, right? And then, as people came along, they go, Well, wait a minute, we can divide that pizza into different parts. And. And it's the same total return relative or prospective return relative to the risk free rate. It's just that now we can attribute, you know, to what is this return coming so we're now coming up with slices, and new slices are a little smaller as they come along, but we do now have five, six slices. And now, would that be a good way of describing it? You

Larry Swedroe 15:21
could describe it that way, but what you're missing from that is some slices have a positive premium like value, and some have a negative premium like growth, a lottery, stocks, stocks you know, that are in bankruptcy. People love to buy them, but 1% of all the stocks that are on bankruptcy, even though they're in indices, so indexes will buy them. 1% of them ever pay out anything to invest. Why do people buy they like buying lottery tickets. That's the explanation there. They love something that even though the odds are against them, it still has the chance to hit the grand slam home run in the bottom of the ninth inning. And you know, you get this massive return, right? So those stocks tend to be overvalued, and the sophisticated investors, it's too risky for them to shorten, okay, so they remain overvalued. Okay, that's an inefficient market. And

Andrew Stotz 16:22
the other question I have is, I believe Fauci and French in their five factor model still do not include momentum in that. Am I correct in saying that? So

Larry Swedroe 16:31
their first model had beta market, beta size and value, then the four factor model added momentum. Then along came the Q factor, which said, we don't need momentum. We just need investment and profitability, and we don't even need value farm. And French went back and looked at it and said, Okay, we will add profitability and investment, but we're going to keep value, but kick out momentum. So that left you with a five factor model, and then they said, Okay, by the way, momentum is still an interesting even if it doesn't add more explanatory power, it individually provide some information, and so they're actually you could run things against the six factor model and show a portfolio's exposure to each of those factors. The most commonly used model now is the five factor, which includes investment, profitability, value, size and beta, that's probably the most commonly used model,

Andrew Stotz 17:45
and just to be just so I understand that is what's being said by Fauci and French, is that one of those five is already representing momentum, like it. Yeah, you could

Larry Swedroe 17:55
say it's their technical term in finance would be, it's impact is subsumed by the other five. Okay.

Andrew Stotz 18:04
And one other question is, in about 1970 fama came out with his efficient capital markets paper, where he was reviewing that, and he talked in that, I believe in that paper, but I know around that time we had weak form, semi strong form and strong form. And I wanted to ask you about strong form. For instance, one of the arguments in strong form is that the market is so efficient, which I think we would argue, the market is highly efficient, that insider traders cannot profit over the long term. Let's say No,

Larry Swedroe 18:39
that's wrong. Tell me more. All you have to do is look at the people in Congress, and how do these people who make 150,000 Larry $20 million like Elon Musk has pointed out, it's because they know that they're writing bills they're going to favor some and no one is stopping them and preventing them from buying those stocks. How did Joe Biden amass all of his wealth? Never made much money, and he never was in a business or any and he just made $200,000 a year or whatever. Right? We also know that there are people who trade on insider trading, and those signals have information. So there is some value there. We know that the markets are not perfectly efficient in that way, but that's why there are rules against insider trading. You if you're gonna buy or sell stock, you have to write it as a plan and say you plan to sell, you know, 10,000 shares every month. Or, you know, over the rest of the year, is to get out of your you know, diversify your position. You can't just walk in and sell on insider information. Or, as Martha Stewart found out, you can end up in jail.

Andrew Stotz 19:59
So. The market is not efficient, not

Larry Swedroe 20:01
perfectly efficient.

Andrew Stotz 20:06
And the argument that people would make that it could be strongly, strong form efficient, is that the market, in theory, would be observing the trading patterns that are hitting the market right then in that stock that's caused by this insider trader, that would trigger a signal to someone who's tracking that

Larry Swedroe 20:24
move the market there. Andrew ang, I think, was the one who wrote a paper called The adaptive Markets Hypothesis, and what he hypothesized is that people discover anomalies, like the accrual anomaly. It gets published, and the anomaly goes away, and as people uncover them, we know the markets can't be perfectly efficient, or Citadel and Renaissance technology couldn't be making all the money that they're making scalping pennies and nickels and dimes on each trade, but they're trading hundreds of 1000s of trades every day. And so it's not perfectly efficient. They spend millions of dollars to get their, you know, computer connections faster access to the data by like, a millisecond, right? And so it's not perfectly efficient. But the best way to think about it is look at the mutual funds, all these experts, highly trained people spending 100% of their time basically on trying to outperform all with advanced degrees, PhDs in finance and math. It's a really smart people access to all the databases, and over 98% of them underperform risk adjusted benchmark before taxes, so the odds of your outperforming are incredibly low. So therefore, how can anyone say the markets are highly inefficient or even inefficient, but we know they're also not perfectly efficient, which gives everyone hope, but hope is not a strategy. So

Andrew Stotz 22:05
going back to our last conversation, when I told the story of Dumb and Dumber, when Jim carries, you know, characters said, So you're telling me there's a chance. Okay? For the

Larry Swedroe 22:19
listeners, chance goodbye. Ah, I had a friend just spoke to him today, who yesterday went in and bought, early in the morning, bought some stocks, and then later in the day, he said, Oh my God, what did I do? Is the market went down. And when he woke up this morning, he went, Oh my God, what did I do? The market was down. And then Trump made his announcement about the delay, and now he's way up. So was he smart or lucky?

Andrew Stotz 22:47
I mean, you know, yeah, interesting. Well, anybody randomly is going to outperform? Yeah, I enjoy the conversation, particularly about efficient market hypothesis and all that, because, you know, it's a cornerstone of finance, so it's fun to talk about it and make sure that we understand it clearly.

Larry Swedroe 23:07
One thing, if the markets were perfectly efficient, then no one could discover anything about a mispriced stock. There were no abnormal behaviors or biases, like investors preferring to buy lottery stocks, then there'd be no incentive for investors to do any research, and then the market would become inefficient. So we're team has to be some incentive for finding inefficiencies, otherwise, the only people who would do it would be idiots, because you couldn't beat the market. So it's unlikely it's a balancing act. And

Andrew Stotz 23:45
I have to ask another question, is the rise of, at some point, will the rise of passive investing go back to the situation where it's actually causing anomalies to then? No,

Larry Swedroe 23:57
I don't think so. Uh, MS, I guess, in theory, if you got to, you know, only five people left trading in the world, but who would those five people be the smartest five people in the world? And who are you exploiting? If you're buying which one of the other four is the dummy who sold you a mispriced stock? That's what people don't understand. If the market is gone from in my lifetime, from about the last 50 years. Call it from about 1% passive to 50. Well, who are the people, as we've talked about before, who drop out? Are these the really smart people who are generating alpha, or the people who are losing and said, I give up? It's right. It's like you're at the poker table with a bunch of average people. The smartest poker player is going to likely keep winning, keep winning, and the losers drop out. And at the end of the game, you got Edward G Robinson against Steve McQueen in The Cincinnati Kid. If you haven't seen that movie, it's a must watch. And who you can't there's no one left to exploit this. This there is no sucker at the poker table anymore.

Andrew Stotz 25:08
Bingen Addie kid, that's one of the great

Larry Swedroe 25:10
there's two great poker movies if you haven't seen that's one of them. And the other is big hand for a little lady, which nobody knows about, but is a great movie with a great cast of actors, including Henry Fonda and a bunch of carrot actors you would all recognize, I'm sure, if you're an old movie buff, a big hand for the little lady. Yes, it's a fabulous little movie. I don't want to tell you anymore, okay, so we give away the story. So we got a big hand. Absolutely great poker movie.

Andrew Stotz 25:43
That's awesome. Wait a minute, I thought the best one was the one my dad and I went to see what was it that played the song, the entertainer with Robert,

Larry Swedroe 25:51
yeah, the Oh, it's the sting this thing, right? Yeah. But that's now that was had a little bit of a poker in it. It wasn't a poker movie. Those two movies are all about poker. Yeah,

Andrew Stotz 26:08
exactly. Well, excellent on that point. Larry, I want to thank you again for joining and I'm looking forward to our next chapter, which is chapter 33 an investor's worst enemy. Hmm, who is our worst enemy? For listeners out there who want to keep up with all that Larry's doing, find him on X Twitter at Larry swedro, and also on LinkedIn. This is your worst podcast host, Andrew Stotz, saying, I will see you on the upside. You.

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future the keys to successful investing. Specifically, we're talking about Chapter 31 the uncertainty of investing. Larry, take it away.

Larry Swedroe 00:34
Yeah, thanks. Good to see you again. Andrew, so this is a very interesting topic. It was an economist named Frank Knight, who really kind of brought this to clarity. I think this issue. So Knight tried to describe the difference between risk and uncertainty. And he describes risk as something where you can either know the odds say exactly, like when you throw the dice, or if you're playing at a casino and you're able to count cards, you know, what are the odds of you getting, you know, or going bust, if you're playing 21 or drawing to that inside straight, if you're playing poker, and you know exactly what the odds are. There are other cases where you don't know the odds exactly, but there's a good science in the data that enables you to estimate them with at least a fairly high degree of certainty, like life insurance companies use actuarial tables now they can't be certain of the likelihood of a 65 year old couple that What's the odds of the second to die by the age of 90? But they can make good estimates based upon the available data. And you know now decades of data on the subject, they don't know exactly, because there could be a pandemic which causes lots of people to die early, how could that possibly happen? Or there could be scientific breakthroughs which would be good for them, which causes people to be allowed to live a lot longer, right? But they can make estimates that are fairly accurate. Same thing in the insurance business. Insurance companies, for example, can estimate the odds of a major hurricane hitting, say, Miami Beach, based on now 100 years of data, but they can't know exactly in any one year what the odds are. And the climate is changing, and it's hard to maybe make you know certainty so, but they can make good enough estimates that they believe they can price the risks with some high degree of confidence. Okay, uncertainty is when you have no clue what the odds are okay. So the problem is, most investors tend to think of investing as much more like risk. They look at 100 years of data and they say that there's no period in the US anyway, where you had negative real returns for more than 17 years, there's about a 30% chance of a negative period in any one year. We get a severe bear market about once a decade, and we've only had one great bear market, the Great Depression, where stocks dropped like 90% okay, but the problem is, there's no way to estimate that what the future will look like with that high degree of confidence, because we don't know in 73, four, nobody predicted an oil embargo. For example, we don't know in 2001 the events of 911, or 2008 the great financial crisis that happened. Or in 2020, right, we had COVID striking all World Wars, which wiped out equity markets in several major developed countries around the world. Or, if you were an investor in Russia, which was one of the largest stock markets at the turn of the 20th century, you got wiped out 17 years later. And Egypt was the fifth largest stock market in the world in 1900 and they got wiped out, never to get returns. So investors, when things are especially going well, like in the 80s and 90s, or in the last period since 2008 especially few US investors, they tend to think about investing more. Along the lines of risk, and they tend to forget that there's a lot of uncertainty. And that's a problem because investing is always about uncertainty. You have to recognize that we cannot rely on historical data to tell us that much about the future, and you certainly can't use historical returns to project the future, because today's valuations typically, certainly in the US, are much higher than they were in the past. So you shouldn't extrapolate that. So the right way to think about this as an investor is just like an insurance company. So any smart insurance company would say, Well, I can estimate the odds of major hurricane occurring in Broward County, county in Florida, but I don't want to have 100% of my portfolio betting on that risk not showing up, right? And you can't price it enough as if you know that worst event. Maybe you get three major class, five hurricanes in one year happening, even though it never happened before, right? So what do you do? You diversify that risk, and you don't put all your eggs in that one basket. You have hurricane risks all around the world, the wind risk. You add earthquake risk and event risk, cybersecurity risks, all kinds of other risks, fire insurance, etc. And so you diversify that portfolio to protect against that uncertainty, because we don't know exactly, and investors should really think about it the same way. There's always uncertainty. There's always the risk of that fat left tail showing up, especially if you're subject to sequence risk because you're in retirement or near retirement, and you don't have time for it necessary to recover, because you're withdrawing from that portfolio before the market gets to recover. So that's really the lesson. You really have to think, just like that insurance company, diversify your bets, if you will, and don't be over confident thinking that you know what the odds of some event like Nvidia stock price collapsing, because that has happened to many other companies that were the Nvidias of their day. For example, I could think, as I'm sure you can, there was once a company that dominated the cell phone industry, and Apple took care of them, and somebody may come along and take care of apple one day. We don't know. So that's really the story. Think, make sure you don't think about investing as so much along the lines of risk, but add that degree of uncertainty in your estimates. Be very humble about estimates, and that's why we've talked about this before. I'm a big believer in running Monte Carlo simulations based upon your best estimates of future returns, but we know you reason you run the Monte Carlo and not assume one return number is there is potentially very wide dispersion of outcomes. There may be only a 5% chance that that bad left tail risk occurs like occurred in 2008 but your portfolio, I'd better be able to withstand that when I was in charge of the investment strategy at Buckingham, when 2008 occurred, that occurred in 5% the bottom 5% of all our Monte Carlo simulations. So our clients should have been prepared, and not that they expected it to happen, but they knew it could happen, and their portfolios should have been able to withstand that shock.

Andrew Stotz 09:06
So Larry, I have just made up a famous quote, and I know it's famous with a certain amount of certainty, and that is so before I go to my famous New quote I have just made up. I'm going to just review what you've talked about. So you've talked about risk and risk being known outcomes, known probabilities. I like to think of them as, you know, various outcomes. And you've talked about uncertainty being unknown outcomes, or unknown probability, which we could call them surprises, maybe as an example, right? And you could say, I can't measure it, and maybe nobody can that type of thing. Now let's take an example of a pandemic as an example for someone who knows nothing about virology. You. That a pandemic may seem, you know, impossible to happen, and they may not even think about it. So for them, it would be an uncertainty. But for a virologist, they spend their whole life studying how pandemic spread. They studied every pandemic and how it went. How did it originate, how did it and they understand the decays and the accelerations and all that. So for them, it's really a risk. But for the other person, it could be an uncertainty because they just don't know. Now agree

Larry Swedroe 10:31
with that. Anne, okay, the reason is they can only make maybe even a highly uncertain estimate of the odds of an Ebola event that strikes the world and we can't come up with the cure quick enough before it kills 30% of the population. Okay? There's no way any virologist can put odds on it the way a life insurance company could put the odds on Andrew living to age 90. Okay,

Andrew Stotz 11:01
so let's, let's look at another event. Let's say an enormous eruption of a volcano, right? And I think we had one in Tonga. I believe we had a huge eruption where it can even slow down economic growth. It, you know, throws ashes in the air and all that. Now, for some people, for them, it's completely unknown. They didn't have anything. Whereas there are other people that are geologists, that are tracking movements in the earth, and they have some sort of deeper knowledge on the topic. And for them, they believe it's a risk rather than an uncertainty. But for the other What do you think about that. So

Larry Swedroe 11:41
the way I would answer that is the the earthquake scientists can say something like, there's a one in 10 chance in the next 100 years there'll be an earthquake, but they can't tell you really whether it's going to happen next year, the year after, or whatever, and that's really even their estimate is highly uncertain. Unless we've got they might be able to tell you, after they experience some minor quakes, that the odds of a big quake coming in the next month or year might go way up, because now they have more information, right? This, there's really, I think the best way to think about it is thinking about it when you know the odds exactly like a roll of a dice,

Andrew Stotz 12:33
right? You are ruining my quote. Larry, I thought I was really smart. Here's

Larry Swedroe 12:37
a way to think about it. Maybe that. Maybe this is helpful. I forgot which US Defense Secretary said this. I believe

Andrew Stotz 12:46
Rumsfeld probably about unknowns that

Larry Swedroe 12:49
we know. There are no knowns, unknown unknowns that we can figure out. What you know? We know that Russia could launch a nuclear weapon or North Korea. We nobody knows what the odds of that happening are, but we know that's a risk. Then we have the unknown, unknowns that you can't predict, that some crazy person gets a whole some virus and then goes and pollutes the water supply in New York City and kills 8 million people. There's no way anyone can tell you what those are, right? So that's the thing about investing. There's always the unknown, unknown that can show up. Nasi Nicholas Taleb, you know, famous author, you know, he wrote his book on Black Swans, and he tells the story in 2000 he was, you know, he was working for a big hedge fund, and he was charged with thinking about what things might happen and tail risk. And he writes in his first book, just he happened to say what would happen if a plane crashed into, you know, New York office towers? Well, he thought of it, right. But how many people were hedging that bet in some way? Probably no.

Andrew Stotz 14:14
And one of the things that I wanted to understand about this, let's say we know that these unknown outcomes, can be catastrophic. Yeah. So for instance, Nicholas Taleb, as an example, has I believe, a fund that's like a catastrophic risk fund, where you're paying every year, but then you get a big payoff when that catastrophe happens. Does this uncertainty mean that we should reduce our long term return by a certain amount to protect ourselves against this catastrophic loss?

Larry Swedroe 14:56
I don't think that's necessarily the case. Uh. Directionally, certainly you want to hold some assets that can perform well in those environments, but you can also add assets that have no economic cycle risk. For example, reinsurance has no economic cycle risk if you're investing in litigation, finance or drug royalties, there's no economic cycle risk. You can invest in Long, short factor strategies totally uncorrelated with the returns to stocks and bonds. So there are some strategies that enable you to reduce the risk of the portfolio, because they're not as correlated with the economic cycle risk that we're worried about, right, or hyperinflation, so don't you can own floating rate credits, and today, the private credit fund that I'm investing in, which has historically had less than 1% defaults and 70% recovery rates, and it's yielding 10% today, net. That's more than I think everyone pretty much expects from us. Stock returns going forward, if you look at capital market assumptions that Vanguard or JP Morgan and lots of other people publish, so you don't necessarily have to reduce your expected returns. You might have to take on different risks. In that case, you're taking on illiquidity risk, investing in reinsurance, and takes on different risks, but it's uncorrelated to the risk of Sox, because if we get a pandemic and lots of people die, it doesn't affect the odds of a hurricane or an earthquake occurring. So that's the way. I think investors are best served by understanding that we have these uncertain events and we need to protect that left tail risk. And the way to do that is to diversify your portfolio away from the fact that the typical, and we've talked about this before, the typical 6040, portfolio for us, investor has about 90% of the risk, not 60% of the risk in equities, because equities are much riskier than the state for bonds that people hold. So I'm a big believer in I use the term hyper diversification. You can think of other people have used the words like all weather portfolios that include things like gold and treasuries, you know that tend to perform well in some bear markets, etc, and adding then things like reinsurance and other things like it requires you to look different than the average investor. And don't care what the market's doing, meaning the S, p5, 100, because that's not your objective. You don't want to look like that, because, in my opinion, that takes on way too much systematic risk that you can diversify with.

Andrew Stotz 18:09
So my, my, my, my cute little saying was for a fool, risk may appear as uncertainty.

Larry Swedroe 18:22
Yeah, I don't know. I'm trying to figure out if I can make that work, but yeah, I think my way to think about this is investing always is about uncertainty. It's much less about risk. We can measure risk by looking at things like standard deviations and what's called skewness, or ketosis, the fat tails and how big they are, the distribution of returns, we can look at things like illiquidity and assign some prices to those things, but there's still uncertainty about what the future looks like in terms of events. Nobody knows if Kim Il Young is going to set off a nuclear weapon and start a nuclear war, or if Vladimir Putin will do it right, or the, you know, Iran gets a nuclear weapon. We just don't know,

Andrew Stotz 19:17
um, before we log off. I just wanted to ask a question on another topic. Just to get some perspective, I was reading a research paper recently where they were showing that the out performance that somebody was saying was coming from an ESG portfolio was actually confounded by the fact that once you break it down into profitability and some other factor, I can't remember large, you know, the large, whatever, it didn't really make sense large, because that means there's a premium for small stocks. I've been

Larry Swedroe 19:54
because they were invested in large, profitable companies. And. In that period that you're looking at large has outperformed for the last decade or more. So if they're claiming outperformance in that because of ESG, okay, it may what you have to look at is the factors and say, let's forget ESG. Isolate the factors and then see if the ESG tilt added. Now, what I would say about this, you could get a confounding factor, and this is exactly what happened in the earlier part of the big move to ESG, which occurred around the Paris Accords in 2015 before 2015 there was a trickle of money coming into ESG, sort of like indexing in the 70s and 80s. Okay, and I wrote about this in my book I co authored with Sam Adams. I think it's the best research book on ESG, called your complete guide to, or your essential guide to sustainable investing. And we showed this so all the ESG funds from 2015 to about 2020, were benefiting from massive cash flows into ESG was going from, you know, call it 10, 10 million a month to 5 billion a month. And so that was driving up the valuations of companies. Call them green relative to the brown stocks, or the sin stocks, okay, so you could look at that and say, well, they outperformed, but it was driving up the valuations, which means, what for future expected returns lower right? And that's basically what's happened in the last few years, as those higher returns, higher valuations have led to because the cash flows have stopped, because people, all the research shows fine, if you're willing to sacrifice returns to express your values, go ahead and do it, but the logic is clear. If you invest in ESG, you should expect lower returns for very simple reason, because if people express a preference for owning green stocks and avoiding or boycotting, say, oil companies, you don't change the oil company earnings by divesting of their stocks, you just drive their price down, and That means their future expected returns are higher what most people I'd be willing to bet. Of your listeners don't know, the highest returning asset classes have not been either healthcare or technology. It's been tobacco, alcohol and gambling, all the sin stocks because many people avoid them, and so you get a sin premium that's been known for a long time. There's even been sin funds that have been created. So I'm not saying there's anything wrong if you want to express your values and investing in ESG funds, go ahead, but you should expect low returns. In my opinion, you're better off investing for high returns and and donating those higher expected returns to some ESG cause you believe in, and then you'll get a direct impact there.

Andrew Stotz 23:32
Yeah, in fact, the outcome of this research said we find that the materiality portfolio does not generate alpha after we account for its exposure to profitability and growth factors. So there you go. It's the confounding factors so interesting. Yeah,

Larry Swedroe 23:47
my book cited probably a dozen papers on this subject, all of which came to the same conclusions that the dominant issue is twofold. One, preferences lead to higher valuations and lower expected returns, and to the other factors are what explain those all else equal returns? That's

Andrew Stotz 24:12
your essential guide to sustainable investing, how to live your values and achieve your financial goals with ESG Sri in impact investing by Larry, of course, and Samuel Adams, published in 2022 great reviews on that one. And I haven't read it, but I look forward to it. Well,

Larry Swedroe 24:32
probably cites 100 academic papers on the subjects.

Andrew Stotz 24:36
I'm looking forward to that. Now, before we wrap up, I just want to end with a little story. And this is going to be short, but let me just get my little story up here. Larry, one second. Now, there's a great movie that came out many years ago, and it's called Dumb and Dumber, came out in 1994 and it was Jim Carrey, was the one that you know was you. Phenomenal in that movie. Anyways, what's happening is that his character, Lloyd, Christmas is his name, asks Mary Swanson what the chances are of the true of them ending up together. He's in love, and she's not so in love with him. And so he she replies, not good, and he asks, like, one out of 100 and she replies more, like one out of a million. And he gets all excited, and he looks at her, and he says, So you're telling me there's a chance. So there you go. He believes that there's a chance, and she seems to be saying there is no chance. That's

Larry Swedroe 25:53
what investors really should take. That advice when they build portfolios, be very humble and don't think, oh, there's no chance of this left tail showing up. All forecasters know that you really need to be humble. I was one of the first this is a little amusing tale. When I my one of my first jobs was at Citicorp, giving advice to some of the largest companies in the world are managing interest rate risk, foreign exchange risk, etc. And my mentor told me so Larry, if you have to give a forecast, remember, you can give a number, but never a date, or you can give a date but never a number.

Andrew Stotz 26:40
That's that he is the master. There you go. Perfect. Well, I want to thank you for this great discussion. Lots of interesting stuff, including the tidbit about your book, which I didn't even know you had that book. You just books come out of nowhere with you, Larry crazy, you are incredibly productive, and I look forward to the next section. We are now moving into Part Four of the book, the final part, where we're going to go through and wrap up some final sections, and then we're going to talk about, you know, some portfolio structures that you've talked about in the book. So this next section is called playing the winners game in life. And chapter 32 is what we're going to next the $20 bill. Hmm, just sitting there right on the floor. For listeners out there who want to keep up with all Larry's doing, go to x or Twitter, and you can find him at Larry swedro. And also you can find him on LinkedIn. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future the keys to successful investing. Specifically, we are looking at chapter 30, the economically irrational investor preference for dividend paying stocks. Larry, take it away. Yeah,

Larry Swedroe 00:36
this is one of my favorite chapters, because it deals with, I think, one of the great anomalies, which is that, despite an overwhelming body of evidence, a lot of investors have a preference for dividends. Even though there's no economic theory to support it, there's no data to support it. And when you show the people the evidence and the data they have a confirmation bias, and ignore anything that you show them that doesn't agree with their preconceived notions. It's simply incredible to me that people can just ignore, you know, all the theory and the evidence because it doesn't happen to agree with their preconceived notions. So it's been long known for that, for behavioral reasons, people have a preference for dividends, even though it is completely illogical and easy to show. In fact, you're an academic, you teach classes, you know, one of the favorite activities of professors is writing papers that disprove what somebody else had written, right? Okay, so in 1961 Merton Miller and Franco Modigliani wrote a famous paper called dividend policy growth and valuation of shares, in which they showed empirically that dividend policy should be irrelevant to stock returns. That was now 64 years ago, and not a single paper has been written that shows anything but that no one has refuted it, and yet we get it. And it's easy to show people, as I describe in the book, because unless you think $1 is not worth $1 then you have to understand dividends are irrelevant. And it's easy to show. So I give an example. Let's say you have a stock that's worth say it's got $10 book value, okay? And it's trading at a at at $10 so it's trading at one times its book, and you have another company that's exactly the same, also as a $10 book, and trading at 10, both companies earn $1 a share, okay, If at the end of the year that one has paid a dividend. What has happened an investor, say, at 100 shares times 10, said $1,000 okay, the stock is still trading at 10 because it's trading at one time book, and therefore it's still worth 1000 but they got $100 in cash before taxes. Of course, in the US, many other countries, you have to pay taxes on those dividends. Okay? Now you have another company that earns the same dollar, but it chooses not to pay a dividend. So now it's trading at $11 or one time book, and you have the same $1,100 before taxes, but since you didn't receive any dividend, certainly for a taxable investor, you're ahead, and if you don't need the cash to live on, you're clearly better off not doing that. In addition to which, if you don't need the cash, okay, the company now has more capital which it can reinvest, and therefore should be able to grow earnings faster than the company that paid the dividend, as long as it earns its you know, cost the capital, so you're ahead from that perspective. Now, despite that simple logic that even if you needed the dividend, you could sell 100 Dollars worth of the stock at $11 so you don't even have to sell 10 shares. You sell nine, you know, point, oh, nine or whatever, and you end up at the same place. But for the taxable investor, okay, you're ahead because you have a your pay a tax only on the portion that's the gain, not the entire amount of the dividend. And so therefore you're ahead that way. And yet, despite that simple logic and simple math of this example, you have people who think that there's companies that pay dividends have like what's called Magic pants. You could take the dollar dividend out of one pocket, put it back in another, and think you're worth more, but it can't be. Your company's stock has to be worth less after the dividend is payment, unless you think $1 isn't worth $1

Andrew Stotz 06:05
simple. So there's, there's a bunch of different angles. I want to tell you a story about a Parliamentary Debate many years ago in Thailand, and they were grilling the finance minister for not distributing enough of the dividends from the state owned oil and gas company, and they said that, you know, you're disadvantaging the treasury of the country by not paying out more dividends. Now, where it became very interesting was nobody discussed on the floor of the parliament that the company was making a return on invested capital of 40% with a cost of capital, let's just say, let's just say 10% right? So they were creating value of 30% now you could have another argument saying they should lower the prices to the consumers, you know, to the to the population, but let's just put that argument aside and just say so here's a situation where, if they took the money out, and at the time, deposit rates were about 1% so they wanted to get the money out of the company and into the deposits, you know, of the finance ministry, and say that that would be better off for the population. What's wrong with that?

Larry Swedroe 07:20
Larry, well, it's pretty simple, if they needed cash flow, which is possible, the government could have sold some of their shares enough to generate whatever dividend they wanted to receive. Investors always have the option of creating a self dividend if they need it. So effectively, this is really important for people to understand when a company pays a dividend, and people don't think of it this way, but this is exactly what's happened. They're forcing you, as an investor, whether you like it or not, to disinvest and sell equity, if you will, in the company. Now you still have the same number of shares, so people don't think of it that way, but the company is worth less, or you have disinvested from that company when you may not want to do it. Now you can replicate that or undo it by dividend reinvestment, which a lot of people automatically do, but you still have to pay taxes on the dividend you receive, which makes it dumb from that perspective. So companies really have a choice. They could keep the cash and grow it. You know, if their return on capital is higher than the cost of capital, that's the logical thing. They could pay a distribution out. If they're unable to earn their return on capital, or if they believe their stock is really undervalued, then they could buy back the shares, and in effect, pay a dividend that way, by driving the price up, and if you need the cash flow right, then you could sell a few shares, putting you right back where you are. It really makes no economic sense to pay a dividend unless you're not earning your cost of capital.

Andrew Stotz 09:22
And it gets really clear when you look at this excessive level of value creation, right, where we're talking about 40% return on capital versus a 10% let's say cost of capital, where from, just from a pure business perspective, you want to have as much money in that company as possible to invest at that 40% rate until it starts to come down. And even if it came down to 30% use deal, even though additional investments have a lower value creation, the value creation is still huge. And so from a company perspective, you. Ultimately, they would never want to take any money out of that if you want to keep that compounding and growing. Would I be right in saying that absolutely

Larry Swedroe 10:08
in fact, while Microsoft investors have done great since they've started paying dividends, they've been worse off than if the company had used it either to buy back their stock, right, or reinvested in the company if they didn't have enough good uses, right? So either way, they would have been better off, because the company has continued to out earn it's cost the capital. Why do you think Warren Buffett has never paid a dividend from Berkshire Hathaway, because he referenced felt investors were better off by him keeping it and he's out earned this cost of capital. Now, there is one thing that we should know, or let's there are two points that we should make: if dividends or an indicator or an explanatory variable of equity returns, then it might make sense to own dividends. However, we have many models that have been developed as we've talked over the time we've been having our discussions, the first model of asset pricing theory was the CAPM, and the single factor was market beta, so that, of course, said, dividends don't matter. There's no dividend in the model. The second model was the farmer friends, three factor model, which was size and book to market again, dividends didn't matter. Then we added momentum, and we still don't have dividend. And then we added profitability and cash flow. And there are other factors that people have used hundreds and not one of them is dividends. Now if you look at value, dividends could be used to determine value in the sense that you get a high dividend yielding stock is a value company, and a low dividend yielding stock would be a growth company. You could use that metric. It turns out that there is a slight premium there, but it is by far the worst of all the value metrics you could use. So price to cash flow, price to earnings, price to book value, EBITDA, enterprise value, are much better explanatory models, so that should tell you again, dividends, dividends don't matter. All else equal. Now, the last thing I will say is this, that dividends can be used as signals by companies to shareholders. So companies, you know, increase their dividend, because we know companies hate to cut dividends because it sends the wrong signal about the future of the company. They're at risk in bankruptcy or whatever. So if they raise the dividend, they have to be highly confident they won't have to cut it in the future. So that could be a positive signal. But it turns out that companies with increasing dividends don't outperform companies with similar metrics of price to cash flow or other other metrics that matter. So even there, it may be a signal that it's a relatively safer investment, but that should tell you it's a lower expected returning, not higher expected returning investments.

Andrew Stotz 13:44
And I have, I have two last questions. The first one is, imagine, you know, in a case, that you are the sole owner of a company, and let's imagine, for the sake of argument, that it's listed in the stock market, which can't really be, but let's just say that there's a market price set every day for your company, and and you decide that you want to, let's say, take cash out of the company. You can do a dividend, or you can sell your shares, let's say, and let's say you're willing to sell it to somebody, and they'll come in as a new shareholder, as an example. But the point is, is that let's now factor in that. Let's say you've got a 40% return on invested capital and a cost of capital 10% when you take that $1 out of the business, the price of the company is going to fall by $1 right? You're going to receive $1 and let's just say you're going to put it in, you know, three, 3% bank deposit, right? You've just, you yourself, individually, has just missed a huge opportunity, because that dollar in your account, your bank account, versus that dollar in the company, is. Just two worlds apart,

Larry Swedroe 15:01
so in terms of expected, but not guaranteed, return, correct? And then you haven't even considered tax implications,

Andrew Stotz 15:08
yeah, let's say forget tax for some I'm simplifying it. As for the simple minded guys like me and we do live in a

Larry Swedroe 15:15
world where most people pay taxes on dividends, right?

Andrew Stotz 15:19
Well, let, let's just say that the tax rate is equal for dividends and capital gains for right now and but

Larry Swedroe 15:24
even if you assume that, yeah, so let's say, in your example, the person takes a million dollars out in dividends, they pay a tax on the million dollars. Now let's say they take it out by selling shares. Okay, let's say the shares were trading at $10 a share when they bought it or made the initial investment. Their cost basis was $5 a share. Now, when you take the million dollars out, you're only paying tax on half a million dollars, which is the gain. So depending upon their cost basis, you're clearly you can't be better off with the dividend, and you could be much worse off. Imagine an investor, okay, who is sitting with a loss on their stock and says to himself, I don't want to sell my stock. It's at a loss, okay? But he takes the dividend, and now he's paying tax in the US, you know, pay the tax on that dividend when he could have, in theory, let's say, not taken the dividend, okay, and sold shares, he would get a tax loss, not pay any, get tax at all. Right, so why would you prefer to own the company that's paying the dividend? There's no logic to it, none.

Andrew Stotz 16:56
And let me just ask one last question about that, and that is when you take that dollar out. And again, we all know that, that, you know nothing is guaranteed. But what you can see is that highly profitable companies tend to remain above average from what I've my testing. So let's say that this company

Larry Swedroe 17:16
some period of period of time we talked about this, that companies that grow their earnings abnormally above the average tend to that rate of abnormal growth tends to revert to the mean at 40% per annum, so they tend not to keep going. And the best testament to that are companies like Kodak and Polaroid digital equipment. And we could go on and on and on, but yes, over the short term, profitability is persistent, but at lower and lower rates,

Andrew Stotz 17:52
and we know in, let's say, a discounted cash flow type of valuation, the earlier periods have a huge, you know, impact. So let's just imagine that, you know, this business can continue on at a very high level of value creation for the next 10 years. And so let's assume that now, when I've taken that dollar out of that business myself, I've missed a huge opportunity for that dollar, right? And so my question is, did I decrease the value of my business by $1 or did I decrease the value of my business by $1 with the potential? Because when we're valuing it, we are expecting this relatively high level of return. So am I taking out $1 or am I taking out $3 with that present

Larry Swedroe 18:43
present value, depending on what you do with it, because you could put the money and buy back the stock, in which case you would be out only the tax differential, and then you could present value that right? But your answer is in if you earn higher returns and put the money in your bank account or spend it, then you've given up way more than the present value of $1 because your cost of capital is below your return on so

Andrew Stotz 19:14
let's now go into the open markets. We see companies buying back shares all the time, and people see it as really good news. It's going to reduce the number of shares. You're going to have a slightly higher percentage ownership in the future. But if it's a very high returning company, is it really $1 comes out of that company and the share price falls by $1 all they've missed is $1

Larry Swedroe 19:42
Well, you got to remember that depends on what they would have done with the dollar. They have to think the stock is undervalued. Otherwise they'd be better off keeping the cash and reinvesting in the business. So they would be make management is making a judgment. That the stock is undervalued, or we can't use all of our capital and get a 40% return. There are only certain investments. Let's say we've got, you know, a trillion dollars in cash, like Apple might have or something, but in this case, they can only put 500 billion to work, and the rest investments would get a lower return than the cost of capital, then they would be better off buying their stock back

Andrew Stotz 20:27
and again, going back to this somewhat persistence of value, making additional value in the company. And now let's now look at another company that's earning for the next 10 years the cost of capital. That's fine. You know, it's not bad, because you've cost of capital has the risk, risk factored into it, but one's got the cost of capital. I can see if you're earning the cost of capital that you take $1 out, it's worth $1 but it's harder for me to see that $1 coming out of a highly profitable company is $1 No,

Larry Swedroe 21:03
it's not in present value. It's in terms of expectations. It's worth more. So it would not make sense. That is why Nvidia and Apple and Microsoft either pay no or very low dividends. So there's a trade off. No, they're increasing shareholder value by retaining that capital.

Andrew Stotz 21:24
So there's a trade off between the fraction that you own in the company rising because of the number of shares falling and the value creation that the company's missing by that money not being in the company at

Larry Swedroe 21:39
the pens again, because then let's say you're only able. In that example, let's say you're apple and you got a trillion of excess cash, you may not be able to invest a trillion at above your account. Which, which? We only, there's only a certain amount of investments, understanding that we'll meet that criteria. Companies always face that decision, right? What's my cost of capital and does that investment exceed that cost of capital? If it doesn't, then I should probably not make it.

Andrew Stotz 22:13
So does this imply that there, when highly profitable companies do share buybacks, their share prices should go down.

Larry Swedroe 22:21
No again we you have to the question management, hopefully is looked at the analysis and said, We're better off buying the shares than to keep that extra cash right, because we have put our cash available in all the investments that we think, on a risk adjusted basis, exceed our cost of capital, this other cash, we're better off. We think our stock is undervalued, and we'll buy that stock back.

Andrew Stotz 22:52
Yeah, and this isn't, this chapter is not really about buybacks, but you as you say, there's another factor, and that's what's the share price. You know, the share price is super low and the returns are super high. Yes, makes sense. One last thing on this topic. That's my last question, I promise. And then you'll get on with your rest of your evening. If the market, if investors are truly irrational in their preference for dividend, how can we as rational investors capitalize on that or take advantage of that? There's

Larry Swedroe 23:25
a there's a paper, I think it's a brand new one. I just read. It might have been somebody sent it to me or whatever, but showing that, at least before costs, let's say, let's take the high frequency traders can clearly exploit it, and because they show that stock prices tend to rise in the month before they pay the dividend, because dumb retail investors overvalue dividends, and then they tend to revert back after the dividend gets paid. So if your costs are very small and trading and you can front run the dumb retail money, you might be able to do that. I don't

Andrew Stotz 24:13
know if at home before they're buying it, before the dividends announced. Yeah, no, they

Larry Swedroe 24:18
know it's coming, but you know, let's say it's expected, but let's say the dividend is paid on March 30, that and they know from history. I'm just now making this up because they didn't read the whole paper in detail. I just read the summary of it, the abstract and the summary. Let's say the dividend retail investors start buying two weeks before a lot of stock brokers tell people what a great strategy. We're going to capture five dividends in just a little over a year. So we'll buy the stock so the high frequency traders come in, say on March 13, buying, knowing dumb retail money. Comes in on March 15, they push the stock up, and then on March 29, or 30th, they sell and push the stock right back down to where it was before. Now again, I don't know if it holds up after, but it certainly tells you you shouldn't buy a dividend paying stock in the month it's about to pay a dividend. You'd be better off Owning the market for that 30 day period.

Andrew Stotz 25:28
Well, I want to thank you, Larry, for this discussion, and we went into a lot of interesting stuff. I know it's valuable, and I'm looking forward to the next chapter. And the next chapter is chapter 31 the uncertainty of investing, where you talk about risk and the difference between risk and uncertainty. For listeners out there who want to keep up with all Larry's doing, follow him on X Twitter at Larry swedro, and you can also find him on LinkedIn. This is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside you.

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was at a research at Buckingham wealth partners. You can learn more about his story in episode 645, now Larry stands out because he bridges both the academic research world and practical investing. And today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically we'll be talking about chapter 28 which is called buy, hold or sell, and the endowment effect. Larry, take it away. Yeah.

Larry Swedroe 00:33
So I actually wrote a book which we started, I think we went through the first half of it, called investment mistakes even smart people make. I think we covered about 40 of the 77 this chapter talks a lot of about what drives investor behavior and the mistakes that we make. And I use a story or an example from Maya statmans work. Mario stattman is one of the leaders in the field of behavioral finance, which is the study of human behavior and how our behaviors in normal life lead to mistakes investing like we tend to be over confident, as we talked about lots of things. So why shouldn't we expect people to be overconfident about their investment skills? So here's what he had to say in his book, what Investors Really Want. He was explaining that investors want more from their investments than just returns. So he says, investments are like jobs and their benefits extend beyond money. Investments Express parts of our identity, whether that's a trader or gold accumulator or a fan of hedge funds. We may not admit it, and we may not even know what he says, but our actions show that we are willing to pay money for the investment game and and the money is paid for trading commission, mutual fund fees and software that promise to tell us where the stock market is heading. He says, some hedge funds for the and we buy them for the same reasons we buy Rolexes or carry a Gucci bag with their oversized logo, their expressions of status available only to the wealthy hedge funds, he says, offer expressive benefits of status and sophistication and the emotional benefits of pride and respect, those expressive benefits, he notes explain why Bernie Madoff was so successful and so that it's people invest because they want to be a member of the club. When Groucho Marx advice was the right one, I wouldn't join a club that would ever have me as a member. The Bernie Madoff example is a great one. Anyone who did due diligence, in fact, people who had done due diligence on Bernie Madoff even went and reported to the SEC that this had to be a fraud. There was no way. There weren't even enough contracts available to execute what he said, what was being done. And that strategy eventually had to blow up anyway, and the SEC sat there and did nothing for whatever reasons. So that's an example he talks about, and we've talked about the need to believe that we're better than average, when, of course, only half people can be better than average. But doctors, for example, and lawyers, they think, because they're intelligent, that they're better than average. Investors. So my example to them is, well, I graduated top of my class at one of the better MBA programs in the country. Would you let me defend your client in a lawsuit, or would you let me operate on your patient for doing brain surgery? Well, there's a difference between intelligent knowledge and what knowledge do you have that allows you to think that you're not the sucker at the poker table. When you're playing against Warren Buffett and Renaissance technology, you're not playing a game like where your competition is even somewhat sophisticated investors like you and I. You're playing against pros, you know, who have decades of experience, access to the best databases, etc. So there are lots of other mistakes how we frame problems we talk about in the chapter, but these are mistakes that we make simply because we're human beings, and I'll just close. With this the framing the problem. I love this example. He frames a problem like a game of tennis, where you go in your against a practice backboard, and you hit and the ball is bouncing right back to you, and you can hit the strokes and look good. And then you get on the court with the tennis pro, and you know he's just going to crush you if you just get the ball back. And we that lawyers tend to think of investing like hitting the ball against the backboard when you're really playing, you know, against the best players in the world. So you're competing against Carlos Alvarez, not against the backboard. And so who's the sucker at that poker table? Right? It's you, only you don't know it or want to admit it.

Andrew Stotz 05:49
And the word endowment is an interesting one, because it's also, when I think about endowment, I think also about, there's another word, like inheritance, you know, but the one of the questions I would like to ask about this is, how do we separate, let's separate the endowment effect, that was something that has, like, a sentimental value. Let's say, you know, you've talked about different sentimental value possibilities, like, for instance, these are stocks of my company as an example. Or my father, you know, gave me these stocks, and you know, there's a sentimental portion of that. But then you also talk about, just simply, you talked about the wine and how, you know, you buy it at a certain price, and, okay, there's not a sentimental value there. There's just a price, uh, anchoring that's happening. So how do we think about, let's just think now. Let's put that, forget about the sentimental value one for a moment. And let's imagine that, you know, someone's owning a fund, an ETF, maybe a stock. It's gone from 10 to, you know, 50 or 100 and how are they going to let go of the 10 that they bought it for and their connection with it so that they can make the right decision with it going forward.

Larry Swedroe 07:03
Well, there's a lot of things that go on this. This, what's called the house money effect. It's the people in Las Vegas who run the casinos know that when people get ahead, they tend to keep playing, because it's the houses money. And the longer you play, you're putting the odds more and more in favor of the house, because you can get lucky in the short term, but in the long term, the laws of large numbers work against it. You know, you can win a game playing for an hour where you've got the odds of 52 to 48 against you. You can get a string of lucky numbers. You play it for 10 days straight, you're going to walk away with nothing likely, right? Although one out of 100 people might get lucky for a few days, right? So the same thing happens with stocks. I had a friend who would had bought some stock of a company. It was like Qualcomm, and it was like $20 and it went up to 100 and I said, you know, why don't you sell some what could go wrong? I only paid 20 for it. They said, that's no every day you own the stock, you're making the decision to buy it because you could sell it. So the simple way to avoid that endowment effect, or the house money effect, in this case, is ask yourself, would you buy the stock at 100 or in his case, maybe put 10% of his assets in and now it's 50% of his assets. Would you put 50% of your assets in the one stock? And the answer would clearly be No, but the house money effect comes into play. That's a really good way to think about it. Is to ask the question, if I didn't own it. What would I pay for it? And that's what I explained to people, and we use that wine example, and they're just for the benefit of your listeners. Let's say you bought a case of wine, put it away, and you pay $20 a bottle, and five years later, you go to drink it, you find out it's worth $500 a bottle. And most people when asked about that so, well, what would you do with the case? Most people say, Well, I'll put away a couple of bottles and drink it and then go sell the rest. Well, if you wouldn't pay $500 a bottle, you shouldn't drink it. You should sell it and go buy yourself a nice $30 bottle of wine now, right? Because you wouldn't pay 500 right? It's what is it worth today? Well, the same thing should be true of stocks, yep.

Andrew Stotz 09:55
And I like to tell people when they ask me about advice. You. And I generally tell them, Don't ask me about relationship advice, because I've never been married. But I can tell you that I can give you one question about your relationship, and that is simple, knowing what you know now about your girlfriend or boyfriend, which you didn't know when you first connected. Now you know, after a year of being together. If that person walked up to you and you didn't have a relationship, would you start it today? And the answer that needs to be yes or no, and if it's yes, then you need to get back into the relationship and fix the problems that you're talking about. And if it's no, then you know you've got your answer. And so same type of thing at the end of this chapter, you threw in some kind of tidbits, some nuggets. You said that you were talking about capital gains, and you mentioned about donating or setting up charitable trusts. I just curious what, what do you what is the rules around that? Yeah, so

Larry Swedroe 10:55
in the US, anyway, okay, when you own stock and you have a large gain if you go to sell it, okay? To help diversify, you would have to pay a large capital gains tax. Okay, currently, let's say it's 23% and then you might have to pay estate tax. In California, that could be 13 that's a big chunk of your money. So let's say you're a wealthy individual, and you're donating, say, $100,000 a year to a charity, and let's say at a million dollar gain in that stock, you could donate all the shares to a charitable trust, which would then be required under the law to give away, say, 5% of that trust every year, and that trust, because it's a charity, would not pay any taxes at all. So if you're going to give away 100,000 a year anyway, why not take the stock, put it in a trust, and now you avoided the taxes? A lot of people might do that if they're trying to pass value on to their family values onto their children, and set up a trust and say, I'm putting this stock in there, and then we can sell it, because the trust is a travel foundation that's not taxable, and you can use that money in there every year to make your charitable donations, and you're forced to, under the law, to distribute, I believe it's like 5% a year, so it can't sit there forever. And then you're passing on your values. You're forcing them to make decisions about which charities to use might help keep the family together as well, because you can say each of the kids gets a vote who they want the money to go to, and you have diversified those Veer, and they're going to give money to charity anyway. So now it's now your money they're giving, not their own, and they can allow their own investments to grow. And

Andrew Stotz 12:59
the tax benefit is there because the family members in this case, are not the beneficiaries. It's the charities that they're giving the money to. Exactly, okay, but they

Larry Swedroe 13:10
are a beneficiary because they hopefully would have been giving money to charity anyway, and now it's coming out of the trust, and their assets can continue to grow. Yep,

Andrew Stotz 13:21
excellent. That's good little advice. Well, I want to thank you again for another great discussion, and I look forward to the next chapter. And the next chapter is chapter 29 which is the drivers of investor behavior. And for listeners out there. We want to keep up with Larry and all that he's doing. You can find him on x at Larry swedro, and also on LinkedIn. He's out there, always putting out great stuff. So this is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now, Larry stands out because he bridges both the academic research world and practical investing. And today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And we're going to be talking about chapter 27 which is Pascal's Wager, the making of prudent decisions. But before we do some of you may say, Well, who is this dude? Pascal. Let me tell you. Blaise Pascal was born in 1623, he was a brilliant mathematician, physicist and philosopher, and by the age of 19, he had invented one of the world's first mechanical calculators. His work in mathematics helped shape probability theory, which is now the foundation of modern statistics and risk analysis in the world of finance and in physics, he discovered Pascal's law, which explains how pressure is transmitted through fluids, something still used in hydraulic systems today. Later in life, he turned to philosophy and religion, and we're going to be talking briefly about that. And he wrote the Ponce, a collection of thoughts about faith and reason. But what I liked was Pascal was also known for his wit and clarity in writing. In one of his letters, he famously apologized for writing a long message saying I didn't have time to make it shorter, his words remind us that simplicity often takes the most amount of effort. Larry, take it away. Yeah,

Larry Swedroe 01:47
thanks. And I in my own writing, I'll often just sit down to write, get the thoughts out, and then I focus on making it shorter. What words can I take out without negatively impacting the piece. So I'm following his advice. It does. It is harder to write shorter.

Andrew Stotz 02:06
Yeah, and that's what you're doing in so many of the posts that I see of what you're writing in your articles is that you're trying to take a very complex, you know, situation and bring it down to something that people can understand. So you definitely have that in action.

Larry Swedroe 02:19
Well, thank you. So Blais Cal Pascal posed this interesting question which will not will relate to financial theory, financial management, etc, but we need this story or analogy to help people understand the financial side of the picture. So Pascal asked the question, how should you act when we cannot prove or disprove if God exists, it's a belief one way or the other. You can't prove there is a God, and you can't prove there isn't one. So how should you act? So Pascal put it this way. He said, If a Supreme Being doesn't exist, then all the devout has lost is the opportunity to fornicate, imbibe and skip a lot of adult church services. But if God does exist, then the atheist rose in hell for eternity, at least if you believe, as the Catholics do so that what he's really telling people here, and this is what relates to finance and financial planning in general, is it's the consequences of your actions that matter far more than whatever you Think the probabilities of the outcomes might be so great example is how we think about buying life insurance. So let's imagine you're an average 28 year old. You got married a few years ago, have your first child, and you have to decide whether you should have life insurance or not. Well, if you buy the life insurance, you know with a very high degree of certainty for the next 40 years, you're going to be paying away a premium to the life insurance company and foregoing their earnings that you could get by taking that money investing in the stock market and maybe get a seven to 10% per annum return over the next 40 years. Yet, most people buy the insurance because the consequences of their being wrong, and they happen to be unlucky enough to die, either through some accident or some disease that wasn't forecasted for them, then their wife and children may be living in poverty and they that's just a consequence that's not acceptable. And then you can relate the same thing with people buying long term care insurance or disability insurance or homeowners. Insurance to protect you against a fire if you happen to live in LA or a hurricane, if you happen to live in Florida, or a monsoon, if you happen to live in Thailand, all right, so we think about what's the cost of the left tail outcome happening? And if it's greater than you could bear, that's why insurance markets are created. I'll give one last example, which is one of the biggest mistakes that investors make. I find but work for a company and own their company stock, especially senior executives. In some cases they're even expected to own large shares, but they're often incented. Employees are given sometimes a 10% discount to buy the stock, and they end up with very large positions more than I think no one should own more than about 10% of their net worth in any individual security, because you're taking idiosyncratic risk, and your company could turn out to be the next Enron or the next hertz or the next digital equipment or Kodak or Polaroid, all one's great is

Speaker 1 06:15
that why they call It idiot Synchron What did you call it

Larry Swedroe 06:20
idiosyncratic? Yeah, idiot, syncretic risk. That's very clever anyway. So you know, no matter how much you think a company is likely to do great and you're a senior executive of the company, I think we may have talked about the case. There was once an executive I met in the late 90s. Worked at Intel, and he had about a $13 million net worth. Almost all of it was an Intel stock. And I pointed out to him the examples of once great companies that no longer even existed virtually or stock prices had crashed over 90% like Polaroid and Kodak and digital equipment and Data General and Oxford computing, which was the first lap, you know, carryable computer, I mean, mass, great innovators, and they were gone, right? And yet he was absolutely convinced. So nothing go wrong. And by the way, if it did, he would know before it happened. And the stock, which was trading at the time at 60, within a matter of months, was down to like 10, and went even a bit lower, and has never recovered, you know. And now we're almost 30 years later, and yet, you know, the cost of his being wrong meant he would still be okay. So he had 3 million instead of 13 or something like that, but his life would have been a lot better, and he would have been able to leave a nice, big estate for his children as well. It just made no sense, because doubling his 13 to 26 which might have happened if Intel did great wouldn't have changed his life in any way close to the magnitude of the negative impact of going from 13 down to three. So that's another example where of teaching Pascal's Wager and understanding the consequences of the decision should dramatically overweight, whatever you think the odds of that event happening.

Andrew Stotz 08:25
And I just had our monthly meeting at my coffee business, coffee works in Bangkok, where I went through our monthly results, which we do at the end of each month or middle of the following month. And we had a discussion about our risks. You know that we see outstanding in the business, and we looked at the probability of those risks happening, in the severity of those risks, and then we apply a score, and we have a discussion about it, and debate the score, the score there, but it's a type of thing that we're pretty used to doing, let's say, in the corporate world. But when it comes to, you know, investing, people seem to put it all aside. I Why do you think that people just kind of put it aside when they're thinking about investing, whereas they'll go to their office and apply that risk management structure in their business or in the company that they work for? Why do they just throw it away? Yeah,

Larry Swedroe 09:17
I would suggest the likelihood is overconfidence. Number one, they think they can forecast what's going to happen better, like that Intel executive, or it's not going to happen to me, that only happens to other people, or it's so unlikely that I don't have to consider the event. And unfortunately, we have events. We've had two of them in the US recently of airplane crashes, which is the safest by far a form of transportation in the United States, you're more likely to die walking across the street in Manhattan and getting hit by a car than by dying in a plane crash. And yet, hopefully, the. People who needed life insurance, you know, and passed away, and those tragic events happened to have it and then weren't overconfident about their likelihood of not having such event.

Andrew Stotz 10:14
I thought about what you said, about how you know, it's kind of like Every dog has its day. Every stock, every big stock, eventually comes down at some point. But you know, I was doing some research, talking to my students in one of my classes about building a business that has longevity, and you find that there's a very small number of companies in this world that do have longevity, which is just you could never predict it at the time. For instance, Procter and Gamble was founded in 1837 and that means it's been in existence for 187 years, and it's been listed in the stock market for 134 so don't think that your stock selection wisdom is so great that you're going to pick the next Proctor and Gamble or Exxon Mobil, that's been in existence in one former number from Standard Oil since 918 70 right, and has been listed for 104 years. Or how about the really obscure company, Northwest natural holding, which is a utility company, which was founded in 1859 and is now 165 years old and 54 years listed on the stock market. So just because we do have some long lasting companies doesn't mean that the ones you picked are going to be long lasting. Well,

Larry Swedroe 11:30
I think we've discussed this before a couple of times, only 4% of all the stocks on the US stock exchanges account for 100% of the equity risk premium. That's because most companies eventually disappear. You know, there's only one company that was in the original Dow Jones that still even exists. Yeah, it's

Andrew Stotz 11:56
incredible. I mean, it's an important point when you're thinking about not only building a portfolio, but building a company. You know, what does it mean to build a company? To last also, you mentioned in this chapter two

Larry Swedroe 12:07
other issues that I discuss in the book related to Pascal's Wager. And this is, should you buy? At least in the US? I don't know in other countries, you may not always have that opportunity, but is available in some whether you buy a nominal interest rate bond, like a US Treasury, or you buy what's called a treasury inflation protected security, or tips, so you're guaranteed to earn the inflation rate plus a rate or a real rate of return. Well, you know, that's a question, what if inflation looks like it did in, you know, Germany in the 1920s or ends up looking like Argentina in the last century, many times over, or Brazil today, right? So you could say, well, I'm getting a higher nominal yield by buying the nominal bond, or I'm even getting a higher expected return, based upon your view of inflation. But what's the cost of that? You might be wrong. In other words, people should be willing to give up some thing, even of significance in terms of the expected return to protect against that last that terrorist. And the other example is this issue, should you invest in active or passively managed funds? Well, the odds are so great, only roughly 2% today of active managers outperform and when they do this, few percent that do outperform tend to outperform by a little bit much less than the ones that underperform underperform by so you have to think about what's the cost of being wrong versus giving up on that hope, or The ability to brag how you pick the best performing stock. I think Pascal's Wager gives you the right way to think about the answer. And then, by the way, you get to enjoy your life much more, because you don't have to look at the stock market, try to pick stocks, follow companies, and waste all that time doing it when it's highly likely to prove unproductive, actually counterproductive. Anyway. Actually,

Andrew Stotz 14:25
it's an interesting one about the tips, because one of the things many countries do not have tips or but what's interesting is I'm going to share my screen and just show some statistics that I look at, and just hold on one second. So here's some statistics. I actually calculate a world inflation, and I do that by taking the inflation rate of all the countries in the world that have consistent inflation data, and then GDP weighted right weighted by the size of the. That economy. And then I hear in this chart show it compared to the US. And what you can see is that even though your country may not have a tips bond buying a US, tips bond may actually perform a portion of the function, because inflation globally tends to track inflation in the US or vice versa. Do you have any thoughts on that?

Larry Swedroe 15:24
Yeah, you know, it's probably at least worth considering depending upon the country, although never treat the unlikely as impossible. If I lived in Switzerland, I'd worry a lot less about it. But you know, if you live in Thailand, you know, the odds are, you know, favor much more likely that if there's an inflation problem, it would be more likely to happen in Thailand, which would weaken their currency, and therefore you would get that benefit, and you would get a real return in the US market, and if US inflation turned out to be high, well at least you'd have the inflation rate going up, which should offset, in theory, the dollar depreciation. So I think that's at least worth considering in most countries, especially where you have that currency risk because the balance of payments problems, profligate governments, historical devaluations of their currencies, like Argentina or Brazil, those kind of countries, just keep our repeat offenders. So I would never have faith in those countries ability control and fight at least you want to make sure that you are protected or have that insurance.

Andrew Stotz 16:45
Yeah. Well, this is a great discussion. I appreciate it particularly. You know, thinking about, you could say, extreme outcomes and helping, helping us all to think that we need to protect against extreme outcomes, and we also need to have avoid overconfidence and thinking those extreme outcomes aren't going to happen to us and for for the for the listeners and the viewers, I also want to, you know, highlight that when you're writing, stop and rewrite and print it out. Look at it. You know, my father always said, Write what you want to write, then print it out and read it, and then rewrite it, and then rewrite it. And I do that pretty much religiously on every single thing I write. And it's shocking how comfortable I am with what I wrote the first time. But when I print it out and I read it as the reader, I'm like, Ah, there's so much I gotta fix here. And I don't know you go through that process, or how is your possibility 100%

Larry Swedroe 17:41
of the time, and just coincidentally, last night, I was asked to help my granddaughter, who's 14. She had to write some paper, and she asked me to help her, and she's at the top of her class in one of the top private schools in the area. Her grade point average is close to 100 and, you know, all her subjects so, and she writes beautifully. And so I basically didn't correct anything virtually. There was minor stuff, but we went through it, and we must have cut out about 40 words. Many of the adjectives like very interesting. Well, it's either interesting or it's not. You don't need to, or you could say, in other words, why do you need? In other words, so we cut out about 40 of the word, and he and I just asked her. I said, Ruby, which words can you cut out of this sentence? And she would find them. I said, Whenever you can cut them out. Do. So that's

Andrew Stotz 18:40
exactly my father went to a private school called Shadyside Academy, and then he went to Cornell for his undergrad. And he went to Cornell partially because of Richard Feynman and his interest in science, and maybe the smartest man who ever lived, yeah, and, and eventually, Richard

Larry Swedroe 18:58
Feynman, and by the way, everyone should read his book.

Andrew Stotz 19:02
Yeah. I mean, all of his books are amazing in the wonder of finding things out, I think it's called and the joy of finding things out. But what I remember is Strunk and what is, what is, what is, the Elements of Style, and we had to study that in class for English. And that was, you know, my dad has, I still have his copy of the elements of style of writing, but my dad always talked about trying to reduce words. It's funny that you mentioned that because, and then he also said, Use more simple words wherever possible. And one of the most agree egregious offenses is utilize. And I simply cannot find a case where you should use utilize instead of use. I can't find it, but everybody likes to use the word utilize. So the for the listeners and viewers out there, keep your writing simple and clean and people. Love reading it. So that's the last thing I would say. Anything you would add.

Larry Swedroe 20:03
No, I think that's a good way to end it. Yep, irregardless of anything else, that's my favorite pet peeve, because there is no such word, and I hear it all the time. Yes, we'll

Andrew Stotz 20:15
scratch that then. So that was a great discussion. I appreciate it. And we're going to go into chapter 28 next, which will be buy, hold or sell, and the endowment effect. And I'm looking forward to that one for listeners out there who want to keep up with all that Larry's doing, following on x at Larry swedroe And also on LinkedIn. This is your worst podcast host, Andrew Stotz, saying, I will see you on the upside.

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now Larry stands out because he bridges both the academic research world and the practical investing world. And today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically, we're going through chapter 26 and the title is dollar cost averaging. Larry, take it away.

Larry Swedroe 00:35
Yeah, this is one of my favorite topics, because it attacks a myth and investing that most people believe and lots of advisors push, and there is a little bit of good news on this story here, but it's mostly a behavioral benefit, not a reality that's a good investment strategy. So there's an interesting question that many people face. They get an inheritance, maybe their parents died, something like that. They sell a company, and now you've got, you know, cash. What do you do? Do you invest it all at once in your asset allocation, whatever it might be? Or do you put the money in what some people call dollar cost averaging. Other people say drip by drip. Just, you know, enter the market, and that way you avoid these big crashes. You're the using a Yiddish expression, you're the chamele or the shelmazo that the day you invest the market's going to crash, which is exactly what everyone is afraid of, right? Okay, so this question was studied very simply a paper written by a University of Chicago professor in the 1960s named Constantinides. And he said, It's dumb. Logically, it's dumb. It makes no sense from a expected return outcome. Okay, and he said very simply this, ask yourself, are stocks riskier than safe bonds? What's the answer? Riskier? They're riskier. That's why stocks have what's called an equity risk premium, right? It's true every single day, right? So every day you're out of the market, you're giving up an expected return. And therefore, and if you run the empirical data, look at various periods, and the vast, vast, vast majority of the time, you're ahead if you put the money all in at once. So the logical answer, from a purely financial perspective, must be, if I have money to invest, I should always invest it whenever it's available. End of discussion. Now, academics love to publish papers showing somebody else is wrong. In 60 plus years, no one has published a paper saying this is wrong, which gives you a hint that maybe Constantine 80s was right, and there are studies showing that, of course, he's right. Now, if you inherited the money on March, 1 of 2000 or October, 2007 of course, in hindsight, you would have been better off dollar cost averaging, but bear markets are infrequent, and therefore clearly the majority of the time you're going to be well ahead. The sales pitch is often, but you buy more shares when prices are down, so you should be ahead, but the math is wrong. It's just again, this simple common sense that every day there is an equity risk premium, and therefore every day you're out of the market, you're missing out on expected but not guarantee returns. In my books on financial planning, including my only God, you'll ever need for a successful and secure retirement. I point out that there is a psychological benefit, and where I would advise people to at least consider dollar cost averaging, but it's only for the people who are so afraid that they're the unlucky soul that the day they're going to put their money in the market will crash, or their biases, their view your Democrat and the US and Trump gets elected, and you're sure because of your bias. Prices that the stock market will crash, or if you were Republican and Biden got elected, or Obama, you're sure the Democrats will screw the economy up. So you don't invest. Okay, so you have your biases that could overcome. If that's the case and that prevents you from investing, then every day you're out of the market, you're giving up expected return, and you could be out a long time. Now, imagine it that Trump gets elected, and you're a Democrat, and the market goes up, as it did in 2016 now it's higher, but you didn't invest. In fact, maybe you sold the markets higher. How could you buy? Now, prices are even higher, and if it went down, you can't buy because you're sure it's gone lower. So once you make the decision not to buy, for whatever the reasons, it's very difficult to get know when to get in. It often will happen months or years later, after the market has gone straight up for some long period of time. So what I tell people is this, if you can't get over that bias, because you're concerned greatly, or you're sure you're the unlucky soul that the day you invest it's going to crash, here's what you should do. Take a piece of paper, write down a plan. I don't care what it is, just don't make the time frame very long. You could say, I'm going to put in 1/3 of my money every month for the next three months, 1/6 every six months, one quarter every quarter for the rest of the year. Don't make it more than a year, because most bear markets don't last that long. And then here's what I want you to do, if the market goes up, congratulate yourself for your brilliance, for at least investing one quarter, 1/3 1/6 Okay, and avoided not investing at all. And if the market went down, congratulate yourself on your brilliance, for avoiding putting all your money in at the same time. Either way, you were a genius, and you feel good about yourself, even though it was the wrong answer from a purely financial perspective, but we are human beings subject to behavioral biases, and if you know you're one of those people, then having $1 cost average plan that you write down and absolutely commit to turn it over to your Financial Advisor, your brother, your sister, a friend, and say you are to execute. And if I try to tell you to do something else, you have my permission to hit me over the head and go ahead and execute it anyway.

Andrew Stotz 07:53
There's a couple of things that I was thinking about when I people ask me about this all the time and and I say, for most people, they're going to dollar cost average. And the reason is, they don't have a lump sum. For most, that's right, I get, you know, people get monthly income, and you should just be constantly trying to get your money into the market to get that long term equity exposure. So congratulations, you are probably doing dollar cost averaging. I would

Larry Swedroe 08:27
say you're changing the phraseology. What you're doing is investing whenever you have cash, which is what I tell people do, you are not dollar cost average, right? You're not.

Andrew Stotz 08:38
You only got $10,000 but I said I was only invest 1000 No, put the 10,000 in.

08:43
That's it. Yeah, that's different.

Andrew Stotz 08:44
Always build your exposure to equity. You know, as early as you can in your life, you can never, no method of investing will beat that, because ultimately that ends up being a large amount of money early on in your life that's able to compound and get that equity return?

Larry Swedroe 09:03
Well, I would just change what you said a little bit. I would not say no method of investing would beat that. Putting all your money at once gives you the best odds of having the most money. But imagine an investor in Egyptian stocks in 1900 or Japanese stocks in 1990 clearly, they were better off dollar cost averaging, but that's in hindsight. So it could work. But if you want to put the odds in your favor, which is the best we can do, because we don't have clear crystal balls, you should put all your money in whenever you have it to invest.

Andrew Stotz 09:44
Yeah, and let's say that you've already worked out. I think you know one of the key things is working out the instrument or instruments or methodology that you're following. Is that just a simple index fund? Is it a US index fund? Is it a global index fund? Is it a combination of that? At plus some of the factors that you know, exposure that you built. But once you've got that set, then you know. Now what we're talking about is you know where to go now. So first thing, as I said, many people don't really even have this choice because they don't have a lump sum. So really, what we're talking about is people who have a lump sum. And the point is that lump sum should would always benefit over time if you put it in now, let not just go

Larry Swedroe 10:30
back again. You're it's giving you the best odds of success. It's not a guarantee to be the best strategy, but we don't want to confuse strategy with outcomes or engage in resulting. If you put it in all at once, that's the right strategy, because the best you could do is put the odds in your favor if it turns out to be March 1 of 2000 you got bad luck. Doesn't mean it was the wrong strategy,

Andrew Stotz 10:58
and that's where, you know, people like to think they have more control over the market, and they because we're talking about another element, which is the element of, I'm going to time the market. Yeah, okay, if you think you're going to do and when you talked about your solution, as you mentioned about, okay, fine, come up with a one year plan that's not for the purposes of timing the market. It's really for the purpose of overcoming your behavioral

Speaker 1 11:25
Yes, exactly right. Yeah, okay, exactly right.

Andrew Stotz 11:29
And I was just looking at the research on dollar cost averaging, and you highlight that in there, but I was just going back that that paper by Constantinides was in 1979 nobody, okay, yep, nobody gains from Dollar cost averaging was in 1992 that's Mandel Knight. And Mandel the fallacy of dollar cost averaging in 1994 by Thor Lee, a continuous time re examination of inefficiency of dollar cost averaging in 2003 and that was mill Veski and Paul Posner. And another look at dollar cost averaging in $2,018 cost averaging the trade off between risk and return. And now, well, I remember many, many years ago reading a book called Value averaging, and somebody has come up in 2011 with enhanced dollar cost averaging, and in 2023 we have smart DCA superiority. Any thoughts on those?

Larry Swedroe 12:27
Yeah, the answer is simple, if you believe markets provide a risk adjusted return or not, okay, it's like saying this, if the PE ratios are high, you shouldn't invest. Well, that turns out to be wrong. It just means that the equity risk premium is smaller, but there's still an equity risk premium. It goes to our same argument we discussed last week on the Sell in May strategy. Yeah, stocks do perform worse from May through October, but there is still, in fact, they perform about half as strong as they do the first the other six months, but there's still an equity risk premium, so you're better off investing. Like I said, there's not a paper that I'm aware of anyway that contradicts Constantinides paper, which was done almost 50 years

Andrew Stotz 13:29
Yeah. Ma'am, excellent. Well, that's a great discussion on dollar cost averaging. I know for some people, they haven't thought about it in detail. This gives you some background on how to think about it. Larry, I want to thank you again for another great discussion, and I'm looking forward to the next chapter. And the next chapter is chapter 27 Pascal's weight. Wag, wager, sorry. Wager, yeah, wait and the making of prudent decision, Pascal. Is he the guy that said that I would have written you a shorter letter, but I didn't have the time.

Larry Swedroe 14:09
I don't know. He may have been, I think he was a French mathematician. Yes,

Andrew Stotz 14:14
I think he was, but I'll have to check that by the time we meet again. Alright,

Larry Swedroe 14:18
we'll discuss his famous analogy, which teaches people how to think about wagers or investment decisions, or any decision, if you'll remind me, I'll tell you the story about how what I did when I gave each of my daughters was old enough to drive a car and and we'll use the Pascal's Wager to explain their behavior.

Andrew Stotz 14:47
Perfect. I look forward to it. And ladies and gentlemen, you can find Larry on X Twitter, at Larry swedro, and also on LinkedIn. This is your worst podcast. Was Andrew start saying, I'll see you on the upside. You.

Andrew Stotz 00:01
Andrew, hello, risk takers, this is your worst podcast host Andrew Stotz, from A Stotz Academy continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now, Larry stands out because he bridges both the academic research world and practical investing today, we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. Specifically, we are talking about chapter number 25 battles are won before they are fought. Larry, take it away.

Larry Swedroe 00:37
Yeah. So Nobel Prize winning professor, hopefully your listeners know the name gene fama. He was the thesis advisor to Myron Scholes, who was credited with the CAPM and stuff at the university. He studied the historical distribution of stock returns, and here is what he found. He found that the population of price changes if it was strictly normal on any stock, then a standard deviation shift of from the mean of five standard deviations should occur about once every 7000 years. The reality, though, is it occurs about once every three or four years in the US equity markets. So we know the distribution of returns is not normally distributed. There are big fat tails in the distribution, which means that investors should be prepared to, you know, have to live through once every three or four years, on average, a big shock to the markets, right? And so I began this chapter, which I called, as you noted, battles are won before they are fought, telling the story of Sun Tzu, which was an honorific title bestowed on Sun Wu. He lived from 544, to 496, BC, and he's famous for authoring the art of war, an immensely influential ancient Chinese book, a military strategy, which many business leaders have quoted the wisdom from that book. The book has got 13 chapters, each one dedicated to an aspect of military warfare. Now investors I felt could benefit from one great insight, which was he said, every battle is won before it is fought, which is why he told the story of farmers inside. If you know that, we get these massive, you know, hits to the market, five standard deviations in moves. Some good examples would be October 1987 when the market crashed 23% in one day. That's the standard deviation over a full year, about even higher than the standard deviation for equities over a full year, which for the S, p5 100, is about 18% if my memory is served. And then we have the, you know, crashes in 1998 Andrew, you're living in Thailand. So you would remember that period when we had what was called the Asian contagion. Went all around the world. We had crashes. Then we had the.com crash. Then, of course, you also had long term capital crash in around the time the Asian contagion, when their models, you know, forgot that left fat Tails can and do hit and that. And also, importantly, they seem to forgot they were relying on the fact that correlations tended to be relatively low with the strategies they looked at. But they if they looked at the history, which you would think smart guys who had won Nobel Prizes would have done, they would have seen that in crises, all risky assets can tend to see the correlations go towards one, particularly for the types of strategies that hedge funds engage in, because they tend to invest in a lot of risky, illiquid assets, and illiquidity dries up. I mean, liquidity dries up, and those assets all get killed at the same time. So, you know, long term capital was relying on, what does Russian debt markets have to do with Brazilian debt markets, or, you know, high yield bond, or the currency of Thailand have to do with Russian debt? Well, they all went highly Carly. Of course, we had. A, you know, financial crisis of 2008 we have the COVID crisis of 2020 and then we had stocks and bonds both get crushed in 2022 So the lesson here is that the markets don't always look like the last 17 years in the US or the 30 years before 1990 in Japan, where they run way up, and then people get too enthusiastic, your plan should always recognize that there are these big risks in markets, and your financial Plans should take into account that they're going to occur once or twice on average or so a decade, and you have to be able to survive that, both financially but also psychologically, because life's too short not to enjoy it, and even if you don't panic and sell but you're losing sleep because Your portfolio is getting crushed. Well, that's a serious problem, right? So the story here is you have to know your investment history. You have to be prepared for these bad events. No one generally can forecast them with any persistent accuracy, and therefore you need to have not only that plan that's well diversified, that can live through these events, doesn't take more risk than you have the ability, willingness and need to take, and you also have the plan B, because we don't want to have the most conservative portfolio. That would mean you know that we assume the absolute worst is going to happen when likely it doesn't over the long term. But if that left tail shows up and we have to cut spending, what are the steps I'm going to take in order to avoid panic? Selling my portfolio right? Maybe to sell a second home. Plan on working longer. Move to a lower cost living area, move in with your mother, whatever the case might be, or have your mom move in with you. Yes, there's

Andrew Stotz 07:09
a couple of things that I wanted to there's two different directions. The first one I wanted to just highlight that the study is done on the market, as opposed to individual stocks, so that for people that have a portfolio of individual stocks, you could see that that movement is even 10 times worse, and some stocks even go to zero. So you could own that stock at 100 and it goes to zero. Right

Larry Swedroe 07:31
factors to give you some statistics there that roughly the standard deviation of the market is roughly 20. Okay, that's the measure of volatility. The average stock volatility is twice that. And if you buy high volatility stocks, it could be triple or quadruple that, and then you have even more risk when that five standard deviation

Andrew Stotz 07:57
event occurs, yeah. So that's the first thing is to be aware about this volatility, specifically about individual stocks too. Now the other thing that that makes me wonder about I'm just thinking about, is when we do tests in academia and we look at whether this was just a random outcome, and we try to understand, did this portfolio manager, as an example, outperform by by just pure statistics that he that there's going to be a certain number of people that are going to outperform by a certain amount, or we're going to say no, in fact, it can be attributed to something. How does a stream events like that fit into that, you know, that analysis that we're doing of persistence in performance, or something like that, yeah, it's

Larry Swedroe 08:50
one of the reasons why you need to have very long periods of data to really understand markets. I mean, I think Ken French once pointed out that to be 100% certain, or if you will, that there is a value or a market beta premium, you need at least 75 years of data. Most people don't have investment horizons that long. So the best we could do is make the best estimates we have based on the data, and what we can say is this, we know, based upon studies by French, Ken French and Gene farmer, for example, that only about 2% of all active managers are produce statistically significant alphas, once we adjust for risk, that's less than you would randomly expect. So it's hard to say that those people have skill. Is it possible they do Sure, but there's no way for you to tell, and therefore you shouldn't bet you know your portfolio on the likely. Hood that they have skill. And if you know, as a great example, one of the great money managers, at least in that era, he accomplished something that no one had ever done before, a guy named Miller at Legg, Mason, value, trust, I think of my memory served. He'd outperform the s, p, not over a 15 year period, but 15 straight years, yeah, claimed him the greatest money manager, better than Buffett or Lynch. None of them had ever done that. And the rest of his career, he got slaughtered, and he got fired twice, if my memory said, you know, or was relieved of his you know, role as the manager, because the results were so poor. So how do you know? You know, 15 years is not enough. I think most investors would say, surely that can't be locked. How to be skill well, did he just one day, you know, have a brain fought and then lost his mental skills? I don't think so. So then you have to conclude he just happened to get lucky.

Andrew Stotz 11:03
So let's, let's now, um, talk about the other thing that I, I always kind of, I have questions about, and that is now, for a typical investor, particularly in Asia, but let's say around the world that they have their own business. Let's say, and they're generating cash, and they're putting that cash in the bank, and they're pretty satisfied with that. You know, they're like, I got my high risk business there, I generate my cash, and then I put it in the bank, and I get one or 2% but I don't care, I put it in treasuries and I get, you know, whatever. But the point is, it's kind of a barbell strategy. This is my high risk part, and this is my low risk part. But now let's say that that person allocates money into the stock market, and they say, Okay, I'll put, you know, I'll put X percent of that money from the bank into a, you know, a Vanguard Index Fund as an example, knowing that there's going to be a time when the market's going to go down. And, you know, in this case, they have the they have the stomach and the income producing ability of their company that they don't even really need to blend in other types of things to reduce risk, because ultimately, let's say they put in 50% of their money in the market and 50% in cash. When you look at the whole portfolio, it's actually when you look at the volatility of that portfolio, you're not pricing it in your portfolio so much. But you can see when the market collapses by this anomaly, then the cash doesn't go down, and so therefore, it's the ultimate, let's say the perfect diversifier. It just said it doesn't earn that much return. So I like to start with diversification, thinking about cash as a starting point. But now let's imagine that they say, Okay, well, I'm going to buy a bunch of different things someone else is buying. They're building a portfolio. And they say every the correlation was fine, until that crisis, and then the correlation collapsed, or, sorry, the correlation rose, and everything moved together. Well, that was for 15 days, you know, that the market crash, and then it all bounced back, and then those correlations went back to normal. So if you were sleeping, you're in the hospital with a coma for 15 days. All the correlations went perfectly positive, and everything went that way. And then it all bounced back to normal. And then you wake up and you go, see your portfolio. Should you have, you know, should you have diversified in some way to prevent that? Or should you have would have been better if you were woken up right at the point where everything is perfectly correlated. So you gotta do something now. How do we think about that point in time correlation?

Larry Swedroe 13:35
We could probably spend hours on this particular topic. Let's see if we can give a short answer. First of all, I think the most important thing I would point out is here is the evidence. That's very clear from a bunch of studies. They found that the more attention you pay the portfolio, so how often you check its value is inversely correlated to your returns. So the more you check it, the more likely are to do something, and doing something is likely to cause you to make a mistake, because doing nothing, as you point out, over that long term, is likely to prove better. And there's a simple behavioral explanation for why that is true, there are good studies on loss aversion. I'm sure you're familiar with that term. What that tells us that the joy you feel from $1 gain is about half the underside of the pain you feel from $1 loss. Now, make it 1002 1000. It's probably triple. Make it 10, you know 1010 1000, or, you know, up to dollar amounts, or 1,000,002 million, and maybe it's 10 times as bad. So

Andrew Stotz 14:57
loss hurts much more than. Then gain and dollars,

Larry Swedroe 15:02
the bigger the difference. All right, so what does that have to do with the markets? What is the percentage of time stocks go up over annual periods?

Andrew Stotz 15:18
Roughly on average, maybe 70% of time. That's about 70%

Larry Swedroe 15:23
or so. So that's pretty good odds. If you can wait 10 years, it's not certain. What's the odds at an annual periods? It's 70% what is it daily?

Andrew Stotz 15:42
I mean, my first reaction to that is 70% but is it different?

Larry Swedroe 15:47
5050? Yeah, about half the time. Okay,

Andrew Stotz 15:52
so, okay, sorry, let's just clarify, just so we all understand. We're just talking about up versus down. We're not talking about the degree versus Okay, I see what you're saying. Yep, that's

Larry Swedroe 16:01
roughly 50% so think about that over say, a month, you have 20 trading days, on average, 10 will be up and 10 will be down. If we give you one point of joy for each of the good days, you have 10 points of joy and 20 points of pain, you're more likely to make a mistake and sell because you're feeling the pain. So that's a real problem, and why you shouldn't look at short term performance. The other thing I would point out is, while correlations tend to go way up of all risky assets, when we have a crisis, volatility spikes, people look for safety, and they sell anything that's risky. But those tend to be short periods, as you know, but those short periods could last two or three years, not necessarily two or three weeks. Sometimes, as in the case of COVID, they only lasted about a month, and the market rallied and from and the great financial crisis that lasted from about, I think, October of oh seven through March of oh nine, a lot longer and much more painful period. And I saw lots of people panicking then. So the right answer is, should you diversify and own equities? And how much should depend upon your willingness to absorb those periods sleep well, not check your portfolio, not panic and sell? And so this gets to in my books. For those interested, my book on your successful and secure retirement. Also, I wrote a book your only God you'll ever need for the right financial plan. It walks through who should own more equities, who and how much? There's another one talking that talks about that. One doesn't go into specifics, but, and I don't talk about who should own more US stocks, and should own more international stocks, emerging markets, real estate, we ask questions that should be asked, and the question of diversification gets into things like for us, investor, if you're going to panic and sell because emerging markets underperform for a decade, you shouldn't have owned them In the first place, because that's going to happen with certainty at some point in your life, and then there'll be another decade where the US underperforms almost certainly, so that that's not a reason, here's my last comment. There every single asset that's risky is going to go through long periods of poor performance, long periods decades. Sometimes that must be true, or there'd be no risk. All you have to do is wait five years or 10 years. There's no risk long as I'm going to live that long so any 2030, 4050, even 60 year old, can own 100% stocks and just wait it out. That's nonsense. We know that's not true. That's not a reason to avoid an asset. That's a reason we diversify and rebalance. And then we know, as we've talked in our series, that risk assets have self healing mechanisms. When they do poorly, it's mostly because their valuations have gotten cheaper and now their expected returns are higher, but you only earn them if you stay the cost and, even better, rebalance. So

Andrew Stotz 19:32
let's go back to this concept of kind of a moment, just because it hits the news every now and then, all assets are correlated right now, you know, and for me, I feel like it's kind of a waste to even think about that. We're not talking about the fact that sometimes low correlation assets have a period of time where they have a higher level of correlation, which is fine, interrupt

Larry Swedroe 19:59
there. But. This is really important for people to understand what they don't. May not understand about correlation. We look at correlation, say, of stocks and bonds. We're looking at data from 1926 to 1924 that's through 2024 that's 99 years. What we're looking at is the average correlation over the period. There are many long periods, in fact, when stocks and bonds are positively correlated. In fact, on average, it's about point two positive. But we know there are also long periods when it's negatively correlated, right? So you know what you have to be aware of when we talk about correlations, we go through different regimes, and you have to be willing to live through them to get that average correlation likely over that long period.

Andrew Stotz 21:00
So yep, and now let's go back to this event. So what I tell people is, I don't really care about high correlation at a short moment in time. And if you got some advisor that's telling you, oh my god, the correlation between stocks and bonds have now gone so high you need to take some action right now. I think that's just a mistake. I mean, unless you're trading on that correlation going back to normal. And therefore, I just don't really pay a lot attention to the concept of assets being highly correlated for a short period of time of crisis, because otherwise your only thing is okay, guy, if you don't want that, then put more money in cash, because cash is never going to be correlated to the market in that way. And then you just cause your return to go down. So just ride it out and come out the other side of that short period.

Larry Swedroe 22:00
I would agree completely with the point to be just to add, you must be aware that those correlations are regime dependent, and you should be aware if someone tells you stocks and bonds basically have low correlation, as I said, they're something under point two, that's pretty good. Diversify, okay, but you have to be aware there are even some long periods, and we saw it in 2022 when they went highly positively correlated, because we had high inflation, and that killed stocks and it killed bonds. So if you can't take that risk for whatever the reason, or don't want that risk, then you have to shorten your duration of those you could still own bonds, but don't own a 20 year bond. Own a two year bond to cut down that risk, and you could still pick up a premium, typically over cash, pick up some of that term premium, or you could seek other assets, like private credit, for example, a floating rate debt. So, you know, you don't have that inflation risk.

Andrew Stotz 23:08
And there's another thing about correlation that I want to talk to you about, just because I'm not sure if I understand it perfectly. But I was just doing some correlations, looking at some you know, I was looking at something that had a very low volatility, but it had a high correlation to equity. Now let's just imagine, for our sake, that it's 100% correlation between these two assets. But let's just imagine that one of the assets has a volatility or a variation in their return that's 1% positive, 1% negative, whereas stock market has 10% positive, 10% negative, you can say that these two are perfectly correlated. When the stock market goes up by 10% this one goes up by 10% on the 1% Yeah, by one here. So

Larry Swedroe 23:54
here's the definition most people I found. I once asked a group of advisors, okay, who should know better? How you know to define correlation, and not one out of about 100 got it right. They all thought it meant positive correlation, mean when one goes up, the other goes up and negative, mean one goes up and one went down. I even met a money manager who was willing to bet me 100 bucks that that was the definition, and I had to show her mathematically, that's wrong. Okay, here's the definition of correlation. When one asset produces above average returns relative to its average, the other asset also produces above average returns relevant to his their average. So if one is plus 10 and minus 10, the average is zero. Okay, so the average return is zero, but its standard deviation is 10, and in your example, yeah. Something that's plus one and minus one. If, whenever the first one went up 10, the other went up plus one, and when the other went down 10, it went down one. The correlation would not only be positive, it would be positive plus one, perfectly correlated. Now let's assume the other way, when, when stocks went up 10, the other asset went down, one, all the time, and vice versa. That would be perfectly negatively correlated. Okay. Now what we would love to see, if there is such an asset, the ideal asset would be negative correlation and high volatility. Why? Because if your stocks are doing poorly, you want the other asset with its negative correlation not only to do well, but to do super well. And if stocks are doing great Well, the other went down, okay, and but your stocks went way up, okay? And now you can rebalance, and you'll get a big diversification return if you're disciplined. So ideally, in fact, now no one should want to, you know, have this kind of thing happen. But I actually saw an example using turkey over some period where the return to the stock market in Turkey was like minus 3% per annum, but it was you ran a mean variance optimizer, it would have told you to own like 5% of Turkey in your portfolio, because it went like this and this at exactly the right time. Now nobody would if you ask them, would you want to own an asset that lost 3% a year for a decade, they would say no, but hey, look, here's the evidence, right? So what the ideal thing is, you're looking for something with a low or even slightly negative correlation, and hopefully not high volatility, because you're trying to dampen the volatility of the

Andrew Stotz 26:59
equity That's great. Well, excellent discussion. It answers a lot of questions for all of us. I want to thank you again, Larry for this great discussion. And I'm looking forward to chapter number 26 which actually, you know, really is one that everybody needs to understand clearly. And I think there's lots of different misunderstandings too. Dollar cost averaging. For listeners who want to keep up with what Larry is doing, just go to LinkedIn or Twitter and you're going to find him there at Larry swedroe on Twitter and at Larry swedroe on LinkedIn, and he responds. So make sure you leave a comment and talk about it. This is your worst podcast host, Andrews dot saying Larry and to the audience, I'll see you on the upside. You.

Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was a head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And that chapter is chapter 24 why? And Larry, come on, why do smart people do dumb things? Take it away? Larry,

Larry Swedroe 00:36
yeah, it's a really challenging question, and we all know people, and probably including ourselves, who have done some dumb things. I recently had, you know my best friend, he had a fix something on the ceiling that was right out the top of the staircase, and the dummy put gets on a step ladder, climbs up and slips, goes down the stairs, crashing, miracle. He only broke his shoulder, didn't snap his neck and die. And you want, you know the guys was a multi millionaire. He could have hired somebody for 100 bucks to fix the thing, but no, he has to get on a step ladder at the stop, top of a lot, you know, the staircase. You know, we do dumb things, right, especially probably for us men, when we were teenagers, and, you know, probably took risks we shouldn't take. So we all know that this to be the case, but when it comes to more important issues, maybe, and when there's science and knowledge, hopefully we can avoid them. For example, I think certainly in the US, especially, the amount of people who are smoking today has gone way down because of the warnings that say from the Surgeon General, smoking is hazardous to your death. You're likely to get cancer. Not everybody stops smoking, but most of the people, clearly, the vast majority, do that. What's really interesting about this analogy is, when it comes to investing, the SEC does provide some guidance and on all advertisements for mutual funds, if you're an actively managed fund, of course, it has to carry the warning that past performance is not a predictor of future performance. Now you would think that investors would heed that warning, but all of the evidence shows that investors money flows into the funds that have had the most recent best returns and flows out of the funds with the recent poor returns. One psychologist said the problem is it's not descriptive enough, and what the SEC warning should say more explicitly is specifically pass out performance has no predictive value as to future outperformance that might make a difference. Maybe, I'm not sure

Andrew Stotz 03:12
that, yeah, and I didn't when I read what you wrote about it, and then I looked at the research and their recommendation, I was like, I don't know if that's tough enough, you know, and you can't, but you can't say it. Past performance does will the past performance will not repeat, you know, because it

Larry Swedroe 03:29
good, right? Absolutely, you know. But here's the thing about we talk about smart people doing dumb things. Here you have the average retail investor. You could excuse maybe their behavior because they're ignorant. I don't mean it in a pejorative sense, like being dumb. I mean, I'm intelligent, at least, I think so. I graduated from at the top of my class in one of the better MBA programs in the United States, but I'm totally ignore about nuclear physics, and my wife and three daughters tell me women is another subject, right? So unless you get an MBA in finance today, you probably haven't taken a single course in capital markets theory. So where do you get your advice from Barron's and CNN and they're going to count, you know, active managers, because that's, you know, they need your attention to sell their ads and all that stuff. Hm, okay, but you would think the big pension plans in the United States will hire world class consultants who certainly have the knowledge about the academic research, you would think that the people are on the board and charged with Mount should be at least aware of the academic research, just doing their due diligence to do their jobs. And yet, here's what the evidence shows on every study done on the. Performance of pension plans. They hire consultants. They measure performance based on, like, typically, three year period, some cases, maybe five, when all the evidence says that's way too short a period. It's noise irrelevant. But they do it every three years or so. And the managers they hire to replace the under performers, they go on, on average, to underperform, and the managers they fired go on to outperform, which means they would have been far better off doing nothing, let alone incurring all the trading costs that are implied when manager A comes in to replace B and they don't like their stocks they're holding. So you got a lot of trading going on, and yet they keep repeating this. Now I've asked, I've had to present at pension plans trying to get their business by using more systematic, transparent and replicable funds like or similar to index funds, okay? And I asked them. I said, How has that worked out? And why do you keep hiring new managers and telling you that something must have gone wrong in your process because it didn't work? So I ask you, tell me what you're doing differently this time in choosing the managers that will prevent you from making the same mistake. And you know what the answer I've gotten every single case is, nothing. Never once got an answer. Why they think they're going to get some different outcome repeating the same dumb behavior. It's amazing. So there's really no good explanation except human stupidity. And there, there's only two things that are infinite, the universe and man's capacity for stupidity.

Andrew Stotz 07:03
Now you know in this, in this chapter, you highlight some great research that talks about what's happening with returns. And I mean, it's so perfectly clear when analyzed. You know about the top performer, the prior top performers, versus the prior worst performers. And if now one of the questions I had, but I thought we should go through that just a little bit so someone understands that gap between it like you talk about the CAPM alpha on page 145

Larry Swedroe 07:38
and go ahead. Go right ahead. And so

Andrew Stotz 07:40
let's, let's just look at this what, what you've what this talked about is. So let's say the average benchmark adjusted return for the median strategy beat that of the winner strategy by 1.32 percentage points, and the loser strategy, meaning buying the losing funds, outperform the median strategy, buying the average fund, let's say, by about one percentage point. And so the loser strategy, buying the loser or the underperformers, prior losers, the prior losers, outperform the winner strategy by 2.28 percentage points. And what you talk about is, okay, well, maybe that's just has to do with the volatility that they're exposed to. But no, when you do a sharp ratio and try to bring in the volatility, you find that the ratio of the median strategy was 0.42 versus 0.25 for the winner strategy, while the loser, prior loser strategy produced a sharp ratio of point four eight higher, meaning better than the other two. So the investors

Larry Swedroe 08:49
a simple explanation that people say, How could that be? Winners strategies tend to be ones that have performed obviously well in the recent past. So valuations have gone up, meaning future expected returns are now lower. And loser strategies, you know, the reverse is true. That's why value stocks have outperformed over the long term. That's really a prior loser strategy. And the same thing is true, by the way, in commodities, you know, Cliff, sorry, AQR runs a strategy based on long term returns to commodities, and they look at five year cycles. They buy the five year loses and short the five year winners, you know, because what happens is, right, your returns are poor. That means commodity prices were down. So what happens? The mines get shut down, capacity shrinks, and then you have a problem. So prices go up, and the reverse is true. And when prices go up, new mines open up, capacity increases, and you get a reversal. So you know the same logic applies when you get out. Performance, whether it's individual stocks or an asset class or any particular strategy that's chasing recent performance. Yeah, and

Andrew Stotz 10:10
I think that when you're talking about like a capital intensive industry, like mining as an example, or oil production or something like that, you just have this natural long term cycle before they can deploy those assets that they decide, okay, we're going to expand. It could be five years before there's any revenue coming out of that expansion. And so it's just a natural, like cycle to get but what I wanted to ask when I was

Larry Swedroe 10:34
agricultural prices, right? Yep,

Andrew Stotz 10:37
yeah. So like, coffee prices went through the roof, and that hurt our coffee business, as we were buying coffee, raw, raw coffee, green coffee, that was, you know, just going up in price constantly. But in theory, that should drive the farmers to be much more aggressive at making sure that they're getting the most out of their current plants and planning more. But it doesn't take three it takes three to five years before a sampling becomes a bean producing and so we end up three to five years from now, we could have a glut

Larry Swedroe 11:07
of coffee. It's possible. Now, of course, climate and other things can impact that.

Andrew Stotz 11:13
Yeah. Now let me ask you a question, because carhartt's model brought in a fourth factor to the three factor model, originally of fama French, and that model was that that that factor was momentum, and he showed that there was value, there was there was a performatory, yeah, yeah. Explanatory power. So how does more and momentum is ultimately buying current winners. So how does that jive here? With the opposite of saying, you know, buying current under performers? Well, that well, you

Larry Swedroe 11:55
have to remember very importantly, momentum number one is a very short term tool, okay? It is short term positive momentum. And long term version to me, you get a reversal, okay, because things can't grow to the sky. So that's why you get some persistence in, like one year, right? Because things are going up. So maybe another on average, momentum works. Call it four to five, six months, right? Sometimes it works a year or longer, sometimes only a few months. But on average, it's somewhere around that. So often a fund that won one year might win one more year, but generally, then over the longer term, you get that reversion because prices get too high. So the problem with that is it looks great on paper, but when you have very short term factors like momentum, what happens to your turnover? Because to capture it, you have to trade frequently, so you easily can have over 100% turnover momentum strategies, which especially and momentum is most powerful in the illiquid stocks like smaller caps, and there your trading costs are much higher. So momentum can be very tricky to implement, and it may not survive transaction. You have to know how to manage your trading course well, or I would not try to run a momentum strategy. And I'm

Andrew Stotz 13:30
assuming that the funds or the ETFs that are done by, I don't know dimension or AQR, that are trying to take advantage to some extent of momentum, they just have such a competitive advantage in the trading costs. Well,

Larry Swedroe 13:43
let me give you an example of how dimensional uses it that actually reduces turnover. All right, which sounds contrary to our prior discussion. So dimensional used to ignore momentum because farmers said it's BS, it's now, it doesn't exist. It's phony. It's in the charts. And then finally, I think Ken French convinced them. The data was so overwhelming they shouldn't ignore it. Okay? But what they did do is this, let's say DFA would buy the stocks in the bottom 20% of P E ratios to keep it now a stock. How do most stocks get to be value? They were once growth stocks, and the stocks do poorly and they're going down once it got to that bottom 20% then DFA would buy it. Okay, okay,

Andrew Stotz 14:40
so just clarify what you're talking about is kind of a D rating where a stock share price is falling down because the fundamentals have slowed down, or something like that. So the market's no longer valuing that stock at, let's say, 25 times. It's now all of a sudden, D rated to be 15 or 10 times, 12

Larry Swedroe 14:58
or whatever the break. Point is, let's say 12 is the break point to buy. So now it goes down to a, you know, a PE below 12 and DFA prior to, I think 2003 would have bought it. They changed that to say, well, it will go on our eligible list, but it's suspended. We won't buy it until the negative momentum stops. So what does that do to your turnover? It lowers it because you delay the trade on the other side, how to value stocks deliver outperformance. They become growth stocks. Their PES rise as their profitability tends to revert to the mean, okay? And they get a turnaround. So the PE may have been eight, and now it's 12 and a half, and now they would sell it. David says, No, we won't sell it. We'll put it in our eligible to sell this, but we won't make it a priority to sell unless the momentum term is negative, so it'll be on the list, but it's not the highest priority in our algorithm to sell it. So that delays the sale, so they have a buy and even a hold range. Well, we'll we won't buy it. We won't sell it when it gets above 12, till it gets above 14, and then we'll sell it. So created these buy in bold ranges. So that's incorporating momentum without specifically trading on a signal to buy or sell. So that's one way you could do it.

Andrew Stotz 16:35
It's like creating buffer zones or places where you don't act but you it's, it's, getting closer to act interesting, right? So what

Larry Swedroe 16:42
that did value historically, if you look at any value fund, they're going to have a negative exposure to momentum if they don't screen for it at all, because that's how you get to be valued. So you have a negative, right, right? And, you know? So the problem is, what that was? So not the problem. When DFA did that, instead of having, let's say, a minus point one exposure to momentum, it went to like zero or plus point oh, five. So a very small amount of positive exposure. And that, if you think there's a momentum premium, for argument's sake, let's say you think it's 4% Well, a point one exposure gives you 40 basis points a year.

Andrew Stotz 17:29
And why? Why would they base it upon when, when the falling momentum stops, versus when the falling momentum stops and rising momentum returns?

Larry Swedroe 17:41
Well, soon as the momentum stops being negative, they say it's not a factor anymore. So that would become eligible the bar,

Andrew Stotz 17:49
okay? And I think that, how would you summarize the key lesson from this as a individual or as a professional, as you think about, you know how I'm allocating what is the key lesson from this chapter? From your perspective,

Larry Swedroe 18:07
first of all, rule number one is follow the empirical research. The empirical research says that past performance tells you nothing virtually about future performance. The best predictor of future performance are factor loadings and the expense ratio. So those are the two things you want to be looking at. And then you could add in turnover, obviously, as well. Those are the three things that you should look at, the construction rules used to create the fund. And then do they do patient trading to slow down the turnover and not pay away. You know, liquidity premiums there, you don't want to be a liquidity taker. That means you're taking the offer price and hitting the bid. You want to be on the other side where you when you have to sell, DFA doesn't go in and hit a bid. They'll put an offer in, maybe in between the bid and the offer, and they hope it gets taken. And if it doesn't, they got 100 stocks they're doing that for and they don't care which one gets taken. They don't know which one will do better or not. So they use these algorithmic trading programs, and that cuts down trading costs. And

Andrew Stotz 19:20
the last thing before we end, I just, you know, I want to highlight a little bonus here the article that you wrote about artificial intelligence and the risk of harking. Could you just tell us the general conclusion you got from that? Like, what were you? What were you? Was it? What you expected? And I'm curious, like, what your thoughts on about because there's some people that think, Oh, now that we got AI. I mean, I just, I just code something, and then I outperform

Larry Swedroe 19:47
right? Well, here's we've always known there's a problem with data mining, and soon as you got big computers and much better databases, the problem became massive. It, because when I was in college and studying, you know, Markowitz and portfolio theory, when if you had a theory, first you had to have a theory, then you would take your punch cards, believe it or not, to the data center, hand them in and pray you coded it right. Because if you made one error, it threw everything off, and then maybe three days later, because it was so expensive to run, you'd get your data back and hope it was right. So you couldn't test like 50 different theories, right? You ought to have some logical reason to believe that this correlation existed, because there was causation there. Okay, once you got big data, you could run all kinds of data mining, like a famous experiment on the United Nations Economic database, and they found that the best predictor of the S and p5 100 was butter production in Bangladesh. Now that's torturing the data until it confesses it has no meaning, right? Because there is no causation there. So now with artificial intelligence, what you have is the ability to use these large language models and much more massive databases you could not have used before because the computers weren't fast enough and you didn't have the large language model capability. So you could tell the computer to go find something and it will deliver but you have no idea about two things. Number one, is there any logical reason to believe that correlation will persist in the future. Is there some hypothesis that was created before the fact, not after the fact? Okay, I configured right? But here's the other thing that most people aren't aware. You have to know how you train the model, because you could have this look ahead bias. You're training it on the data that includes the data you're training it on. So what you should do is, let's say you're looking at the period 1929 through 2024 you should train it maybe on the data from 1929 to 2000 that's your in sample. See if we're and then run it on the out of sample. Post 2000 so you don't know unless they specifically tell you how they train the model. That's another risk. So you can get this stuff without any hypothesis. You know that's the problem. It's really a dangerous thing. And in the paper I wrote there, these are top level economists, they trained a large language model to look at like 200 factors and write peer reviewed academic paper qualities on all these factors, and it would cite the citations. And sometimes, by the way, it's stated phony stuff. It's amazing. They're not always accurate. So it can be a real problem. So if, if a

Andrew Stotz 23:15
young person comes to you and they say, Why do I have to learn all this stuff? AI is going to produce performance for me in the future. And I'm going to be a, I can be a hedge fund manager, and I've got, I've got a better AI model than the other guy, and therefore AI is going to replace fund managers, and these models are, you know, going to deliver? How would you say? Would you say, Yeah,

Larry Swedroe 23:42
I would say, from everything that I've read, that AI is a tremendously powerful tool that only works well when you have human beings overseeing understanding the processes, the construction of the models, how it builds portfolios, and all of the research that I've read so far has said that when you if you run just aa models and look at performance, or you run it combining a models with human intelligence, the human intelligence with the models does better than either human intelligence alone or the models alone, and

Andrew Stotz 24:24
I can outperform, I think I've highlighted so I can outperform. Now

Larry Swedroe 24:28
you may be able to outperform if you can figure it out before everybody else. That's the problem, because everybody, once you discover something, you know it's not like Renaissance technology is the only firm out there doing it. You got all these other big hedge funds in Apollo and AQR, they're spending 10s of millions of dollars, if not more, to try to figure this out. And once somebody figures it out, they may be leaving sought their own funds. And replicate. So the advantages are going to tend to be very short lasting. In my opinion, you'll have to keep out running it to gain any real advantage. But I don't mean it won't disappear. We've seen the hedge funds like Renaissance do well for you. But here's another indication of the capacity problem you read almost every month now, some big hedge fund that was highly successful is returning billions, if not 10s of billions, to investors so they can manage only their own money now, because they can't manage more than that, because the capacity won't allow for and I think that's a result of the problem we've just discussed, yeah,

Andrew Stotz 25:46
and it reminds me of the book Future hype, which was all about teaching us that that advancements, you know, are so like, if I think about how long it took for people to catch on to what, let's say, what's the medallion fund, the, the one you just mentioned, the the Simmons guy,

Larry Swedroe 26:14
yeah, Renaissance, Renaissance, sorry.

Andrew Stotz 26:17
So you know it took, it took the world many years to catch on what Ray Dalio and Renaissance and these guys were doing. But nowadays, if AIS now my AI is going to compete with your AI, and all of a sudden, the gap of time for inefficiencies to survive could possibly just get tiny and shorter and shorter and shorter,

Larry Swedroe 26:39
and a lot of it could even be legislated away. I don't know why the SEC, for example, doesn't put a stop to the high frequency traders by forcing them to stop these ghost bids. So in other words, it should force them to say, if you put in a bid or an offer, it must be outstanding for two seconds. But they ghost them, and they put and trying to out Fox everybody else. And so you see phony bids, and it tries to be misleading, but they could put a stop to all of that immediately, and that would cause a lot of their profits even to disappear.

Andrew Stotz 27:15
Well, the other thing which we see in the space of startups, particularly here in Asia, is that for years, it was free money. You know, any startup could get funding, and all of a sudden. And the same thing with AI models and all the funding they're getting and all that. But at some point, you know, I gave a speech last week where I talked about how a typical AI search is 10 times more energy consuming than a Google search, and at some point that's going to come that price is going to come home 100 times. The number I saw was 10 times

Larry Swedroe 27:46
I thought I read. That's even bigger than that.

Andrew Stotz 27:49
Yeah, my study that I had looked at may have been, you know, limited, but I wouldn't doubt it if it's 100 times, but let's just say it's massively more energy intensive than a Google search as an example, I

Larry Swedroe 28:02
don't want to we're short of energy capacity. Certainly in the United States, we're setting records now. I mean, we may not have enough heat or electricity for Texas and Florida because of a cold snap there. And imagine when you're adding, I mean, Amazon alone is spending 80 billion in the next year to build data centers. Where's the power going to come from, and where's the water going to come from? We're short water to cool all of these computers. We're short water, and they're building these things in the desert where land is cheap but there's no water,

Andrew Stotz 28:40
huh? Maybe it makes sense to buy a big piece of land in the northern hemisphere that's really cold and surrounded by water. Yeah? Maybe one last thing I was just going to say,

Larry Swedroe 28:54
maybe that's called Greenland. Maybe that's why Trump's trying to Yeah, that's

Andrew Stotz 28:58
where all our data centers go. I want to go back to 1967 I was two years old. My father graduated in his PhD in organic chemistry in 1965 and a movie came out in 1967 called the graduate. And in that movie, the young man, or the young man, was getting advice, yeah, and he got advice, and he said, what's the future? And he said, plastics, yeah, and my dad was going to work for DuPont, and he sold plastics his whole career, and he rode that way. And now, ladies and gentlemen, if you're listening in the future is power. And on that. I want to thank you, Larry, for this great discussion, and I look forward to our next chapter, and that is chapter 25 battles are won before they are fought, which is going to be a fun one, because we're going to talk about sunsuit and the Art of War, where we kick off. So I'm looking forward to that one. So. And for listeners out there who want to keep up with all Larry's doing, including that piece that he did on AI and all of that, just follow him on X, on Twitter at Larry swedro. And also, you can find him posting those things on LinkedIn. This is your worst podcast host. Andrew is not saying, ladies and gentlemen, I will see you on the upside. You.

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically we're talking about chapter 23 framing the problem. Larry. Take it away.

Larry Swedroe 00:33
Yeah, it's a part of the field of behavioral finance explores how we as human beings are subject to biases and mistakes in all kinds of ways that we're almost certainly not aware of. And Wall Street has learned to take advantage it by how they frame our problem. And I was reading a book on US on the subject, and they use this example to show how a question or a problem is presented, and could lead you to give the answer the questioner wants you to give. So the question you're faced with, in this case, is you're the commanding officer of 600 troops and you're surrounded by the enemy. After you call your lieutenants around, you decide carefully analyze the situation. You analyze it, and you decide you have two choices. Alternative, a is to fight it out until the reinforcements arrive. You estimate that you'll have 200 troops out of the 600 who are going to survive if you do that. Okay? Alternative B is you decide to try to sneak out in the middle of the night, and if you do that, you estimate there's a 1/3 chance everyone will make it out. Okay? So then they ask you, which alternative you would choose. Now, they then ask another group of people the same exact question from a mathematical perspective. They just changed the framing to read it this way is in the first case, alternative a, instead of saying 200 will survive, you say 400 will die if you choose to fight it out wait for the reinforcements. And alternative B is that there's a two thirds chance that everyone will die. If you go, turns out, in the first case, everyone chooses to try to save the 200 and there, you know, and the other case, they don't do that right, because it's framing it they're going to die. So it's a different framing, and a simpler example that I like is one on they use this in supermarkets, in shoppers. So I asked you the question, Andrew, you're presented with the question there on the table are two kinds of chopped meat that you would use to make for hamburgers. One of them says 90% fat free, and the other says 10% fat. Which one tastes better? Well, we know it's exactly the same thing. But depending on how you frame the question, right, you get different answers, right? And you know, so the same thing has happened. So what does this all have to do with investing? In my view, the best example is annuities. How they're presented is a guaranteed income, and depending on the features, we're guaranteed to at least get your money back and stuff. They guarantee you some return of an index, right? But they never tell you all the hidden parts, because you would never buy it if they describe the negatives in there, like the hidden expenses, and you're getting a return of an index. Now, for example, the S p5 100 last year went up 23% but they an investment in an S p5 100 index fund went up 25% now how did that happen? Well, the fund paid 2% dividends, that doesn't show up in a price only index, and so they're cheating you out of that 2% that's a cost that you don't see. And there's all kinds of things we describe in. Book, have these hidden expenses, chew up all of the benefits, and there's virtually no one who should buy any of these annuities that are higher expense. There are annuities that can make sense. For example, in the US Vanguard has a no commission annuity, and there's no extra hidden fees, and you do get the mortality credits that are inherent and annuity. So that might make sense for somebody, but all of the products that are sold by the typical insurance company and Wall Street firms are laden with all kinds of, you know, glitzy features that they're selling you. In each case, you're paying an excessive fee to get that benefit, but they're framing it and you're getting this benefit without telling you that the costs far exceed the mathematical odds of your getting that benefit.

Andrew Stotz 05:55
And a question for you is, for a person that's never heard of annuity or doesn't know much about it, if you were to think about the general concept of an annuity, and maybe use that Vanguard one as an example of kind of a base case. What is an annuity?

Larry Swedroe 06:09
Yeah, the best way to think about it is the original annuity was actually called the tan team French word, and it was a great idea, except it had a moral problem. So in the like 1600s I think was the beginning of the tontines, say 10 people would get together and they'd each put, you know, $1,000 worth of whatever the currency was, into a pot, and the last person alive would take all the proceeds now the other people wouldn't need it, because they'd be dead, right? And so you would get a big return on your investment. You can invest it in, say, in French government bonds in the meantime, and then the last person alive would get all of the proceeds. Okay? The problem was, in those days, someone figured out, well, I could just hire somebody and execute, okay, that's a moral problem. That's a big moral problem. So the way you get around that and the US is you have to have, at least the laws were then written. You have to have a vested interest in that life. You can't just make an investment in somebody's now that's changed, but so what happens is the insurance company is going to issue a contract, and let's say it takes somebody that age 65 they know the average life expectancy today for a 65 year old person with a certain, you know, health traits is say 20 years. Yup. Okay. Now they know with certainty, or as close to certainty as they can get, that maybe 3% of them will die next year, and, you know, 5% will live to 100 about 85 and they come up with

Andrew Stotz 08:06
this great statistics on this. I mean, it's very clear

Larry Swedroe 08:09
we have great now, of course, science changes, right? And you can have plagues that kill off lots of people and die early, and the insurance companies win, or you get drug companies inventing with govi and solving diabetes and you know, obesity and people might live longer, and so that can change,

Andrew Stotz 08:32
but the insurance companies can adjust for that.

Larry Swedroe 08:35
Can adjust, right? So what happens is the people who die early are basically subsidizing the people who live longer, and you get what are called these mortality credits if you do live long, because they know they're not going to have to pay out the full amount for the next year, because, say, 1/10 of them will die next year, so they could pay out more on the back end, because some well, okay, and those mortality credits, once you get to about 875, which they don't tell you this, almost nobody generally should buy an annuity when they're in their 60s, or, You know, early 70s, maybe. But the mortality credits, once you get to age 75 become large enough to offset the insurance companies cost the capital, their cost to originate and market the products, and then it becomes a worthwhile investment. I bought an annuity for my mother in law at the last age you're allowed to at age 85 at a time when interest rates were close to zero and she was getting near double digit returns because of the mortality credits. In her case, she happened to live 11 years, and it turned out to be a great investment. She had died early. I would have been a bad investment, but she went in. Needed the money. So an annuity is buying what I would use the words longevity insurance, and you shouldn't care if you die early and say, Oh my God, no, you don't need it, right? And take it with you. A little less,

Andrew Stotz 10:14
maybe you literally can't take it with you. Yeah.

Larry Swedroe 10:18
The purpose is to protect your lifestyle, not worried about your children, and

Andrew Stotz 10:23
you don't. I mean, ultimately, the ultimate annuity is if you amass enough money that you can earn income, or, let's say, earn return on your money and draw down your money, and you're creating an annuity. In that case, you don't need to buy an annuity. In that case, correct?

Larry Swedroe 10:43
You could create an annuity, if you will, by buying in the US treasury inflation protected securities, which gives you the inflation protection lock in a guaranteed return, but you don't get the benefit of the mortality credits. And that could be a big benefit, especially once you get to age 80 or even more. Now, recently in the US, a company called Stone Ridge created a product which technically is not an annuity, but it acts like one or very close to it. It's not an annuity because it doesn't guarantee to pay out for life, but it pays out as close as you could get to a guarantee to pay out to age 100 if lots of people live longer than expected, maybe it'll pay out to age 99 but you I would recommend not buying it until age 80, because until age 80, it's not an annuity. They're just paying you, like the yield on tips, and so that's a big benefit. It's the only annuity that gives you true inflation protection. The US, all the products, except this one, have a cap if they have any inflation protection, typically of no more than 3% a year. And that's not good. Just ask people in places like Thailand or Argentina or Brazil, especially when you're talking about hedging the risk of longevity for maybe 20 or 30 years. So I would never buy an annuity that didn't give me full inflation protection.

Andrew Stotz 12:25
And this is called Life x funds. Life

Larry Swedroe 12:28
X, L, I, F, E, x. It's available in a mutual fund form, and I think they're not in an ETF

12:37
form as well. Yeah, I think, I think I'm seeing it, it,

Larry Swedroe 12:41
you could buy it as a product, and it pays out like the annuity, but you don't get any mortality credits until age 80. And the reason is, it doesn't annuitize until age 80. You because you have the right to cancel, which is nice, because a lot of people say, what if I need my money back and I need whatever the reason? So they say, Fine, we're giving you the right to cancel up until age 80. Once you turn 80, it automatically annuity. So my point is, Why buy it? Just wait till age 79 you know. And then you could buy it.

Andrew Stotz 13:18
And does a reverse mortgage help in this case too. Like, for instance, if people have got their money in their house, their asset rich but cash poor, let's say they have a $500,000 valued house, they do a reverse mortgage and basically receive income from that. Well, they

Larry Swedroe 13:36
won't be receiving income. They'd be receiving cash flow and depleting its negative income, but cash flow, and then it gets repaid when the person dies and stuff. So that could be a very good mechanism for people who are, let's say, living in California, and you're not, house hasn't burned down with the fires, and these people tend to be wealthy, but cash poor, because the house may be worth $4 million but they have no financial assets. So this is a way to create the financial assets you I think you can typically borrow something like 60% of the value of the house, and you create an annuity out of that, and you're charged the spread, of course, because you're borrowing and you're not getting mortality credits. But that's a really good way for people, for example, who maybe I'll use the term die with dignity, don't want to go to a nursing home, stay in my home, and that'll give them enough money to last maybe five or 10 years, and they can have a much more comfortable life, and you can never get kicked out of the house. Yeah,

Andrew Stotz 14:50
the last thing I wanted to talk about, about the annuities, just for a second to kind of understand it from a big picture perspective, from a big picture perspective. You're giving money. So there's, you're giving money to an insurance company, and a portion of that money, they're investing with the objective that they're going to earn a certain return over time that's going to be able to fund, you know, what they've got to pay out over time and and the question that I have is that, you know, these insurance companies are limited as to what they can invest in by, you know, regulators and others. It's not like they're putting 100% of that money in equity. So already you could say, you can assume that an insurance company's return is going to be, yeah, I don't know, somewhere between, you know, 3% and 7% or, I don't know what, what is the breakdown in the US on what they can actually get.

Larry Swedroe 15:41
Yeah, so the insurance companies are playing a game that they could basically invest in relatively safe investments, let's say investment grade bonds that have low historical default losses and pretty good recovery rates and the net return might be 2% over treasuries, so they're guaranteeing you the Treasury rate, say, and they're earning that spread, and of course, they're making a bet that their annuity tables are right, and of course they're going to charge you fees to cover their cost of capital and marketing expenses. But so it's another thing I would never invest in an annuity unless the company were rated at least double A, preferably triple A, because you're making a long term bet. And the US there are insurance pools. Each state has a guarantee. So if you stay within the state guarantee, the state guarantees that if the insurance company goes bankrupt, the pool will take over. And what the state does is, let's say XYZ insurance company is issued an annuity to your mom and they go bankrupt. Okay, let's say you live in New Jersey, and there are 100 other insurers the state goes to the other 99 and says, you're taking over this policy and you're going to make the payments. And they know that's a cost of doing business there. So that's a good protection. None has ever defaulted as long as you stayed within the state limits. So that might mean you wanted to buy a $3 million worth of annuities, and the state limit was 300,000 you might have to go buy 10 different annuities to stay within that limit, which I'd certainly recommend you do. Yeah. And

Andrew Stotz 17:37
so when I think about annuities, the first thing I always think about is, okay if I invest my money over the next 20 or 30 years, and I was just to do all equity, let's just imagine for a moment, and I'm young, and I'm just going to, you know, go 30 years all equity, ultimately I'm going to be able to earn a return higher, just naturally, than any insurance company is going to be able to because they're limited by the regulator.

Larry Swedroe 18:06
The key word you left out is you have a higher expected but not guaranteed return. Your left tail risk is significant. You could end up losing a huge percentage of just ask. Let's say you were a young Japanese investor in 1990 and looking at the prior 2530 years with spectacular returns in the Japanese economy, it's taking over the world, all right? And the next 30 years, it had no returns before inflation, right? So you would have been clearly better off just buying Japanese yen.

Andrew Stotz 18:43
A Japanese insurance company would also assuming that it's investing in Japan, as you're assuming that I, as an individual, would be adjusting in Japan, they're faced with the same situation, right? That they can't, you know, they can only allocate so much to stocks because of the regulator.

Larry Swedroe 19:00
They may not even be allowed to invest in any equities. They typically have to be. They have capital rules. They might be allowed, let's make something up, but it might be like 70% has to be in government or investment grade bonds, and you could have a small allocation to real estate or things like that. And I don't know if you're allowed equities at all, or whether the insurance company would even want to take the risk of investing in equities, because if the equities do poorly, they've got to guarantee they have to pay

19:36
out. Yeah,

Andrew Stotz 19:37
so it's an interesting one. I know in Asia and in Thailand, it's really a hard sell by these institutions. And you know what you've talked about? You know, we've talked about the framing and we've talked about this, but we also need to just highlight that the commissions related to this are, can be enormous, and the, let's say, all the fees bundled. Up. That's what people really need to be very careful about. Yep,

Larry Swedroe 20:03
they're going to tell you, you get an index return. When we talked about part of that problem, you're not getting the dividends. You're getting principal protection. They offer, in many cases, a minimum guaranteed return might be like 3% or something like that. They offer it in the US anyway, tax deferred growth. So that's like a nice thing, the income options that guarantee you at least get a return of some principal and some Death Benefit Guarantee, and that's what they sell, and they never tell you about, except in the fine print of 30 pages of all the things that you really should know but nobody reads.

Andrew Stotz 20:49
Yeah, so that, and I would say, CFA, the CFA Institute, after the 2008 crisis, came up with a publication that was the 10 investor rights basically that individual investors should exercise. And one of those rights was you have a right to understand the fees that you're being charged. And therefore that means you also have the right to continue to ask for them, to explain them in language that you can understand. And

Larry Swedroe 21:22
to me, it should be simple. The law should be written a consumer protection that the language must be readable by a sixth grader, or something the equivalent in plain, simple English, you know. And then you can have the footnotes that go into greater detail. Now, the expenses are 2.3% fees. There's a 5% commission. There is this, there is that, one sentence, very simple. There's a guaranteed death benefit, but that cost you, here's the it lowers the annuity payment by 2% and you know, something very simple, 10 little points so you could read it and make a decision. But that's not how they're sold. At least I've never seen one sold that way. Yeah,

Andrew Stotz 22:10
and that's where I teach in my ethics and finance class, I teach my students that you could be in ethical violation just by bad language. Yeah,

Larry Swedroe 22:21
it's ethical malfeasance, yeah,

Andrew Stotz 22:23
well, that's a great discussion, and I want to thank you again for that. Larry, it's always fun to talk about and dig into these things, and I'm looking forward to next chapter, which is, why do smart people do dumb things

Larry Swedroe 22:41
again and again, yeah,

Andrew Stotz 22:43
over and over, yeah, we should add that in, over and over. So for listeners out there who want to keep up with all that Larry's doing, follow him on X Twitter and Larry swedro, and also you can find him on LinkedIn. This is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who, for free decades, was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry stands out because he bridges both the academic research world and practical investing. And today we're diving into a chapter from his recent book, enrich your future. The keys to successful investing in the chapter is chapter 22 and it is some risks are not worth taking. Larry, take it away. Yeah.

Larry Swedroe 00:35
So as we always do in my book, we begin with an analogy that has nothing to do with investing to help people understand the difficult concept. And the analogy I came up with for this chapter to help think about what risks and investing are not worth taking, is from one of my favorite books by a phone named Lawrence Gonzalez called Deep survival, about how to survive in the wilderness, for example, if your plane crashes or something. And he described this particular situation, he said there were eight snowmobilers that had just completed a search and rescue mission. They stopped at the base of a hill well known for climbing what was called hammerheading. Hammerheading is where you race up this hill until it gets to see how high you can go on that hill. Okay, till and the one who wins is the one who can get up the highest the I you know, the this particular Hill, though, was known to be dangerous, that avalanches could be caused. Now these are professionals number one, who should know better than anybody, and should know what risks are worth taking or not. But of course, their confidence in their skills could lead to that all too human trait we discussed before, called overconfidence, and two of the eight couldn't resist. One of them went up quickly, and then the other said, Well, if he's going, I'm going to go to unfortunately, the sound of their engines triggered a avalanche, and both of them died. That's what we mean by that. There are some risks that clearly are not worth taking, because the consequences of being wrong, if the risks show up, are so bad that you should never take the risk, regardless of what you thought the odds were. Let's say these people said, Yeah, could be an avalanche, but it's a 1% chance. It's just not going to happen? Well, if you did it 100 times, one of those 100 and you're dead, you know. So then, how does this relate to the world of investing? This was around late 99 early 2000s I was a consultant to registered investment advisor in Atlanta, and one of their clients was a very senior Intel executive. And this executive net worth was about $13 million almost all of it was an Intel stock, and he was confident, of course, that this stock was, it was the best company. It was, in fact, you might think of an analogy. Here was the NVIDIA of its day. It was the chips that was powering the whole.com revolution, okay, trading spectacular levels. He had watched it go up and up and up. And I pointed out that there were similar situations not all that long ago, from the 60s, for example, when we had the Nifty 50 bubble and once great companies like Xerox and Polaroid and Kodak and many others disappeared, even great computer Companies who led the whole innovation era in computers, like data, general digital equipment, they were gone already, and these were among the leading stocks. And he was convinced that, because he was a senior executive, he would know, and I pointed out to him then that some risks are just not worth taking. Have $13 million sell it all, or most of it, and then just build a nice, safe, diversified portfolio, mostly even bonds. You could withdraw a half a million bucks a year from it pretty safely, or maybe more in those times, because interest rates were higher and that was far more than he needed. Didn't matter. Couldn't convince them within literally, like a year or so, if my memories was correct, the 13 became three, and the stock has never recovered, even 30 plus, or roughly 30 years later. Now to that price, that's an example of. Some risks are just not worth taking, regardless of what you think the odds are. And whenever I have stories like that, I'm always reminded, I think, correct me if I'm wrong here, Andrew, but I think we've discussed Pascal's Wager before, so that's where Blaise Pascal, the mathematician, said, Look, you can't prove whether there is a God or not. It's a belief. So how should you act, given that you can't prove it? He said, Well, think about the consequences of your action. If you believe there is a God and you're wrong, what's the consequence? Well, you led a good life. You on your tombstone will say he was a good father, good husband, great friend. Maybe you missed out on a few good frat parties or stuff like that

Andrew Stotz 05:50
because you called a code of ethics that was built around that religion. Let's say yep,

Larry Swedroe 05:54
yeah, right. Exactly. On the other hand, if you believe there is not a god, and it turns out you're wrong, then, at least according to Christian theology, you're doomed to burn in hell for eternity. So it doesn't matter what you think, because the consequences of being wrong are so bad, you should act as if there is a God. And that's the mistake this Intel executive made. He should not have said, I think this is a great company. Odds are great. It doesn't matter. You should think about the consequences of being wrong, because none of us has a clear crystal ball.

Andrew Stotz 06:32
And you know, I think I've also told the story of my the advisor, that when my mom and dad, when they first retired or went, went to North Carolina and retired there, because my dad had a portfolio that was probably both, you know, my mom, my mom and dad's portfolio was probably 70 or 80% DuPont stock because they had been given incentives to buy it where they were buying it at below market prices. So my dad was, or

Larry Swedroe 06:56
after the bull pal incident,

Andrew Stotz 07:01
that's good question. This was 1992 so I can't remember. Bhopal was probably before that. I think that's and, but I think wasn't both all Union Carbide. I can't remember now,

Larry Swedroe 07:11
maybe it was union COVID. You may be right. I But, but the point

Andrew Stotz 07:15
was, was that they, they went to meet this financial advisor, and they said, how can you help me? And he said, Well, first thing I'm going to do is I'm going to reduce that DuPont stock in your portfolio. And my dad said, over my dead body, you will. And my mom was sitting there listening to it all, because she recounts this story now at 86 and I tell my students about it, because my mom basically said she was listening in and, you know, just observing. And the guy said, you know, DuPont stocks, what, you know, 100 or whatever it was at the time, what would happen if it went to, you know, 20, you know, and my dad, you know, my dad said it is never going to go to 20. It's Dupont. So next topic, well, this guy worked hard on my dad, and eventually he reduced the portfolio of DuPont stock, got him diversified, so maybe he had 15% 20% DuPont stock, or whatever it was at the time. And sure enough, my mom told me, DuPont stock went to 20 and luckily, they had gotten out before that. But you know, it's just a great example of, you know, no matter how much you love it, everything can go down.

Larry Swedroe 08:22
Yeah. And the other point that investors should learn is once you have enough to live the life that you're comfortable with, doesn't mean you get everything you want, but you have everything you need to live a high quality life and enjoy things, right? Why do you want to take the risk of that happening when you have no need to do it anymore? Because the marginal utility of wealth is close to zero once you have enough. Whatever that number is, for most people, it might be, you know, they can generate 100 and, say, 20,000 a year. So it's 10,000 a month. You can't live on 10,000 a month. You know something might be wrong with your value system, but whatever the number is for you might be 20,000 a month or 30 but once you reach that number, why are you taking more risk than you need to take when the upside is not going to change your life in any meaningful way. Maybe you can buy a portion instead of an Acura, but that doesn't change the quality of your life in any meaningful way. Or you know, so

Andrew Stotz 09:30
why take the risks? And can we invert this and say when you're young, you should take the big risks?

Larry Swedroe 09:38
I wouldn't say should? I would say you have more ability to take the risk youth is only one thing in your favor. There you have more horizon, and you have the ability to generate new capital through your wages, but your ability to absorb the stomach acid of the markets. You know, going way up and down should play an important role there, and your ability to take risks should also and by that we mean if you've got a stable job, you're a young doctor, and you've got a good practice, and your income is stable, you want to take some more risk, I'd say fine, because you get another global recession, your income might come down slightly, but it's not going to be impacted in any meaningful way, where, if you're a construction worker, an automobile worker, you could get laid off and out of work for years, and now you have to sell your portfolio to generate Cash Flow, and then you can't recover because it's been spent already.

Andrew Stotz 10:44
And before we wrap up, can you just settle one of the disputes I had with a good friend of mine. His name's Eric, and he always gives the advice, you know, take risks while you're young. And in my book, How to start building your wealth investing in the stock market, I say, don't make mistakes when you're young, because the compounding effect of a mistake. Let's say you make a bet you're 25 and you got excess cash, so you basically give it to a friend to go do a restaurant, and he loses it. Well, you've just lost the potential to have 500,000 you know, a million dollars when you're 60. So be very thoughtful about the, you know, mistakes that you could possibly make. But he's like, no, no, the world is clear on this. Andrew, make your mistakes while you're young.

Larry Swedroe 11:29
Yeah, well, I think you're both right and you're both wrong. Okay, you're both right in the sense, or he's right in the sense that you have more ability to take risk when you're young, right? You have more time horizon to wait out. You could take a lot of equity risk. You get a bear market as long as you're employed, the bear markets actually help you, because you get to buy more you know, at lower prices and expected returns are higher if you are a 25 year old, say, a 30 year old, and you've now, and it's 2000 and you've just paid off your debts, your student loans are paid off, and the market crashes, and now you're first able to invest. That was the best thing that happened the 30 year old and 95 in that situation, he's buying at higher and higher prices, right. On the other hand, if you're 65 years old and you're withdrawing, the worst thing that can happen is a bear market early, because you can't recover. So one you do have more investment horizon. So he's right, but you're also right. The cost of being wrong is infinitely higher when you're young, because, as I point out, when I talk to people who evaluate sending your kids, say to a private school or a good public school, and they say, well, it's costing me say 20 grand a year extra. I said, No, it's costing you a million and a half dollars in your retirement, and that's worth X 1000s a year on withdrawal. Now I'm not telling you shouldn't send the kid to the private school, but you have to think about the compounding and the expected return on that investment. That's the real cost. So you're both right, but You're both wrong in that you have to look at the picture in a more holistic way, and not just consider your ability to take risk, which is the only thing he's considering there, and you're looking at the downside without also looking at your ability to be able to take more risk. So you could do that,

Andrew Stotz 13:41
that should be found. Maybe the answer is, when you're young, start your investment account, you know, and start that and start contributing to it, and you know, but it's not all of your money. You can risk it on some other things.

Larry Swedroe 13:54
You can take a portion of the portfolio and say, I'm willing to take this portion and put some risk, but start on my plan, and most of it will go into that investment plan that you know is a more rational diversification of risk.

Andrew Stotz 14:11
You know, these days the stock market's pretty high when you particularly look at the top five to 10 companies, and a lot of times we look back at 2000 the.com bubble and compare, but the difference is that these companies are highly profitable. Now, in those days, companies were really not very profitable, but when you talked about Nifty 50, it made me think that maybe that's a better comparison. For instance, I just was looking at, you know, revenue growth on average for those companies was about 12 to 15% and Roe was 20 to 30% IBM, great companies, yeah, and so it was just a simply great companies that people were massively overpaying for.

Larry Swedroe 14:52
Here's the mistake that most people make, and there's no guarantee here. Okay, all of the research. Research that's been done over 60 years says this, that maybe one of the biggest mistakes investors make is they assume that abnormal earnings growth will persist for a long time. And fama and French did a famous study on this, I think, in 1998 and they found that abnormal earnings growth both positive and negative. So really bad earnings growth, they tend to revert to the mean at a rate of 40% per annum. So what do we mean? Just to help your audience understand this, let's say you know, companies are growing with the economy. Let's call it 6% a year, 3% growth, 3% inflation. Okay, so you're growing 6% earning and you're growing at 26 that's spectacular. So your abnormal earnings growth is 20. That means you should expect, on average, that instead of 20% abnormal growth, it'll be 12 the next year. So if the economy continued to grow at that six, you're now going to grow at 18, not 26 and the next year, it'll drop by 40% again. Now there are the rare companies like Nvidia that you know continue to grow earnings more rapidly, and that's why we see 4% of all the stocks account for 100% boiler is free, but good luck trying to find those 4% and be able to buy and hold them through that entire time and not buy and hold them like Xerox, which was the greatest company, maybe of all time in terms of innovation, right? And you know, they're the ones who invented what became Microsoft, for example. Most people don't know that, but you know, their labs out in Palo Alto, invented all that stuff, and they just sort of let gave it away. But anyway, you know,

Andrew Stotz 17:08
research that you saw in that you were saying it's

Larry Swedroe 17:13
farmer in French is paper? Okay? You can find it in my books somewhere. I've signed that. Yeah,

Andrew Stotz 17:20
excellent. Well, but there's

Larry Swedroe 17:21
there. I do remember the name because the title is great. It's called higgledy Higgledy Piggledy growth. And then there was a sequel called Higgledy Piggledy growth again. So if you Google those, you'll see this research was known back in the 60s that this kind of excessive abnormal growth does not persist. Now we know why. Logically, if you have abnormal growth, what's going to happen? It's going to track competition that wants to get at that abnormal growth. And when you have really bad earnings in industries, what happens? Supply disappears, companies go bankrupt, plants get shot, and then supply shrinks, and then profitability can be restored.

Andrew Stotz 18:12
Oh, so much to talk about. Well, Larry, I want to thank you for another great discussion about creating, growing and protecting our wealth, and I'm looking forward to the next chapter, and the next chapter is framing the problem. Made me think about the great song by Alex Harvey called I've been framed that he sang. I don't know if he wrote it, but and then in this you say, in other words, you've been framed. So listeners out there who want to follow up with Larry, he's got so much going on. In fact, on Twitter, we were just talking about the release of an interesting mash up of a series of podcasts, I think is what you were saying. And so just follow him on Twitter at Larry swedro, and you're going to find a wealth of knowledge. He also is on LinkedIn. So just go there. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.

Andrew Stotz 00:02
tell fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedro, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry stands out because he bridges both the academic research world and practical investing. Today we are diving into the chapter from his recent book, enrich your future is the key to successful investing. And this is chapter 21 and the title is, you can't handle the truth. Larry, take it away.

Larry Swedroe 00:37
Yeah. So we've talked before in previous sessions, I think, more than once, about the all too human behavior of overconfidence or bias that causes us to think we're better than average at all kinds of things. And this is the problem here is not only that we think we're overconfident, but we have the ability to delude ourselves about our ability, and that leads to persistent errors, like taking more risk than we should take. You know, thinking we can estimate the odds of a recession or a bear market better leads us to concentrate assets, because we can pick the best stocks or pick the best money manager, because we could do that, although all the evidence says you can't, and the institutions can't, as we've discussed. And my favorite story about this, which I began this chapter with, is there. It's well known. One of the most famous studies was done in Sweden about drivers, and they were asked, Are you a better than average driver? And something like typically, when people are asked that type of question, 80 to 90% say they're better than average, which, of course, is impossible, right? Only 50% can be better than average, you know. But my favorite story about this, to show how we can delude ourselves, and then we'll talk about how that relates to investing, is this. So in 1965 50 drivers were asked to rate their skill and ability the last time they were behind the wheel, and about two thirds said that they were at least as competent as usual. Many even described their skills as exceptionally good. What is particularly interesting about this study done by two psychologists was that the participants they chose had ended up in an ambulance headed for the hospital. Based on that was the last time they were driving and police reports showed that almost 70% of those that were in those ambulances were responsible for the crashes, and almost 60% of them had two past performances, a similar number that totaled their cars, and almost 50% faced criminal charges. Yet, two thirds of them said they were at least as competent as usual, and many were better than average. If that's not evidence that we can self be, you know, delude ourselves. I don't know what more you could say.

Andrew Stotz 03:31
Yeah. I mean, that's I just can imagine them saying it was just bad luck. It was just bad luck.

Larry Swedroe 03:37
Yeah, you know, and you know. So that's the problem. So you know, the problem with being overconfident is it, as I mentioned, can lead you to think you can outperform the market and therefore trade a lot. And the evidence we know, as we've discussed before, is the more you trade, the worse you do also you're going to concentrate risks when only 4% of all the stocks account for 100% of the risk premium, as we've talked about, what are the odds you can identify that 4% when we know the vast majority of professional investors with far more skill spending 100% of their time on the effort failed with great persistence, and only about 2% today of actively managed mutual fund managers outperform on a risk adjusted basis with any statistical significance, And that's even before taxes, let

Andrew Stotz 04:41
me just ask. The ability

Larry Swedroe 04:42
to delude ourselves, we know it's possible to beat the market. Is it likely? The evidence says no.

Andrew Stotz 04:50
Can I just ask you know, is it? Is it only in this space of investing or maybe driving that you know that people are overconfident? Because you would think. So if people are overconfident to this level in their lives, they just be falling off of buildings everywhere, because they would be overconfident in their ability to balance, and they would be overconfident in their ability to get across the street. It's just like people would be dying everywhere or causing huge problems. But what it is, I mean, obviously investing is, you know, super competitive, as you've explained in the past. But I'm just curious, is there another mechanism that's offsetting the overconfidence in other parts of our lives? Or how does that work? I

Larry Swedroe 05:30
think the simple answer is common sense. So Andrew, if you're an average person, and I ask you, are you a better than average driver? The odds are pretty good, 80 90% you're likely to say you're better than average. Now let's say you're out driving. You've had a couple of drinks with dinner with some friends. You're not drunk or anything, but it's a monsoon rain, as happens in Thailand, pouring down, and highway you're on has a speed limit of, say, 70 miles an hour, but it's pouring rain. Are you likely to try and speed that? Your common sense would probably override that, and, say, or to keep a little extra distance slow down a little bit, so common sense overrides that, but overconfidence one of the reasons I believe, and I'm not a trained psychologist, why we're overconfident, it's actually healthy for our egos. Imagine Andrew, if you woke up in the morning, looked in the mirror and said, I'm dumb, ugly, stupid, and nobody likes me, the suicide rate would be through the roof if people did that. So it's good that we, 80 to 90% of the people, think they're better looking than average, they're smarter than average. They friends like them more than the average person, and they're a better than average lover. I mean, all these things people have been tested on, and 80 to 90% is the typical answer. But that doesn't cause them any harm. It actually makes them feel good about themselves. The problem is, when it comes to investing, if you think you can forecast the future better than others, you're going to ignore risks that you shouldn't ignore, because you'll treat the unlikely as if it's impossible. You're likely to concentrate your risk because you can pick which of the stocks are going to win, obviously, and the evidence shows how bad we are at that. And as I mentioned earlier, we really delude ourselves to protect our egos. Again, I'm not a trained psychologist, but my belief is we delude ourselves to make ourselves feel good. So let me give you another example from a study done by Money Magazine, a US publication on more than 500 individual investors. Now the Dow have returned that year 20 let's see the Dow returned 46% over that prior 12 months, 1/3 of the investors stated that their portfolio had returned between 13 and 20 another third said they earned between 21 and 28 and about 25% said they beat 29 4% admitted they had no idea what they did. All right, while the S, P returned 46% and it outperformed more than three quarters of all the investors. And we know, if you ask people, did you beat the market, most of them will say they did so, right? That's the problem. I'll give you one other study here. 30 30% in one study done, 30% considered themselves above average. And those investors, when their actual performance was reviewed, they overestimated their own performance by almost 12% a year and 5% believe they had experienced negative returns, when actually it was fully a quarter of them, or 25% had negative returns. And of course, the markets go up, right? It's really difficult. The investors believe that they're in charge. They have a great ability to delude themselves about their ability, and that allows them to continue to make these mistakes, because they can't admit they're wrong. Their egos won't let them, and they probably don't even look at the data to compare, because it would create. Eight damage for their egos. Yeah. I

Andrew Stotz 10:02
mean, the title of that research was great. It's why inexperienced investors do not learn. They do not know their past portfolio performance. Yeah. I mean, people just don't know

Larry Swedroe 10:13
it's and I think it's, they don't want to know, yeah, at least for some people, anyway,

Andrew Stotz 10:18
for some, I mean, it's hard, it's hard to, I mean, if you're not getting it through an app that, you know, provides you the exact information you got to try to do that in Excel, you know, very it's not easy for some people.

Larry Swedroe 10:30
Here's the best story about that. There was a group of ladies called the Beardstown ladies. You may know that story. I

Andrew Stotz 10:39
bought that book when I was young. I was like, wow, this is the key.

Larry Swedroe 10:44
Yeah, this you were one of the suckers who bought that book. They were touted and millions of people books was a best seller. Sold far more than any of my books. Unfortunately, for the people who bought the books and should have been reading mine instead, but they reported these spectacular returns until and well after the book was published, like years later, even the publisher wasn't smart enough to maybe ought to check, because what are these odds that these ladies who had zero experience in investing could outperform It was possible. It could have been random luck, but without that, they certainly weren't skilled in terms of having more investment knowledge than the professionals. What were the odds they would have outperformed by that much? The problem was that the ladies were counting as return their monthly contributions to the Investment Club. So if they, if there were, I'm making this up, if there were 12 ladies, and they each put in 100 bucks every month. That $1,200 they showed as a return, not as an increase in their cost basis. And that's how they got these spectacular when the actual data was published,

Andrew Stotz 11:59
returns, how could the book publisher not have noticed that, or asked to check? They

Larry Swedroe 12:05
didn't ask. They sort of asked for an audit, right? Yeah, prove that you actually had these great returns. People want to delude themselves so they believe in these fanciful tales.

Andrew Stotz 12:18
You know, you talked in, you talked at the end earlier, about the people who feel in charge, and here you're talking about how they're the worst.

Larry Swedroe 12:28
Yeah, that's, I think. You know, there's good studies, one by Brad bar and barber and Terence odean, called boys will be boys. And it looked at a gender study, and it found that men and women are equally bad at stock picking. They both the stocks they buy go on to underperform after they buy them, and they stocks they sell go on to outperform after they sell them. That means they're being exploited. Somebody's on the other side of those trades. Obviously, it's a zero sum game. It's institutional investors who are a lot more sophisticated. They're exploiting the naive retail investors on average. The problem is that there aren't enough of these naive retail investors. So while they outperform the stock picks of the institutions, roughly about 70 basis points from a study Russ worm is did about 20 years ago, their costs were like one, you know, 220, basis points in total, including their expense ratio trading costs, the cost of sitting on cash, which underperforms the market over the long term, and so you end up losing significantly. There just aren't enough of these naive investors. So you know that's the problem. You know that that we have, there's they think they can outperform. But here's the the the new month of the story, while women are just as bad at picking stocks as men, women actually outperform men, and the reason was simple, they had less over confidence the men, I call it the testosterone factor, think they're much better than they actually are, and that leads them to trade a lot because they're all and the more they traded, the worse they did. And of course, the women tend not to be, you know, have as bigger egos as the men. They don't have as much testosterone, maybe, and they just are more cautious and don't trade as much. They don't think they're much smarter than the market. And here's the other thing, married women do worse than single women, and married men do better than single men, because each side has some. Somebody either pulling them down or preventing them from doing as bad as they would otherwise. And just,

Andrew Stotz 15:06
I thought we would wrap it up, just if you could revisit the S and P dow jones indices statistics that you have in here, I can later update some stuff in the post about 2023 but just to give a picture of like, the percent of funds that outperform you have it in your possible comma, not likely section,

Larry Swedroe 15:30
right? So the annual S, P report from SPIVA, which is the active versus passive measurements, reported that over the 20 year period, ending in 2022 95% of large cap funds, 94% of mid cap and small cap funds underperform their s, p indices. Now that's before taxes, so if you you know, if you're talking about somewhere between five and 6% are outperforming before taxes, it's probably more like half of that after taxes. And I don't know about you, but those kind of odds are something I wouldn't try to overcome, especially when the average investor has far less skill knowledge training than the mutual fund.

Andrew Stotz 16:23
Yeah, and at the end of this, you say it's important to measure your investment returns and also compare them to appropriate benchmarks. Doing so will force you to confront reality, rather than allow an illusion to undermine your ability to achieve your financial objectives. And I think that really is a great way to wrap it up to say, you know you must, you must understand your exact performance, and that without that type of you know information, you're just going to be deluding yourself, as we've learned from this chapter. Yeah.

Larry Swedroe 16:55
And one of the things we've talked about before, Andrew, I know you've pointed out to your listeners, portfolio visualizer as a regression tool, so allows you to look at if you've chosen a mutual fund to see if it's actually generating alpha on a risk adjusted basis, or that they just beat the market because they happen to own, say, small value stocks in 2013, or 16, when small value dramatically outperformed, right? And if they're underperforming the market, because they're in small value doesn't mean that they were poor stock pickers, it just means that those asset classes in that particular period underperformed. They may have even outperformed a risk adjusted benchmark. So that's a really good tool for people to learn to use,

Andrew Stotz 17:45
and I'm glad I used it when you showed me, because I did a screenshot, a video, and I showed buffet Berkshire versus the index, S, p5, 100 over 20 years. I recently went back to to redo that, and they changed the policy where you only get 10 years of free data. So that's fair, but maybe we need to get get them to be a sponsor of the show. Huh?

Larry Swedroe 18:08
There you go.

Andrew Stotz 18:11
So Larry, I want to thank you for another great discussion about creating, growing and protecting our wealth, and I'm looking forward to the next chapter, 22 which is some risks are not worth taking. For listeners out there who want to keep up with all that Larry's doing, follow him on X or Twitter at Larry swedro, and also you can find him on LinkedIn and he responds, this is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry stands out because he bridges both the academic research world and practical investing. Today, we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And this is an interesting chapter. This is chapter 20, and it's called a higher intelligence. And what's interesting about this one is Larry's going to set up a scene, and in that scene, he's going to tell us a little bit of he's going to set a scene that's going to help us to try to understand how we should be thinking about the way we think about investing and prudence in investing in the like. So Larry, take it away, right?

Larry Swedroe 00:53
So the story is about a group of higher beings, an advanced intelligent society out there in space somewhere, and they're monitoring the radio waves and other forms of communication from earth to see how these lower beings on Earth are progressing in the society. And they became very interested in a specific set of communications related to popular theories that were being espoused about how you should invest, that people were trying to pick stocks and time the market, and it was kind of going against all the evidence that they had known for centuries, and even the evidence of the people themselves who were engaging they were persistently underperforming the market because of their strategies of actively trading, trying to pick managers, when all the evidence said, that's a loser's game. And they kept watching, you know, what was going on, and they felt compelled to come visit, to investigate this strange investment phenomenon, and they arrived at the New York Stock Exchange. They watched CNBC and Bloomberg and trying to figure out what's going on. And they're very disappointed that people are following these strategies, which we know, Andrew, you and I, at least know is a loser's game. Not that it's impossible to win, but the odds of doing so are so poor, it's simply not prudent to try. So the visitors decided, maybe there's some hope here for the humans, at least one of them. So let's go check the library to see what the laws say. And they were encouraged by what they found when they read something called the third restatement of trust, written in 1992 which is written by the American Law Institute, and it laid out very clearly what you and I know and I presented in my books, that all the evidence suggests that While it is possible to beat the market, there is no evidence that past performance is a predictor. You're taking unnecessary idiosyncratic risk, which are generally not rewarded. And the markets are highly efficient and becoming more efficient as research uncovers anomalies and once they get discovered and are published, then the anomalies, certainly, if they're behavioral in nature, will tend to shrink, if not disappear. And then they found a particularly interesting set of quotations from a professor named Michael share from the University of Minnesota's Carlson School of Management. And I need to read this because very specific. I think it's just absolutely brilliant analysis. He says ethical malfeasance occurs when an investment manager does something deliberately or conceal seals it like he knows he's drunk, but he drives anyway. For example, consider the manager who invests intentionally at a higher level of risk than the client chose without informing them, and then generates a subsequently higher return. The manager attributes the alpha or the excess return to his superior skill instead of the reality which he was taking more risk, so it was just more exposure to beta, not Alpha. Okay, then he says at the malfeasance occurs when a sorry, ethical misfeasance now occurs when investment does something by accident. The manager really believes he's sober, but he's not, and he drives. Thus the manager doesn't know what he's doing and shouldn't be managing money. Share concluded this managing money and. An efficient market without investing passively in index funds, or what I call funds, that are systematic, transparent and replicable in their strategies. So they're unique in how they define their universe, but once they define the universe, there's no individual stock selection or market timing. He then noted not knowing that such a market is efficient his investment misfeasance, because you should know it. It's in the law books. You don't even have to read the investment research. Just go look at what your duty as a trustee or you are, you know, managing money in effect, with that responsibility. In either case, he says he believed that such conduct may be imprudent. Per se, there's no excuse for the manager driving whether he thinks he's sober or not. The bottom line is share felt that passive investing this systematic, transparent and replicable strategy is the more ethical way to go. So these higher beings read this and feel comfortable that at least there's good directions and humans, over time, will figure it out. And the good news. Instance, I first wrote that story in the early 2000s the market has shifted dramatically. At the time I first wrote that story in one of my books, the market was maybe 10 or 15% invested in this more prudent way, and today, the estimates are maybe 50% or even more than that. So humans are waking up and maybe even the majority of the money, or close to it, is now managed in that systematic way.

Andrew Stotz 06:47
Yeah, so misfeasance has to do with, uh, improper or careless performance where you

Larry Swedroe 06:54
don't know what you're doing. It's an accident malfeasance, you know, it's bad and right? And I would suggest that most investment advisors who engage in active management surely by now know that it's malfeasance well.

Andrew Stotz 07:10
And if you combine that with yesterday's class I did at my university about the CFA code of ethics, we have responsibility for diligence and thoroughness in our research, which would mean that to claim misfeasance that you didn't understand or know something would not be acceptable under the CFA code of ethics, because you have an obligation to understand that. And as a prudent investor and as a person who's also, let's say, representing the interests of others, you have a certain obligation to do the diligence you know that gets you to those understandings before you take action.

Larry Swedroe 07:43
Yeah, what every active investor has to admit is you're taking on significantly more idiosyncratic risk, for which, if markets are efficient, you're not compensated for, because you'll have a concentrated portfolio. So what that means your potential dispersion of outcomes has fatter tails. You do have the opportunity to get greater than market kind of returns, but you also have the opportunity to have much lower returns. And the evidence on active investing is the managers that tend to outperform on average, outperform by a little bit, and the ones that underperform tend to underperform by a lot. Either they don't have the skill and they have higher expenses, and the ones who have who have skill enough to beat the market, most of that skill is offset by their higher expenses. So it's really still incredibly hard to generate alpha.

Andrew Stotz 08:43
And what can you recall, what you think would be the best research on the impact of fees that you've seen like, what is there? Is there a person that's associated with that? I'm looking at different papers and thinking about that, but I'm

Larry Swedroe 08:58
trying to think there are tons of papers on that there. Russ wormers did a paper early on in the 90s that I cited in my first book, if my memory serves. He found that the average active fund on a after underperformed, because even though the stocks that they picked out performed by roughly 70 or 80 basis points, right, their transactions cost was like 70 basis points, their fees were 80, and they're sitting on cash, which is an opportunity costs, on average, if the market gets 10% and T bills are, say three or four, you're losing that right? So there's a cost for sitting on five or 10% of your portfolio might be in cash. So those three costs meant that even though you had skill and you were generating eight. Basis points of gross alpha, your net alpha, which is the only kind that investors get to spend, was minus 160 on average.

Andrew Stotz 10:11
Yeah, and I see in the Journal of Finance, his article came out in 2002 mutual fund performance and empirical decomposition into stock picking, talent style, transaction costs and expenses. Yeah, there's

Larry Swedroe 10:23
another. Ken French did another major study later, maybe around 2010 and found something like 70 basis points and expenses. Trading costs, another thing. So you know, you have to overcome all of that, you know. And so investors will literally leaving 10s of billions of dollars every year on the table, and that money is going to the fund sponsors, the brokers you know, and the market makers who are shaving off those bid offers. And now you could add high frequency traders who are picking you up. Yeah.

Andrew Stotz 11:01
And one last thing I would say is just that, let's say a question I would ask is, are there times that active management can work? I guess one question you could say is, if a fund management company could build up a size that's big enough that the fee can get closer to a passive fee, possible? Yeah, so

Larry Swedroe 11:23
here, first of all, in aggregate, it's virtually impossible for active managers to win, because all stocks have to be owned by somebody, and if one active manager outperforms, because they overweighted outperforming stocks, that must mean that other active managers underweighted it, because the passive investors in aggregate, own the market pro rata, right? So it's impossible. Now we know that the markets are not perfectly efficient. In the warmer study, he found about 80 basis points of stock picking skills now that I believe today would be a lot lower. Why do I say that? Because coming out of World War Two, 90% of individual stocks were owned by individual investors. So Warren Buffett's of the world and the bright fund managers had a lot of dummies they could exploit and outperform over time. What we obviously are going to see are you have two groups of investors who are trying to beat the market. Andrew, you have the ones with skill and the ones without skill, right? Which group of investors are likely to abandon the efforts of trying to beat the market because they see their results at the ones without skill, with ones without skill, right? So they drop out, which means the remaining competition must be getting easier or harder, harder, harder, because you don't have the dummies to exploit. And today it's only about 10% of the trading is done by the naive retail investors, so you don't have a lot of them to exploit on top of them. When I got out of college and was looking to become a security analyst. Very few of those people had degrees in finance, because I actually graduated with one of the first degrees in finance, because there was no finance theory until the late 60s and early 70s, William shop and others created the CAPM finance was taught maybe in an economics program or an accounting class, and they finally became a profession in the 70s and 80s, and you had MBAs in finance. So today, everyone who manages money virtually has an MBA or a PhD in finance or physics or more. They're rocket scientists, literally, I mean that, and they have access to far more databases, and, you know, high speed computers, and so the competition is incredibly harder, yeah, so I think it's getting much harder because the supply of victims has come down, and the people who you're trying to be Warren Buffett is no longer competing against the Larry swedros of the world. He's competing against the citadels like Ken Griffin and Renaissance technologies. That's who do you know, the vast majority of the trading. So here's what I would say. I still believe that there are likely some people with enough skill to generate gross alpha, just super smart and access the databases everything else. Clearly, some of these high frequency traders in the citadels are all they're doing it, but they're more doing it by shaving pennies off of each trade. And they do. You know, 100,000 trades a day, often, but if you get your cost low enough, then maybe you can generate alpha. So I've done, I haven't done this in about 10 years because the SEC stopped allowing it. I used to look at do a study of all the major fund families, one at a time, and took their biggest active funds, benchmarked them against a five factor model, and compared them then to the funds like dimensional fund advisor, which is systematic, transparent and Vanguard Index funds. And I found only one single fund family that managed to generate alpha once you adjust it for factors, and it was Vanguard's active funds. It wasn't statistically significant, their out performance, and it was very slight, but they're able to do it because their average cost and their active factors were in like the 20 or 30 basis points, not 80 100 or or more, right? So, yes, if you can get in other words, let's say at this active management does not fail because it's stupid. It fails because of costs. And the market is super efficient, but not perfectly. So, yeah, so there's nothing that prevents the active managers, say a Vanguard, from doing the same things that the dimensionals and aqrs of the world do, like, avoid buying stocks that are indices, but the research shows are bad, like Penny stocks, stocks and bankruptcy small cap growth stocks with high investment and no profits, and they can trade patiently instead of demanding liquidity, cutting their market impact. So if you do all those things, you got a much better chance. But even then, you're not likely to win by much. So I think investors are better off avoiding it. But if you're going to use active managers, you want to use fund families like Vanguard, that does two things. One, they're systematic. They don't stray. If you're buying a Value Fund, you won't find them buying growth stocks, so something like Wellington and they have low costs and low turnover, so they look like Warren Buffett, if you will.

Andrew Stotz 17:31
Well, what a great way to end. I mean, we started this. This section is part two of your book, strategic portfolio decisions, and we ended on a clear note about using passive rather than active in almost every case, it makes most sense. Remember that part one was how market how markets work, and now we're going to be moving into part three, which is behavioral finance. We have met the enemy, and he is us. And I'm really looking forward to chapter 21 which has a great title you can't handle the truth.

Larry Swedroe 18:05
Great with Jack Nicholson's famous and maybe best line of his career. Yeah?

Andrew Stotz 18:10
What a great. What a great. A great show. Good

Larry Swedroe 18:13
men for those who don't recognize that line, yeah, check it out. Great. Exactly,

Andrew Stotz 18:18
exactly. Larry, I want to thank you again for another great discussion about creating, growing and protecting our wealth. For listeners out there who want to keep up with what Larry's doing, find him on Twitter at Larry swedro. You can also find him on LinkedIn. This is your worst podcast. So you got something you want to add?

Larry Swedroe 18:33
Larry, yeah, I just wanted to add something for those who want to follow me. You can go on X or, you know what used to be Twitter and LinkedIn, and I just posted, I think, a really wonderful podcast that I did with Adam Butler from resolve and Pierre Dali, and we spent an hour and a half going over some really important And interesting topics. So I highly recommend listening to that podcast for your listeners and even you. Andrew,

Andrew Stotz 19:05
yes, I'm going to listen. And I saw that you posted that, and I'm going to put a link in it in the show notes, so feel free to click on that, and let's listen to that. This is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry stands out to me because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. Specifically, we're going to be going over chapter 19. Is gold a safe haven asset?

00:35
Larry, take

Andrew Stotz 00:36
it away. Yeah.

Larry Swedroe 00:37
So I think the best place to begin this story is the reason that I hear the most. There are generally two reasons people want gold in their portfolios. At least want to consider it. I think we probably could agree the most common one is it's a good inflation edge. Okay. Well, unfortunately, that's only true if your horizon is about a century long. And I don't know anyone who has an horizon of a century, although the Yale endowment might have one of that long, no individual does so even at 10 years, the research shows that gold is not a good inflation hedge at that horizon, the best hedge against inflation, of course, is to own, at least in the US. US investors who own an inflation link bond in the US, they're called tips. There are other countries that also offer inflation linked bonds, and that gives you perfect hedge against it, against inflation. But if someone doesn't believe that evidence, this is the empirical research. Here's a specific story that I think should convince anyone you should not buy gold because you think it's a good inflation age. So in 1980 gold hit a high at that time of $850 an ounce. 23 years later, it was something like 270 and inflation averaged 4% a year for that 23 year period, roughly. So that meant that gold lost 86% of its real value during that period. If something's a hedge, it should lose zero. So anyone who claims gold is a good inflation hedge over any normal investment horizon is just simply wrong. So that's number one over a long horizon, it is true. And the great example is this, if you go back to the time when Jesus walked the earth, a Roman Centurion could buy a good suit of clothes, armor for about an price of an ounce of gold. Today, an ounce of gold is about, I think, $2,500 something like that. And goodbye you a nice Armani suit and tie and, you know, shirt and shoes and so you got that so you business armor the hedge. It gave you the hedge, but you had a zero return for 2000 years. So to me, that's a pretty lousy investment. Okay, now that doesn't mean that gold may not play a role in its second reason that people consider it, and that's as a safe haven against bad geopolitical risk. People could think of Nazi Germany, for example, or you know, Cambodia, or Russia or China, or you know, these kinds of places, especially you know India and China. People there board gold for that, those types of very reasons. One of the things I point out, before getting to the research on that, is, keep in mind that, for example, the Jews in Germany who had gold the Nazis came with machine guns and took their gold. So unless you have the gold stored someplace where you could leave and get to it, it's not going to do you any good. Maybe nice as jewelry you're wearing it, but it won't serve for the reason that lots of people you know actually do buy it with that said, here's some more evidence that gold serves as a safe haven sometimes. But nowhere near as often as people think. There in the periods when the stock market goes down, okay, it's about 17% of the months when the market goes down, gold goes up. So that's good the Pro or sorry, 17% of the time when go when the market is down, gold also goes down. 19% of the time when the markets go down, gold goes up. So it's close to a 5050, coin flip, where the gold will act as a hedge when the stock market is going down. So that doesn't look to me like a very good hedge, especially when two thirds of the months the markets are going up, and so you're not gaining much of an advantage when it's going down. Having said that there are other periods when geopolitical risks show up and gold does well, so I don't have a problem with people allocating a very small amount to their portfolio, but they should only do it if they're prepared to earn lousy returns most of the time, like 23 years, and then when the risks do show up and governments become powerful, getting spend too much money, you get spectacular returns, you know, for a short period of time, right? But the only way you earn those returns if you're able to stay the course, and I don't know too many investors who are able to wait out 20 or longer year periods and not only stay the course, but rebalance. So that's a real problem, I would tell my advice was never shouldn't. Probably own more than 5% of your portfolio is gold, but if you really feel that you need a hedge against geopolitical risks, you know that's okay, but you have to remember today gold is an opportunity cost of Almost 5% because that's the riskless rate in T bills, and if you own an ETF a convenient way, that might cost you another 30 basis points or whatever. So five and a quarter percent, so gold has to go up, you know, five and a quarter percent a year for you to be even right. And gold is also not taxed that efficiently. It's, you know, stacked as a combination, at least in the US, somewhere between capital gains and ordinary income as treated as a commodity. So that's my thinking. You know, on gold, it does act as a safe haven on occasion, but there are also many times when it doesn't and it actually doesn't even hold up. It actually goes down. And it's a 5050, coin toss historically, you know, slightly favoring gold. When the equity markets go down, the gold will also go down. And one reason is markets often go down when the Fed tightens monetary policy, and that means the cost of owning gold is going up because you're giving up that carry, giving away the interest income you're going and tightening fed means likely less inflation risk, so gold goes down as well. So that's my thoughts on gold.

Andrew Stotz 08:43
So inflation hedge you talked about, and it's not really an inflation hedge. And if you run an inflation hedge, a

Larry Swedroe 08:50
very long horizons, right? I can say a minimum of like, 2530 years.

Andrew Stotz 08:55
But if inflation is your worry, then tips is a better, much better. Not

Larry Swedroe 09:01
even close. Yep.

Andrew Stotz 09:02
Okay, and that is a perfect hedge. Okay, it

Larry Swedroe 09:06
moves exactly with at least the reported CP. Your inflation rate may be higher or lower than the Consumer Index, depending upon what your mix of spending is, but it's a perfect hedge against the reported inflation and

Andrew Stotz 09:23
gold as a safe haven in the case of geopolitical events and stuff occasionally, and, you know, but not always for sure. And then the other one is currency. You know, for a lot of people, they look at the US dollar, and they think, at some point this, this currency is going to collapse, and I don't know where to put my money. Do I put it in Chinese? Do I put it in Euro? Do I put it in, you know, where do I put that? And so some people say, Oh, well, I think I'm going to use gold as a hedge against the US dollar collapsing.

Larry Swedroe 09:56
You know, the evidence shows of the long term, gold is. Not a good hedge against currency risk. It can be a good hedge, as we've said, over the long term, against inflation, and the only reason the dollar should collapse is if you get high inflation. So I'd rather own tips than on

Andrew Stotz 10:16
gold. All right. Okay, so tips, pretty much does the main thing that most people are thinking about when they go into

Larry Swedroe 10:22
you get a real rate of return today, guaranteed of about 2% right, instead of no real expected return with for gold over the long term, it's been zero for 2000 years. So

Andrew Stotz 10:36
let's, let's imagine now, you know, I do a lot of correlation analysis, just like for fun, like looking at three year rolling correlations of different asset classes or different ETFs or whatever, relative to, let's say, the S, p5, 100 as an example. And the problem that you so when I'm thinking about it, I'm thinking about, obviously, I don't want to damage my returns too much, but I'd like to find something that has a low or negative correlation. If you do something like, let's say, Take REITs as an example, or commodities funds, which may include gold, what you find is that, generally, these things are highly correlated to the market most of the time. So they, although they may have some good returns, they're not really a diversifying asset. Then when you look at Gold, you see that, well, the correlation is zero. Yeah, I would like to have negative, but I definitely don't want to have, like, highly correlated, or else I just hold that in the s, p5, 100. So, but, but I also know that, okay, the cost of having zero correlation is, you know, it is going to lower my overall portfolio volatility by a small amount, but it's also going to damage the return. So I would say that, you know, lower correlation is, in theory, better, but if it damages your return, then you have

Larry Swedroe 11:58
to think of that as the cost of insurance against inflation risk or geopolitical risk. Five, you know, up until 2020 or right through 2022, even you know, their carrying costs of gold was zero. The Fed had the interest rates, my opinion, extremely foolishly and eventually created all kinds of problems, bubbles in asset prices and stuff, but the carrying costs of gold was zero. So fine, you want to own gold, it's not costing you anything terms of carrying costs today. That's not true, right? If I what I'm using as what I think is a better, you know, protection against inflation risk is owning private credit that's senior, secured and sponsored by, you know, high quality private equity firms. The average loan to value is about 40% in the fund that I'm in, and the yield is 11 and a half and it's all floating rate, and the historical default losses are under 1% so I'm getting 11 and a half percent and have inflation, but now I am taking some economic cycle risk, because you get a soft procession, right and before that's a big price, that's a huge premium right over say T bills, which are five, so I'm getting six and a half percent, which is an equity like return, historically, with literally about 1/5 of the downside risk, or even less than that of equities. So to me, that's a superior way, especially if you take the allocation from stocks, because now you've lowered the overall risk of the portfolio, right? Because, you know, they're like, 20% or less risky than stocks, and yet you got that kind of return. If you take the allocation to gold from equities, now you're really lowering the expected return of the portfolio

Andrew Stotz 14:12
and and what? What about the role of bonds? If you take a general let's say a bond, ETF, let's just say government bonds. Let's forget about credit risk and things like that, and take a Vanguard type of ETF of bonds, what you're going to find is the correlations are even lower than gold. So over time, that's not true. What are the correlations between? Yeah,

Larry Swedroe 14:36
people don't realize this, but the long term data, people tend to think of the correlation of stocks and bonds is negative, and that's because we had this great moderation when the Fed was suppressing interest rates right and suppressing economic volatility as well. But the long term. Data is the correlation between stocks and bonds is about point one seven, if my memory serves so it's actually positive, and it can happen at exactly the wrong time, which, by the way, happens 50% of the time with gold. We said right, roughly 50% of the time when the market's down, gold is down, but 2022 we had stocks down double digits in the US, and bonds down double digits in the US. And that's happened, I think, three or four other times in history. So it doesn't always work that way. Okay, so I like shorter term boxes that hedge against inflation.

Andrew Stotz 15:44
So let's say that somebody builds a portfolio of equity. And let's say that, you know, they've got that. Let's just say it's 100 million, $200 million $500 million Portfolio. So let's say they can only trade in ETFs. Let's say they're in Thailand as an example. They're not going to go sign up at a fund. Management Company in America as an example. And they have what they want for their equity exposure, whether that's us, whether that's global, let's just say they have the VT fund that owns every stock in the world. So you know, they've got their equity exposure. And it's, it's, it's as low as you can get, the risk on that you're still going to be exposed to market risk. With that market cracks, it's going to collapse. But from a diversification perspective, within equity, you kind of own every stock. So let's just start from that point, super simple. And now the person saying, Okay, I want to reduce the risk of my portfolio. And that means I want to add, I want to allocate somewhere between, you know, five and $20 million out of a, let's say, let's just take 100 million. Just to keep it simple, I want to allocate two to 10 million into something that's going to, you know, help me to reduce the overall volatility of this portfolio? What would they add?

Larry Swedroe 17:02
Yeah, so the first and the easiest way for people, simplest just go buy a short term bond fund, say a Vanguard short term ETF, something like two years or something. So you have very little duration risk, very little inflation risk, and that would be one way to do it the and you if inflation does pick up, and that's what you're concerned about, you're fine. I don't think there's much risk on the reinvestment risk side, because of all of the printing of money around the globe by central you know, by governments. So, you know, it's certainly possible rates could go down, but maybe they go down to two and a half. You know, you have to remember, central banks in the world are targeting inflation of two. They don't want to see it less than that. Historically, treasury bills have yielded 50, 6070, basis points above that. So let's call it 270 for where you would expect the T bill would be in that world. So you're at, you know, five, 475, to five today. So the most it likely would go down, unless you're in a severe crisis or financial is 2% but if you get high inflation, it could easily go back, like it did in the 70s, into double digits. So I think the risk is much higher, that they go up, and especially with budget deficit problems around the globe. So that would be one thing, but, and

Andrew Stotz 18:41
just, and just to highlight for a second, for people that may not completely understand it, really short term bond fund really is getting pretty close to cash, right, right? So, you know, the simplest way someone could say is, I have $100 million and I have 10 million or 5 million in cash and 95 in equities. Well, you are, in theory, diversifying in that case, but here you're going to get a little bit of return and the like. So what would be your next step?

Larry Swedroe 19:07
Yeah, what I think is a superior overall way of doing things is to hyper diversify the risks. So you could add something like reinsurance. So the reinsurance fund today that I'm invested in ETF, just, just so, unfortunately, it's not an ETF, yeah, I don't even know if it's available to foreign investors, but it's called, it's stone ridges reinsurance fund. A symbol is S, R, I x, the expected return this year was about 23% and I would guess the expected return next year will be similar. The fund is actually up 23% this year, just a matter of luck, but it has no correlation to stocks at all. Like gold, like a two year, right? It does have more downside risk in a really bad year, might go down 25 30% but the expected return is 23 and there's no correlation, and it has a bit of an inflation edge, because part of the at 23% is the return on Treasury bills they hold until the year is over, because they have to hold the reserves in case bad events happen. So if rates go up, as they've done, four years ago, they were earning zero on their cash. Today, they're earning 5% and up until a couple of months ago, they were getting five minutes. So that's one which

Andrew Stotz 20:44
is great. But my in my situation I'm explaining for the listeners, is that they can't buy they be, they got to be in a relatively large and liquid ETF. Let me ask you a question about the short term bond fund. Is there any reason to hold a tips fund if you have a short term bond fund,

Larry Swedroe 21:02
yeah, because if you have the tips, you can lock in the long term rate. If you think that's attractive when it was negative, I wouldn't have done it today, you're up around 2% or so. And I think that's a reasonable one. I remember in the early 2000s it was at 4% and my entire tax advantage portfolio was all in tips. I thought it was the body of the century, and it did turn out to be that way, 4% real return, risk free. To me, that's far better than equities, especially today, when the expected real return, you know, probably isn't 4%

Andrew Stotz 21:49
if we think about it, from a 2030, year horizon, you know, we're talking long term horizon. Someone doesn't want to be in and out of these different things. They're happy with their VT fund as an example. Should they be adding the short term bond, ETF and tips ETF? Should they? How should they think about the Diversified that's

Larry Swedroe 22:09
tax advantage, money you probably want to own tips, because the yields, real yields, I think, are attractive. Again, not super attractive, but quite reasonable, and you can lock in that real yield if you're short term you know, you have that reinvestment risk showing up, but you eliminate the inflation risk with tips. You have no reinvestment risk because you could buy a longer term tip and lock that real rate in, you know. So that's a big if you own the short term tip for the 10 years before 2022 I mean, you were earning negative real returns or zero, all right, and you know, so then it might have been better to own the shorter term bond fund, but you weren't getting anything either there. I mean,

Andrew Stotz 23:03
Neither of these instruments are going to provide a huge return like equity, really, I would say the person that's got that 100 million dollars is really putting it in there for the diversification benefits. And so if you look at the short term bond fund, and we looked at the TT, Tip, Tips, ETF, which one do you think would have a better reduction in volatility over a 2030, year period?

Larry Swedroe 23:29
Well, the volatility will be lower in the short term bond fund because you don't have the risk of real rates moving. But that shouldn't concern you, if you like, the two year current real yield on tips, all you have to do is hold it to maturity. What do you care? What the volatility is? In the interim, it's irrelevant. You're going to get a guarantee of a 2% real return plus whatever inflation is. So that volatility shouldn't matter, right? It's not. It's silly to even think about it that way. Okay?

Andrew Stotz 24:03
And last question is, we've got these two instruments that we're talking about as potential risk reducers for this, you know, long term, 100 million dollars in equity. Is there any other, anything else that you would add, I know in the research that you reference in the chapter you talked about Pim Van fleet's research about gold, and he talks in his research about getting low risk, building a portfolio of low risk stocks. Does that make sense?

Larry Swedroe 24:34
Yeah, you can, you know, I'm not a big fan of that strategy, and because, if you own low volatility stocks, okay, well, let me say it this way, there's a low volatility stocks on a risk adjusted basis of outperformed high volatility stocks, which is a violation of the capital asset pricing model that's. Big anomaly, which is why the capital asset pricing model is wrong, and everybody knew it like immediately when the cap M came out. But it's a nice theory allows you to help you think about how markets work. But it's just not true. But if, if you have a low vol fund with a market beta of point eight, you sort of have 80% exposure to the market. The Mark goes up 10% you're going to get eight likely, and if it goes down 10% you'll only lose eight and low volatility strategies have only worked and added higher returns when they were in the value regime, so they were cheap and low beta, and today, because of the popularity of these strategies, it's kind of neutral, so there's no premium. So why own them now? They actually got so popular they became growth stocks, and then that low volatility performed very poorly. The most important thing for investors is they should screen out the high volatility stocks out of their portfolio. You do not want to own them, but the average retail investor loves them because they look like lottery tickets and they hope to hit the lottery, but the average return is god awful. So, but let me add this. I think if you can accept the fact that you will bear some downside risk, okay, I would much rather own real assets than gold, because they have our expected real return. So, for example, real estate over the long term, real asset prices go up because part of the cost is land and buildings, construction costs, and real estate will act as a good long term edge. And remember, gold only works as a long term edge, right? And you real estate is basically provided similar returns to the equity market, but might be a better inflation head from that perspective. The other asset, which people, I think can buy, certainly I know, are available in private markets, but they may be available are infrastructure,

Andrew Stotz 27:21
because infrastructure, ETFs and the like,

Larry Swedroe 27:23
yeah. So they, for example, own toll roads and water facility and things that when prices go up, those things, you know, raise their prices with the inflation rate. And it can act as a hedge that way as well. So I'd rather own something that has a real expected return, rather than something with no real expense. But you should probably always have a sufficient amount of the really safest, most liquid, like treasuries or tips, so you can rebalance in a bear market. Right? The other assets may be more difficult because they're going down maybe at the same time. Um,

Andrew Stotz 28:06
and you mentioned real estate. The problem that we face with real estate is, every time you go to think, Oh, I'm going to invest in real estate, all you find is REITs and then, and then you're all of a sudden, you know, you there's a rental income, and it's like, as opposed to, let's just say, the most simplest situation of this guy, this man or woman who has $100 million is that, well, take ten million and buy a piece of property in the city that you like, and, you know, own a piece of land, build a house, something like that. Would that be the diversification benefit? Nope, that's

Larry Swedroe 28:38
really the wrong thing, unless you're an expert in real estate, and they'll make the mistake of think confusing the familiar with the safe. Oh, I know that building. I know that air. It's like owning one stock. It's got a unique undiversified risk of that location, that region. Maybe it's exposed to some industry, certainly exposed to one country, and it's exposed to one type of real estate, where, if you own a broad Real Estate Fund, you own hotels and warehouses and data centers and all kinds of, you know, commercial real estate, residential real estate. So that's the way I would prefer to own it, in a very broad, lower cost vehicle, if you're using public then Vanguard's fund or dimensional fund would be very good choices.

Andrew Stotz 29:30
And are these? Are they? What are they owning? Are they? Is it just a bunch of

Larry Swedroe 29:36
Vanguard owns an index of real estate that excludes mortgage REITs. I think they also exclude prison REITs. So it owns hotels and warehouses and data centers and, you know, apartment buildings and all kinds of stuff. So you're highly diversified. And at least the US fund is us. You can own International. As well. I'm sure of that they're available,

Andrew Stotz 30:05
interesting. Well, the real estate one is a challenge, because every time I see a liquid, large liquid, REIT, I correlate it to the US to the market, and I find a very high correlation. And then I ask myself, and then and then and then, to make matters even worse is that, what what many of these REIT funds? Let's take an ETF as an example. What they own is listed reads which are already in the index. So I'm just carving out a sector and doubling my exposure to that sector.

Larry Swedroe 30:36
But the correlations aren't perfect. You're still getting a benefit and you're getting an expected, real return. And remember that the correlation with stocks we may hold like you're getting down markets, like maybe 2022, both stocks and REITs went down, or Oh, eight, they certainly both went down, right. But over 10 year periods, it may be very different. And remember, gold is not a good inflation hedge, even in 10 years. But I bet, if you looked, I haven't looked, but I bet the correlation with inflation and real estate is probably higher and Okay, certainly over long horizons real estate would be a reasonable inflation edge, and that's where gold so would you rather own something with a real expected return of zero or one with a real expected return, you know, maybe in the 4% or something like that range? So let's be higher today, because, read, prices were so distressed.

Andrew Stotz 31:40
So let's go. Let's then wrap this up by going back to this person. They're not highly sophisticated, but they want something super simple. They got $100 million they can invest in ETFs. They've got that 100 million and they've got a 30 year time horizon. They're not short term, and they don't want to buy and sell. They want to set it and forget it. To some extent, they're 100% exposed to equity through, let's say, the VT fund. So they own every stock in the world. They're not interested in doing a lot of different stuff in that. That's okay for them. They're they're thinking of, I don't know, five or 10% of their portfolio going into something. We've talked about short term bond funds, we talked about tip ETF, we've talked about low volatility stocks, and we've talked about real estate. We've talked about real estate and going out and buying a piece of land versus real estate investment trusts and other types of funds, and we've talked about infrastructure funds. Okay, now, now they've heard that discussion and they're going to say, okay, so what would be the one thing that would be the best for me, over a 30 year period to add five or 10% to this portfolio to reduce risk of volatility a bit. What would you say?

Larry Swedroe 32:50
I would say you start with tips, and that should be your first five or 10% that should be mandatory in the portfolio, if you will. And then you could look at adding some of these other assets. And if you have access to private markets, which I know, higher net worth individuals probably have, you know, most places in the world, you could own private real estate, private credit. And the cost of investing in these types of vehicles is coming down. It's come down dramatically in the US. So or I never would have invested in private credit 10 years ago. Now, 10% of my portfolio is in private credit, and 10% of my portfolio is in private real estate, which is much more tax efficient in the US than REITs are.

Andrew Stotz 33:41
So what a comprehensive discussion about this, starting with gold, and then going through and realizing, okay, it's not all it's cracked up to be, and therefore there are other alternatives. We've been through different alternatives. Uh, excellent discussion. So I appreciate that Larry, and I'm really looking forward to the next chapter, which is chapter 20, and you titled it a higher intelligence. And I just want to read the quote, because it's such a great one by Victor Hugo that says there is one thing stronger than all the armies of the world, and that is an idea whose time has come. And I guess, since Trump just won the election, maybe that was the idea whose time has just come. So excellent. And for those of you that want to continue to follow the discussion with Larry, find them 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. You.

Andrew Stotz 00:03
Andrew, hello, risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedro, who for three decades was head of Research at Buckingham wealth partners. You can learn more about his story on episode 645, Larry stands out because he bridges both the academic research world and practical investing world. And today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And that chapter is chapter 18, Black Swans and fat tails. Larry, take it away. Yeah,

Larry Swedroe 00:36
the term Black Swans was a very common expression in the 1500s because nobody thought there was anything other than white swan. So a black swan was thought to be an impossible event, until 1697 when people were exploring the world. Eventually, they went into Australia, found that there is such a thing as a Black Swan, and then it became known more as something that's highly unlikely, right? And that term became popularized in finance in 2001 when Nicholas Taylor published his book called black swans. And the point of his book was to show that stock returns really have big fat tails. Their distribution of returns are not normally distributed, and fat tails means that unlikely, what people think are unlikely events are really much more likely than people think likely, meaning what might be in a normal distribution, but a a distribution with what's called crypto excess kurtosis, it's going to have big fat tails, and that means the probability of that unlikely event is probably higher than you think. And the academic research on this has been very clear. It's been known for a long time. I think it was in the 60s. Ken gene Fauci wrote a paper showing that, you know, stock returns were not normally distributed. And if anyone doubted that, just think, in the last 24 years, we've had three big quote, Black Swans, things that you would think might happen once a century, maybe. And we've had three, right, the events of 911, 2008 the great financial crisis, and, of course, COVID, right? So we've had three of them, and there's been some good research. I think we've talked about some of this before, but a good example of this is that if you take stock returns, and if you in the last 100 years, you cut out the best one month a year, not each year the best month, but just take out 100 months that were the best returns, right? That's clearly a fat tail that's 1% of the distribution. You would think you wouldn't lose all that much of the returns. But the fact is, you lose 100% of the returns. So that's the good fat tails. And of course, similarly, if you avoid the worst months, then you know your returns become spectacular, and the evidence is very clear that trying to time the market because these are unpredictable events, is the wrong strategy. So the fact that you have fat tails in the data doesn't mean you should try to time the market or engage in active management strategy, because we know the evidence says that doesn't work. What it does mean, very simply put, is your investment strategy, your investment policy, your asset allocation decisions must take into account that these fat tails exist, that there is the risk of extremely large losses. They're unpredictable, and therefore you shouldn't take more risk than you have the ability, willingness and need to take. So just summarize the way to think about it is we know that say typhoons and hurricanes are rare events. They may happen twice a year in some particular location, maybe so the other 99% of plus of the time you're safe, but you don't build a ship to avoid just safe in those. 99% of the time it's got to be able to withstand it. The same thing is true of a home. If you're in a hurricane prone area, you've got to build the home to withstand that. So you are aware of that. Well, the same principle should apply to investors. That does to home builders and ship builders, and you have to have a plan that can withstand those fat tails, because we know they exist.

Andrew Stotz 05:25
You know, I did some work on the Thai market, and I know he also talked about international markets, this Javier Estrada in this research. And he's actually quite prolific. I'm just looking at his research. A

Larry Swedroe 05:40
lot of his papers, very good stuff. Yeah. Sequence taking this, which applies greatly to the sequence risk, because if that Black Swan hits like in the year or so that you retire, your whole portfolio can blow up, even if he gets good returns over the rest of your life, because you're withdrawing and you can't recover, even if the markets do, because you've taken that money out.

Andrew Stotz 06:05
Yeah, and that's his paper called sequence risk. Is it really? Is it really a big deal? Which you put out in 2021 I think is what you're referring to? Yeah, yeah. Now I have a counter argument here, Larry, which you tend to help me, you know, get my thinking right.

Larry Swedroe 06:24
Let's see if we can do that this time. Let's see. So

Andrew Stotz 06:27
I also did this type of study, and I found, and I don't know if he talked about it in that paper, but what I found, too, in addition, was that best days often followed worst days,

Larry Swedroe 06:40
sure, and that makes common sense, doesn't it correct? Because the worst periods what happens? We know that stock prices are much more volatile than corporate earnings, yep. And therefore stock prices often crash because of two things. One, earnings will fall, but then the risk premium investors demand go way up, and it's the risk premium that determines the expected return. So that is why Warren Buffett tells people don't try to time the market. But if you can't resist, what you should do is buy when everyone else is panic selling and sell when everyone else is being exuberant. Yeah. So what should they know?

Andrew Stotz 07:28
So let's take this. He noted that the maximum daily return maximum was 15% up and the minimum was 20 basically 23% down. Yeah,

Larry Swedroe 07:39
that was Black Monday, uh, October of 87

Andrew Stotz 07:43
so, okay, you just put 100 into the market, and it just went down to become 77 let's say, and then the next day it, let's say it doesn't rise back to 100 No,

Larry Swedroe 07:58
it didn't go up. And market kept going down for a bit more. It took two years to get back, I think, to recover the full loss.

Andrew Stotz 08:07
So there's two things that we can think about here. One is, okay, the black swan event that leads to a decline in the market. Well, now it's just you're in a decline in the market. It's not necessarily that, oh my god, there's this black swan event. It's just an awful decline in the market that started with a big loss. But what I saw most of the time was that those bad days, let's say that's the worst day, but let's say many, many bad days are followed with a bounce back. So maybe you learn you go from 100 to 80 and then you're back up to 92 or 95

Larry Swedroe 08:45
and sometimes it goes down again right after that's called the dead cat bounce. Yeah, again,

Andrew Stotz 08:51
again. If you're in a down market and just going down and down, you're being exposed to a down market. And it just happens to have some violent days during it. But most of these worst days that I did, what I saw when I did this research a while ago, was were followed by bounce backs. And therefore, in those cases, does it even matter? You're a long term investor, you went from 100 you went down to 80. Now you're back up at 95 and things continue on. I'm not talking about a case where that was just a sign that, okay, we're going into a down cycle. That's a whole different thing. But when we just think about these black swans, does it really matter to a long term investor? Yeah,

Larry Swedroe 09:33
it certainly does. Because first of all, you don't know that it's going to come back. There's no guarantee. Think about the many rallies we've had in Japan, and it's still 34 years later, a zero return. Now, obviously you did

Andrew Stotz 09:50
that's on top. That's a down cycle,

Larry Swedroe 09:52
but you Yeah, but you don't know that when it's happening right? When two thought, when we had the.com bubble burst and. Then you had 911, there was no guarantee the US would come back. 2008 you know, the US went into a recession, and two months after, or three months after the market bottom in March of Oh, nine. So what do you knew then? Yeah, right. So that's the problem. You don't so here's the let me just finish this. Yeah, try to answer you you don't know, and because you don't know, there are two strategies you have to employ. One, don't take more risks than you can stomach, and you have to be prepared to rebalance the portfolio to take advantage of those drops and buy more when things are down, and so you can't panic and sell, or you don't get that back. So it matters. You may think you're a long term investor, but if your stomach screams, get me out, because emotionally, you can't handle it. Or maybe, like in Oh, eight, there was a economic crisis, and now you get laid off from your job, and you have to sell because you have to put food on the table and make your mortgage payment. So even though you're 28 years old, you thought you had a long horizon, that black swan showed up, and maybe you shouldn't have been taking that much risk, because your economic cycle risk was correlated with your human capital risk. So investor behavior, psychology matter, and then the sequence risk matters. I would argue anyone who's 65 in normal health is a long term investor, because if you're a 65 year old couple in normal health, the second to die life expectancy is 25 years. Now you've got sequence risk to deal with, so the other part of the strategy should be, not only don't take more risk than you can stomach or need to take, but then you should what I call hyper diversified, so you don't have all your risk in economically risky assets like the stock market, so you can have a more balanced portfolio owning things like just for example, reinsurance, which has no correlation to stocks and bonds, because so that helps you stay the course, because your whole portfolio isn't collapsing, long, short portfolios, trend following strategies or other examples. Trend following in particular, tends to underperform most of the time, because most of the time the market's going up and it lags. But when you get an extended bear market, it gets short and stays short, so it can help you. So that's the other lesson, not only don't take more risks than your stomach will let you take, but also diversify and not concentrate your entire portfolio, and that can even include what people think are safe bonds, because you could have the stock market crash at the same time, interest rates are going through the roof. Just think of what happened to the people. Say, in Greece, in 2010 11, when they had that crisis, interest went through the roof. Their stocks crashed. Not good.

Andrew Stotz 13:18
I still don't get it. Let me, let me go through my thinking, and then I want to hear your feedback to help me improve. So first of all, I agree with the diversification concept that you talked about, and you've talked about alternatives and like so let's just say that that that I simulate through a Monte Carlo simulation or any other way, and I adjust my, my my diversification, so that it, it does lower my return a little bit, but it reduces my, my drawdowns and my downside. And I'm happy with that. So I'm sitting on, let's say, let's say, in my case, 10% what would be considered maybe counter cyclical or low correlation assets in my portfolio, that's 90% tied to equity. Let's say I'm a 30 year old and you know, so I've chopped off a portion of my downside, and I've sacrificed a little bit of my upside, but I'm okay with that. That's the balance that I want to set for the long term. So now a one of these worst days comes, and let's say that there's two potential outcomes here. One is, it's a worst day that was like the flash crash and it bounces back, which is, I would argue, is probably 70% maybe. But then the second option is that, okay? It's the sign we're going into a down cycle. And who knows how long that could last. It could last 30 years. It could last three years. So what? What should I. Do on that day when the market goes down 15% let's say, or let's just say, the market goes down 10% My thinking is, do nothing. I've set my portfolio. I've set my strategy.

Larry Swedroe 15:11
If you set your strategy right, that means you anticipated that those days would happen and you should do nothing. The question is, did you set your strategy right? Did you take into account the intellectual capital? If you were a construction worker, I would say you should never be 90% equities, because there's a you get in a 2008 or an other serious recessions, like in 73 four or in the 80s, we, you know, early 80s, we had a similar one, when the Fed drove interest rates up to 20% those kind of things kill certain industries. So if you're going to get laid off, you may think you got 20 but you may be forced to sell because you can't put food on the table otherwise. So I agree with you completely, if you have taken those things into account and built a portfolio that can withstand the black swans and your stomach won't force you to sell, psychologically or economic events won't force you to sell, either. That's the key, I agree completely. And in fact, what I tend to do is sin a little so I'm going to be a little more aggressive than yours. Your point, which is, after big crashes, I know expected returns are much higher, because all risk assets have what are called self healing mechanisms. When you get a down market, it's not only because earnings are down and they may not even be down at all, like in the flash crash. It's because PE ratios also collapse, and that means the discount rate at which earnings are discounted has gone way up, so my expected return has to be much higher. So where I maybe was 50% equities, just to pick a number and I was comfortable I was able to take and willing to take, say, 60% equities, but I didn't need it, because I only needed a lower return to meet my goal. So I decided on 50. But now the expected returns are so much higher, I might be willing to say, gee, if I could live with the 60 still now I might decide so typically, after severe crashes in returns over long periods. So for reinsurance, for example, went through three really bad years from 18 to 20 the expected return went from about 8% up to 33% 70% of the money left the asset class, and in particular, fund I was in, and I doubled down because I could take that risk, and now the expected return was much higher, so I was willing to put in because the risk had actually gone down, because the deductibles had gone down, the underwriting standards had gone up, so I had a much higher expected return with much less risk. So I said, Okay, now I'm willing to add a little bit more, because valuations matter. You should, all else equal, be willing to take more equity risk when the equity risk premium is larger.

Andrew Stotz 18:40
So let's go back to this guy that's suitable. A 9010 ratio is suitable for him, and he's 30 years old, and then he lives stable

Larry Swedroe 18:51
job. Yep, right. He's an accountant for a big firm, and he almost certainly, he's, in fact, a son in law of the managing partner, and he's not getting fired,

Andrew Stotz 19:03
yep. So it's suitable. Then all of a sudden he reads, you know, Black Swan, or he, you know, goes through, and he gets scared. And then an advisor tells him, you need to prepare for black swans. You know, they're going to happen and you can't. There's nothing you can do about it. They're going to happen. And you know, even in your conclusion, you said, don't take more risks than the ability, willingness or need to take, and never treat the unlikely as impossible or likely as certain. He reads that, he listens and thinks, yeah, I need to prepare for black swans. So how does he do it? He increases that ratio from 10% of, let's say, uncorrelated assets, and he says, I'm going to hold a certain amount of cash. I'm going to hold a certain amount of things that just don't move, or if I can find anything that's counter, I'm going to buy that, and I'm going to be 60% Equity now and 40% other things that are tied to other cycles, and now I've protected myself from when the black swan event and the market goes down by 10% in a day, I'm only going to go down by 7% or 6% or 5% so he has protected himself against these black swan events, but he also likely has reduced his long his terminal value and his long term return certainly

Larry Swedroe 20:26
had. So his mistake was not expecting the black swans in the first place, because so he underestimated his stomach acid test, and he failed it, and he was going to panic and sell everything, but the advisor hopefully convinced them. You know, let's just lower your equity. It's better than panic selling, because you'll never know when to get back in. There is never a clear sign that says it's safe to invest in the stock market.

Andrew Stotz 20:56
So is it correct to say that the main thing we're, we're we're working around, is whether this person is going to panic sell their whole equity portion of their portfolio on a terrible day. That's what

Larry Swedroe 21:14
are some significant portion of it. And here's the thing, no investment advisor should ever allow an investor to invest just because they took some risk tolerance questionnaire? My opinion, they're garbage. They don't tell much of anything. What you have to do is show them real life history and say, Okay, it's January 119, 73 and you have a million bucks, and we put it in the market, and two years later, your million dollars is now 500,000 and I tell you, we need to rebalance and buy more equities. Would you do it? And if the answer is no, then you're taking too much risk.

Andrew Stotz 22:03
Yeah, I have a strong opinion about those risk surveys and having worked in different banks, and that is, they work very well at reducing risk. Larry, yeah, it's just the risk of the institution, not the Exactly.

Larry Swedroe 22:20
Yeah, they're required now, under SEC rules, you're required to give them some form. It's a scam. Yeah, and we know they don't work. It's, it's

Andrew Stotz 22:33
the exact, it's, it's captured banks, captured regulators working with big banks. You know, it's just a that's a whole nother story. Yeah, you it's

Larry Swedroe 22:43
really the advisor's job is to show financial history, show what happens in the worst case scenarios when you're running Monte Carlo, show them the worst case scenarios, which include fat tails. Okay, when we ran Monte Carlos at Buckingham in 2008 it included what happened. It was in the bottom 5% so all our clients knew that that could happen, or it could have even been worse. You know now that doesn't mean 100% of them told us the truth and said they could stay the cost, but a very, very high percentage did, and if you found out that they were guilty of maybe the most common human mistake which we discussed, which is people are just overconfident of all their skills, not just the ability to take investment risk. Well,

Andrew Stotz 23:35
a good advisor understands that, and then they also make an adjustment for the answers that that clients make to adjust for the common behavioral mistakes that you know. So, yeah, sounds like you took care of a lot of clients and helped them reduce their risk in a proper way that didn't really destroy their long term returns.

Larry Swedroe 23:56
Well, the biggest thing that I think that helped people is I drew for every client I spoke with a curve called the utility of wealth curve. So you might hold up a little graph there, Andrew, that shows, you know, the axes like this, and a curve that looks like this, right? If you could show something to the audience, we can, yeah, hold on. Do that? Describe that for them, what it shows is that more wealth is always better than less, right? We always are happy to have more wealth, but your margin utility of wealth is a steep curve up and then flattens out like it's sort of, you're looking at the back of an elephant, right? And that's what it looks at. So let's take that point where it goes flat. Andrew, yeah, and let's put say, just to pick a number, 5 million. Yeah. I think if most people think that at 5 million bucks, and we're going. To withdraw general rule 65 is a 4% so you could get 400,000 a year, sorry, 200,000 a year on 5 million, and you're getting maybe 50,000 a year in the US and Social Security, some number like that, got a quarter million bucks. You can't be happy living on a quarter million bucks, I suggest something's wrong, right? So you have no need to take more risk. Now, what this is showing is the utility of wealth. It never goes flat line. This should always go slightly up, made an absolutely straight line. It should be a decline, yeah, more like that. That's and so what this shows is, when you have start out with very little and the next dollar, you know, if you take an extreme case of a homeless person, you give them 100 bucks, you greatly improve their life. Spend the night in a decent shelter, put a cup, get them a couple of meals, 100 bucks to the $5 million investor, means nothing. It's not going to change anything. So the first million is worth far more on utility than the second. The second is worth far less than the first, the third, etc, by the time you're at in this example, 5 million more is good, but it doesn't change your life in any meaningful way, right? And therefore you have no need to take risks. So you should be dampening your equity exposures and exposure to other risks. Generally, I tell people your job is to figure out separating needs from wants, nice to haves. Make sure all your needs are covered. Make sure, if you got the money, some of your wants are covered. You don't want to die with millions of bucks you didn't get to enjoy, you know, the things you wanted. But once you have those things that really make you happy, like, Hey, I'd like to take two trips around, you know, go somewhere in the world every year, on a nice tour, like I do with a company called tau, right? So if I had to cut back to one, it's not the end of the world. And if I took four, I wouldn't make me twice as happy. I'd be happier, but not that much more. So once you reach that point, you might say, and I tell people, you probably shouldn't take unless you have other objectives, like leaving it's important to you to leave a large sum of money to charity or your children, whatever. Unless that's a high priority, you probably shouldn't have one less than 20% equity. And the reason is there are periods when stocks do well and other assets do poorly, especially bonds, and there are but you probably don't need to have more than, say, 30% because you've got enough. And there are other assets you could include in a portfolio that will allow you to safely withdraw that 4% so that's the key. A lot of people have told me, Larry you and greatly improve the quality of my life. Because when all the bear markets in oh one starting 2000 oh two happen in 2008 and 2020 when they happen, we were able to sleep well through it. We never panicked, where lots of our friends had difficulty. Some of them had to work much longer than they expected. Some of them lost a large part of their wealth and then panicked and sold and then never got back in because they're afraid of loss. So it was the fact that they were able to enjoy their life safely and achieve their goals that really changed things for them.

Andrew Stotz 28:51
Well, lots of great advice there. And once you realize what your number is like. In this case, you said 5 million as an example, then it also helps you think, Well, how do I get there? You know, how do I get there safely and quickly? And one of the things that I like to do is separate the concept of creating wealth and growing well. And for most people, they're creating wealth every single month through the difference between their salary and what their, you know, their expenses. And business owners create wealth by generating profit every month. And ultimately, the question is, you know, how can I crank up my wealth creation machine so that my contributions get me to that 5 million faster? Because if you go into the stock market thinking that's where I'm going to create my wealth, you're really in for trouble.

Larry Swedroe 29:40
It certainly could be. You may get lucky, like if you start out in the US in 1980 and you got a 20 year horizon, you live through the best period ever the stocks, like 19% per annum, right. On the other hand, if it was 1990 in Japan, you got 34 years and no returns and no. Buddy knows which one of those things will happen in the US over the next 20 years.

Andrew Stotz 30:04
Yeah, it happened with my mom. And in this case, when my father passed away about eight years ago, almost nine my I brought my mom to Thailand, and, you know, I looked at her portfolio and we talked about it, my sister is taking care of it in the US. And we have an advisor there who's been taking care of my parents for a long time. And basically, we stayed aggressive with that portfolio. We didn't move to the point where we had to go, you know, to a really low equity allocation, because my sister and I also are in pretty good condition to support her in case something was to happen and she had the ability to take more risk, yeah, and so we saw it more as a family wealth, rather than mom's individual wealth. To to you know that we had the risk

Larry Swedroe 30:51
part of Thailand, which cut our living expenses right down, I'm sure. Yeah. Now

Andrew Stotz 30:55
what we the bet that we had to make, too, was that we couldn't get reimbursement for medical Yeah, so we had the

Larry Swedroe 31:02
medical care is a lot cheaper, I'll bet, in Thailand, than it is in the US.

Andrew Stotz 31:06
It's incredible. I mean, us is the most expensive in the world, and it's out of control. In the US here, it's not expensive to pay cash. And also, you know, we had to make some assumptions. You know that hopefully, well, I think in mom, mom's case, we had a discussion that was that we're not going to prolong life. That's not what she wants in her health care directive, anyway, so we made that decision. Well, it just so happens that the stock market did pretty well over the last eight years, and so even though we draw drew down a lot to cover the expenses over eight years, we still are in pretty good shape, so it just the luck of the draw. A lot of times.

Larry Swedroe 31:44
That's the one thing I'd caution careful. First of all, it sounds like based on what you told me, You did all the right things, the strategy was right because you thought through all these issues about ability, willingness and need to take risks, took into account these factors about medical care and other things, but the outcome didn't have to be that way. What if the market had crashed right after those eight years? So you don't want to make the mistake we call engaging and resulting, which is judging the quality of decision by the outcome. My opinion your decision was exactly the right one, and you put the odds in your favor and the left tail didn't show up. The odds are it won't, but it can, and does happen. It's why we buy insurance, by the way, knowing the odds are against us making money on that bet.

Andrew Stotz 32:41
Yeah. Yeah. Well, with with insurance, we would be even more comfortable getting aggressive with one portion of the

Larry Swedroe 32:46
Yeah, exactly, exactly, right.

Andrew Stotz 32:49
Well, what a great discussion. Larry. I appreciate it, and some great stuff on on Black Swans and how to think about it. And I think you clarified a lot of things in that chapter, so I want to thank you for that. And the next chapter is, oh, my God, I has, you know, I, I'm supposed to go out and give a presentation on Friday on this so, but for ladies and gentlemen to hear it, we'll, we'll talk about this one. Next chapter, 19, is gold a safe haven asset? Hmm, well, you're going to be interested in the answer that Larry comes up with. So for listeners out there, we want to keep up with all that Larry's doing. Follow him on Twitter, at Larry swedro, and also on LinkedIn. This is your worst podcast host, Andrew Stotz, sane, I'll see you on the upside. You.

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now, Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into the a chapter from his recent book, enrich your future the keys to successful investing. And that chapter is chapter 17. There is only one way to see things rightly. Larry, take it away.

Larry Swedroe 00:36
Yeah. So, as always, we'll begin Andrew with an analogy to help people understand the concept, and one of my favorites is to utilize sports, because many people understand the concept it's related to sports. So one of the players, who's considered one of the greatest players in the National Basketball Association is a fellow named Stephen Nash. Now, if you looked at his career statistics, that are the two that people probably look at the most Steve Nash averaged over his career, which lasted 18 season, he averaged just 14.3 points and just three rebounds a game. Now despite those kind of mediocre statistics. He was named an eight time all star, a two time most valuable player, and is generally considered the greatest point guard of his era. So why is that? Well, he happened to also have over eight assists a game, which is one of the highest in the history of the NBA, but Nash made everyone else around him a better player, and today, when we do more sophisticated analysis with sports, for example, in the National Hockey League, you also see not just goals and assists or saves for the goalie, but for the players on the ice, you see a plus minus score. So a guy may never have many goals or assists, but when he's on the ice, his team outscores the other team, and it's because of his contributions making the other players around them better and being a defensive player as well. So there it's the point being that you should never look at things in isolation, but how it impacts the whole so the expression is, there's only one right way to see things, and that's in the hole. So what does this all have to do with investing? Well, Harry Markowitz, who's the one of the fathers of modern portfolio theory, pointed out that you should never look at the risk and return of an asset in isolation, but you also should consider how its returns and risk co vary with the other assets of the portfolio, okay? And to show that point in the book, I give the example of the 25 year period from 98 through 22 the Vanguard 500 index fund returned 7.53% per annum, and it outperformed their emerging market fund, which returned just 16.14% so it outperformed but almost one and a half percent a year. And you said,

Andrew Stotz 03:34
you said 16, you meant six, right, sorry, I'm sorry about that. So seven and 7.5 and 6.1 roughly, okay, yep, keep going, almost

Larry Swedroe 03:43
one and a half percent difference. And on top of that, the volatility was roughly 16% for the S, p5, 100, and it was almost 23 so why would you ever want to invest in this and include this emerging market fund your portfolio.

Andrew Stotz 04:03
And let me before, before you go into that, let me just, you know, help people visualize that. Here we have a fund with a lower, lower return and a much higher volatility. How could you ever benefit from bringing that into a portfolio that has higher return and lower volatility. It seems impossible that that would have any positive impact on a portfolio. Yeah.

Larry Swedroe 04:32
And if you ask the vast, vast majority of your audience, I bet they would say, if you had the choice, would you include that? The right answer would be, I don't know. I need to see the covariance of the portfolios to see what the correlations are. The correlations are low enough, right? Then you can benefit. Because when the S, p5, 100 dramatically out. Performed, you would buy more to keep your portfolio in balance. Say you wanted to have 10% emerging markets, or 20 or 30% now, instead of 10, you're at eight, or instead of 20, you're at 18. So you would buy more and sell some of the s, p, when it had done really well, and vice versa, right? When the if there was some periods when the emerging market fund did better, which was the case of most of the early part of the first decade of this century, then you would sell some of the emerging markets fund and buy more of the s, p to put you back in 500 Well, it turns out, if you did do a 9010 allocation, I showed that you would have increased your return from seven, five to seven, six, and you would have had the same sharp ratio, so same risk adjusted return, But you would have actually earned a higher return, and it would have even been slightly higher returns, also, if you included a 20 or 30% allocation to the fund. I've even seen examples that was an extreme case in the 90s, when you if you added Turkey to a portfolio of US stocks at a time when Turkey had negative returns, but it was negatively correlated with the s, p, and the volatility was so high that you were selling when it went way up, because The volatility was way high, and then you were buying when it crashed, and you got it cheap, and it would eventually recover, even though it had negative returns for the whole period and dramatically underperform. You would have been ahead. And too many people do a line item analysis and look at each item to see how it's done in the portfolio, instead of considering how the total portfolio did because of its inclusion. And that's really the moral of the tale here.

Andrew Stotz 07:14
Yeah, it's, it's, uh, one of the things that always comes to mind, and I think we're going to cover it in another chapter. Is, you know, what do we do about the fact that in the past, let's just take Turkey as an example, that it behaved, you know, perfectly. It was perfect. You know, great correlation. But then we say, well, okay, is that going to repeat itself in the future. How do you respond to that when someone asks you that question? Yeah,

Larry Swedroe 07:46
well, I wouldn't use that as an example to illustrate the common sense of that. What I would look at is to see if there is common sense about should you expect there to be low correlation, and should you expect there to be risk premiums which would allow you to invest? And that low correlation is there. So it is logical to believe while the correlations of emerging markets and international stocks are going to be positive and maybe even fairly high to the US, because we're all subject to the same, some of the same economic cycle risk, especially when we have global systemic crises like 2008 for example. Or if we had a Persian Gulf War and oil supplies have disrupted, it would be likely that all equities around the globe would be negatively affected. But the fact that the correlations are not perfect, when things calm down, there will be some periods, almost certainly, when emerging markets underperform, and there'll be some periods when they outperform relative to the US, and that's common sense, and that's a good reason to diversify, because you're adding unique sources of risk. And there are other better cases where you see absolutely no correlation with something like reinsurance, because earthquakes and hurricanes don't cause bear markets, and generally, with maybe some possible major exception, earthquakes and hurricanes are not going to cause global bear markets. So there's logic. Even if the data happened to coincidentally for some period showing a high positive correlation, the odds are good that was luck, because there's no logic behind it. So you want to look for the logic of, should you expect low or at least, not extremely high correlation, and any asset that is imperfectly correlated should. Should be at least considered to add in your portfolio if it meets the other criteria that we've talked about, of having a premium that's persistent, pervasive, robust, of various definitions, has logical reasons for you to expect it to continue to persist.

Andrew Stotz 10:16
The last thing, and we're gonna, we're gonna get off this call. But the last thing is, last week, we talked about different funds that are alternative and providing much lower correlation. I did some work on that, and what I was struggling to find was, Can Are there any ETFs, or are they all going to be structured as funds?

Larry Swedroe 10:42
There. The good example of a fund that's available in a mutual fund is aqrs alternative risk premium from that goes long short, four different factors value, what they call defensive, which is buying high quality and shorting low quality momentum. So it goes long stocks, bonds, commodities and currencies that are doing well versus ones that are doing poorly. And the same thing for the carry trade, which is buying and selling stocks or currencies or bonds that have higher yields and shorting the others. So this, it turns out that not only are each of those factors low correlation to stocks and bonds, but they're low correlation to each other. So I mean, it's possible that AQR could turn that into an ETF, although it might be difficult, because they have 500 or 700 positions, making it difficult to replicate in an ETF. But in theory, you could if someone created an ETF of reinsurance risk that would make sense, private floating rate credit might make sense, although that is difficult because they don't have liquidity. That's why that's in interval funds. So there are, most of the assets are likely to be in either private vehicles or interval funds, which often means you're also earning a illiquidity premium, plus you're giving up the ability to trade it daily. And people love liquidity even if they don't need it, and you get rewarded with generally a large illiquidity premium if you're willing and able to take that risk. So

Andrew Stotz 12:40
for those in the audience, just go to black swans chapter eight, and Larry talks more in detail about the AQR style premium alternative fund and what it's doing. And you know the value that it brings.

Larry Swedroe 12:53
Here's an interesting point about that fund, Andrew, that's very important. And again, it shows the low correlation the first four the fund is now in existence. This, I think, is the 11th year, the first five years, it performed just about as you would have expected for the five years were positive returns, it yielded, I think, something like a four to 5% risk premium above t bills, which is what we had estimated it would be. And then the next three years were god awful lost like 30% or maybe a bit more as a drawdown, lots of people fled the fund, never to return, right? And because of the problem we've discussed of recency bias and thinking three years is a long time when any risk asset will go through, at some point, much longer periods than three years of poor performance. So most of the money left the next to me. Five the next four years, including this year, have been spectacular returns, something like 20% a year for the four years and so including 2022 when stocks and bonds both did poorly, and yet, the three years it did poorly, stocks did well. So there's good examples of an asset you should love because it has low correlation. You're buying if you have the discipline after it does poorly when the expected returns are higher, and now you've been selling some taking advantage, especially in 2022 the fund, I think, was up 25% when stocks and bonds got killed, both losing double digits. Unfortunately, most investors were not around because they panicked and sold. Same thing happened with reinsurance for the Stone Ridge reinsurance fund. First four or five years were fine. Next three bad years in a row, people, 80% Of the investor money fled, and then last year, the fund was up 44 and a half percent. I just checked this year, after two bad hurricanes that just hit Florida, back to back, the fund is still up 22% or something like that for the year. But again, most investors aren't there for recency bias, even relativity bias, and they need to and you you should love assets like that, because if they don't have periods of bad performance, then there's no risk, because all you have to do is wait three or four years and the returns will turn around. But we know that can't be true, so you want to that's a reason why you want to diversify, not avoid an asset class. So that prevents you from having all of your money in the asset class that happens to do poorly. Say you're a Japanese investor in 1990 after the most spectacular returns in history for Japan over the previous 25 years or so, right? They were on top of the world. Japan at that point was something like two thirds of the global market cap, and now it's 20% of the market cap or so, and they've had zero return for 34 years, virtually, right? So the same thing could happen in the US. I'm not predicting that, but it's possible. And investors make the mistake of treating the highly unlikely as impossible, and what they think is the highly certain, the highly certain as if it will happen when it may not.

Andrew Stotz 16:46
Well, let's end it on that. Larry, I want to thank you again for another great discussion about creating, growing and protecting our wealth, and I'm looking forward to the next chapter. The next chapter is chapter 18, and that is black swans and fat tails makes me think of the Black Swan book,

Larry Swedroe 17:06
yep. Well, thanks for having me. Glad. Hopefully this was helpful, and I'll see you next week.

Andrew Stotz 17:11
Fantastic. This is your worst podcast host, Andrew Stotz, sane. I'll see you on the upside.

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedro, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry is unique because he understands the academic research world, as well as the practical world of investing. And today we're going to discuss a chapter in his book, enrich your future the keys to successful investing. And the chapter is 16. All crystal balls are cloudy. Larry, take it away. Yeah,

Larry Swedroe 00:36
the story, or this chapter, begins, as all my chapters do, with a story that provides an analogy that helps people understand the issue, and then if you understand the analogy in a common subject, you're able to then translate into vessel. What's ironic about this the timing of this chapter will become evident to your listeners, especially those who happen to live or know people who live around Asheville, North Carolina. So in 1977 this spring, the people in a town called Grand Forks, North Dakota became very concerned about the potential risk of flooding in what was called the Red River. Scientists predicted that the river would crest at 49 feet, and given where the flood stage would be, which was a little above that, they felt okay. The problem was, the scientists didn't guess exactly right. The River crested at 54 feet, and there was massive damage. People had to rapidly abandon their homes. Of course, the same thing just happened. We know in Nashville, North Carolina, especially where people living in the mountains don't worry about hurricanes. Typically, when you're central part of the country and up in the mountains. The problem with that line of thinking is some it has to do with investing, is that all forecasts, such as those that deal with estimations of probabilities. The problem is, people tend to think of them, or what I call a deterministic way. Okay, let's say you're a baseball fan. You predict the guy's going to hit 300 Well, the odds are close to zero. He's going to hit exactly 300 the way to think about it is like a bell curve, normal distribution with a median and then the mean might be 300 but there's a 50% chance might hit more than 300 a 50% chance it hit less maybe there's a 30% chance it hit more than 320, and a 30% chance he might hit less than 280, and a 10% chance he has a really bad year, hits less than 250, and a 10% chance to have a great year hitting, say, over 350 Well, the same thing is true with stocks. You get all these analysts, and I laugh when they predict the S, P is going to close at 5913 like, you know the position really is accurate, right? And it's telling you something right the only right way to think about that is that's your median of an estimate, and you should think about the possibility distribution of returns, and when you're looking at longer time frames, the same thing applies. We don't know. There is nobody who can accurately predict where stock returns are going to be, because there are lots of surprises in the future. No one could have predicted, say, a 73, four oil embargo. No one could have predicted the internet bubble and then it bursting where no one could have predicted 911, there are lots of events this year, and then the last year or two, the war in the Ukraine, the war in the Middle East. And nobody knows how those events will turn out. We also have an election. So how do you think about returns? Again? You should think about them, and we've talked about this a bit before, is that distribution and your estimate is only the middle point, and your plan has to be prepared for either the good tail to show up, which is easy to deal with, that usually will allow you to take chips off the table, reduce your risk, because you'll be well ahead of your goal. But if the left tail shows up, you may have to either work longer, plan on saving more, you're going to have to maybe rebalance, and that means, you know, buying stocks at the, you know, at a very difficult time. But the next point that we want to talk about. Gap is this issue of all crystal balls, not only being cloudy, but even if you could see the future in some sense with perfect endgames, the order of returns which you can see can really impact the outcome of your portfolio if you're in the withdrawal stage of that portfolio. So we have a table you can put up that illustrates this point. And the story begins. It's 1973 and we know that stocks have returned 8% in real terms and 10% in nominal returns, and we've had similar results, you know, over the next 50 years, since then, all right, and so say an investor in that time frame says, well, returns were 8% in real terms, I'm going to withdraw in real terms 7% every year from my portfolio, because I know with my perfectly clear crystal ball that we're going to get 7% for the next, you know, 50 years, and I'll be dead by then. But my, you know, if I'm maybe 60 and I retire, I want to live at least 30 years make it to 90, and I have to plan for even longer than that, so I know with certainty I'm going to get 8% real, and I'm only withdrawing seven, which means if I take out, say, 100,000 just to make the math easy, the first year, and inflation is 3% to keep My real spending the same I have to take out 103,000 so now you're clear. You have the only crystal ball that's perfectly clear. And the fact of the matter is that within 10 years, you're bankrupt, as this table shows, because what is called the danger of sequence risk. The problem is, if returns are negative early on, and inflation 10 could be high, which is one reason the returns could be negative, then you're withdrawing large amounts early and when the market eventually recovers, you don't have that money, it's been spent, and you can't recover. And this shows how dangerous sequence risk can be. So what that tells you is the importance of, you know, managing that sequence risk is not taking too much risk early on in the retirement because if you get that negative outcome, you really could have a problem, be forced into cutting back your spending more than you want, or, you know, maybe having to move to a lower cost living area. So

Andrew Stotz 07:58
you're talking about sequence risk, and just for the people that can't see the chart, the table, basically, this table shows two very significant falls in the market. In the first year in this table is 1973 and the market fell by about 15% and then in 1974 it fell by about 27% the rest of the periods, you know, not bad. In fact, if you just look at, you know, you had 75 you had 37% even in 1980 you had 32% so actually, when you look at, if you were to do a simple average of this, it wouldn't be so bad. But it was the point that that 14 and that 15% and that 27% happened right at the beginning of your investing. And for those people that can see it, you'll notice some notes, because just like lots of people out there, when I read Larry's books, I take a lot of notes. And in this case, one thing I highlighted was he was mentioning that from January of 1973 to October of 1974 when the bear market ended, the S P had lost 48% so that's how you started that period of investing. And for those people that are seeing it, you'll see WB on the right hand side. I was just fiddling around and looking at what was Warren Buffett's returns in those years. But the point is, how do we deal with sequence which and I was asked a question recently Larry and somebody said, Should I do dollar cost averaging, or should I do lump sum investing? And I said to them, well, it basically lump sum investing is always going to be better than dollar cost averaging, as long as you know that the initial returns are going to be high and come you know and that ultimately, so you're not dealing with sequence risk, and if you know that, you're at the bottom of the market. But of course, we don't know that, and then that makes it much more difficult to think about lump sum so how do we think about this situation?

Larry Swedroe 09:51
Well, this question was answered 60 plus years ago by Professor Constantinides OF THE. University of Chicago. And the answer is very simple, from a risk that, from a expected return standpoint, you should always invest a lump sum, because stocks always have higher expected returns than, say, safe bonds or Treasury bills. And that means every day you're out of the market, you're sacrificing expected returns. So from a expected return basis, you're always better off. But what you have to be aware of is that sequence risk you know exists, and therefore you shouldn't take more risk than you're willing and able to deal with should the sequence risk comes up and then you should always before you invest, have a plan B. What do I mean by a plan B? So you have a plan, and you don't want to plan on the worst outcome happening, because then you will underspend likely what you could have spent. You don't want to plan on the worst 5% in that left tail, like 1973 four, right? We have one of those every 40 or 50 years, right? We had in 73 four. The next one happened in 2008 really, I was the really bad returns for the market. So, and the one before that was 29 through 33 maybe, right? So they don't happen often, but they can happen. So plan B says, well, Plan A is, I don't want to expect the worst, because then I may be only unable to spend 50,000 a year, when, if I assume more normal markets, I can spend 70,000 a year. Why deprive myself of that? But I have to have what Plan B is to say, if that risk shows up, here's my plan. I will work longer. I will cut out my annual vacation to Europe and drive to, you know, some local beach or something, right? And save that money. I might move to a lower cost of living area. I might downside, but you should write that into your investment policy statement. So you're thinking about that when you're not under the pressure, oh my god, what am I going to do? And then your stomach is going to make bad decisions, right? You're more likely to panic and sell rather than all right? I thought this app, here's what we're going to do. So that's the way to address that, so make sure you don't take more risk than you have in the first place. The other point of, by the way, maybe if you put that slide up again, just for the people who can't listen, I think it'd be helpful. If we took 7% of a Million Dollar Portfolio, you will withdraw 70,000 the first year, but then you have inflation, which was significant. It was 8.8% so we had a now withdraw to keep our spending the same in real terms, 76,000 but your portfolio was now down to 930,000 and then the market dropped another 26% your portfolio is down to 716,000 and because inflation was 12% you had to draw 85,000 and now you're down to 441,000 and by the end of 1982 you're when the market went down. In 81 you're stuck with less than 20,000 then you're supposed to withdraw 160 so in nine years, you went bankrupt because of that sequence risk. Now, if you could have waited it out, you would say, you know, 30 or 20 years old and 73 you would have actually earned that 7% real, and your portfolio would have been fine. But you don't always have that luxury. So the right way to think about these things are in probabilistic terms. So it should be like, you know, I have a 90% chance of being able to, you know, be able to withdraw, let's say, 5% a year for my portfolio. But there's also maybe a 30% probability that I'll have at least a million dollars. But there's also a 20% probability that I'll have nothing at age 90. And then you have to decide, is that distribution probability acceptable to you? And if it isn't, then you should adjust your plan. And

Andrew Stotz 14:56
just to highlight for those people that can't see but for those that. Can see, I'm just going to highlight that. I think what you're saying is that we're getting a double whammy. Number one, we're getting sequence risk in the first two years, and number two, we're also getting massive inflation in those two years. So not only are you losing the value of your investment in the stock market, but you're also using losing your purchasing power, and that double whammy is what's really causing you to have to draw down more and have less correct and

Larry Swedroe 15:29
yeah, and the same thing happened to allow to somewhat lesser degree, in 2000 we didn't have high inflation, but the stock market went down in 2001 and two, same thing happened in 2008 sequence, risk showed up. There was a really bad year, and then it happened again in 2022 when we had a really bad both stocks and bonds got hit, and inflation ran up so and luckily, you know, things turned out a little better, but there's no guarantee that that was going to happen, right? And so the benefit of the Monte Carlo is allows you to look at these distributions, and then it allows you to do scenario analysis, to say, Okay, let's say there's an 80% chance when you put your assumptions in of success if I withdraw 5% of my portfolio every year. But then you can look at, well, what if I cut it to four if I'm willing to do that, and that drives it up to 95% chance? Well, that's a big difference. A 20% risk of failure at 80% versus a 5% risk of failure at 4% now you might decide that, hey, that's worth I'm willing to sacrifice. But what if it moved it from 80 to 81 well, most people say I'm only picking up 1% I might as well spend the extra money. So the Monte Carlo analysis allows you to do that shifting your asset allocation, to see what that does. If I take a little more risk or less risk, if I shift your withdrawal rates a little bit, what does that do? If I save a little bit more now, what does that do? And you play this scenario, and that can really help you make those decisions.

Andrew Stotz 17:26
So Monte Carlo simulations basically construct the normal distribution, or the distribution of outcomes, and

Larry Swedroe 17:34
then with fat tail. So many of them don't, you know. But the point here is this even, and you know, none of us has the clear crystal ball, and we showed you an example, even if you had a long term crystal ball showing a paper, you know, 50 years down the road, and you got the result you wanted, but didn't know what happened occurred in between, even a clear crystal ball would not have helped you unless you got the newspapers in between. Let me give you one other great example, which just happened this month, even with a clear crystal ball. I think it was September 18 that the Fed announced its change in interest rate policy, and they lowered rates. I'm willing to bet every one of your listeners would have bet the yield on the 10 year would have fallen. I think at the time the 10 year was at 375, it's now 404. So if you bought long term bonds at that time, you would have taken a bit of a bath at that point. So that's a good example. And you know, none of us has that clear crystal ball that knows tells us what will happen. So

Andrew Stotz 18:55
let's talk just briefly about the concept of extreme values on that distribution. Larry's written a book called reducing the risk of black swans, where he talks about that. And those are extreme values. You know, are a different factor. But I think what we're talking about right now is understanding that it's a range of outcomes, and it could be even the statistics that you've shown in 73 and to 82 we're not talking about three or four or five standard deviation events. These are, you know, kind of normal outcomes. My question to you is, this is my last part is, it's very possible that from today forward the next few years, we could see strong negative returns possible. You know, some people are predicting that. Let's say we get two years of minus 20 or 30% or something like that. It's also possible that we could face an inflationary period. We certainly printed a lot of money, and so let's just imagine that we're going into. For a moment to do this as an exercise. We're going into a 7374 period, where market's going to be down by a sizable amount, and inflation is going to be up by a sizable amount. And let's now imagine that, yeah, we're not talking about a 20 year old who has, you know, 70 years to compound. We're talking about

Larry Swedroe 20:17
to happen to a 20 year old as long as they don't get unemployed, because prices will be much lower, returns will be higher, yeah, but it's the worst thing that could happen to a 65 year old. Let's

Andrew Stotz 20:32
say that. Let's now say we have a perfect crystal ball. We picked it out. We think we've seen the negative scenario. We think it's going to happen, let's just imagine that we're right, and how would we prepare ourselves for something like that? Now

Larry Swedroe 20:47
the better question related to that is we all agree that that's possible, which means you must build that possibility into your plan, regardless of what you think is going to happen. And we have discussed many times the worst mistake maybe that people make, and certainly it's the most common, is they're overconfident, or their abilities to see what is going to happen. And so you must build that possibility and think always in probabilities. So the way to deal with what is very simply put is uncertainty. We don't have certain future. There's only one way logically to deal with uncertainty, and that's diversify, of course, assets that have unique risks. So you don't have all your assets in the risk that could expose. So for example, if you own a lots of stocks that could get hit and the same time, inflation is a risk to you because you're retired and not working, your wages aren't going to go up with inflation, and you're not the same as that young, tenured professor at you know some university who's not going to get unemployed, right? He's rooting for that bear market, if he's smart, right? So he could buy a lot cheaper your stock, so you should know a lot of long term bonds, because that sequence risk combined with high inflation would kill you or could destroy you. So my belief is you should be all investors. Basically should be hyper diversified, not just owning the traditional 6040 stocks and bonds, because there are periods like you saw 73 four, and a reminder was 2022, when stocks and bonds both can get killed. And I can certainly construct an argument for why that could happen again, because of all the budget deficits that the whole world, all the industrial world is facing, and all this fiscal stimulus that's incurred, so it's possible. So you want to own lots of assets, maybe that don't get hurt by inflation, right? Things like private credit, which is all floating rate debt, but there you want to make sure it's not exposed to a lot of credit risk, so you don't want to own a lot of junk bonds. So I own senior secured and backed by private equity. The fund has an average LTV of about 40% a 20 year history of less than 1% defaults and default losses are less than that, and the fund is currently yielding 11 and a half percent, and it's all floating rate, and correlation is close to zero for stocks, it's non zero. Clearly, if we get a bad recession, the faults would go up, but the you know, so that, but it will go down nowhere near as much as stocks, maybe 10% or 15% as bad as the stock market. I own things like drug royalties, life structured life settlements that you know, basically buy life insurance policies. All right, that's their returns are totally uncorrelated. I invest in drug royalties, reinsurance, none of those things correlate at all with either and in fact, they some of them are inflation protected because their underlying money is sitting in treasury bills or floating rate notes

Andrew Stotz 24:43
in the book you've got on page 269 a list of reinsurance, alternative lending, diversified alternatives, giving some great either funds or ETFs. So yeah,

Larry Swedroe 24:53
50% of my portfolio is there because I'm a big believer in hyper diverse. Vacation. Now, 10 years ago, I will say that I wouldn't have owned any of these funds because the ones that were available were way too expensive, typically two and 20, meaning 2% annual fee and 20% carry, which meant that the providers were taking all of the benefit. Just think about, say, you own a hedge fund that's getting 15% gross returns. You're charging two and 20 the 20% is 3% 2% is five. You got 10. The market got 10, and you've got daily liquid in the market. You're trapped maybe for a decade or longer.

Andrew Stotz 25:44
Somebody gets rich with hedge funds today, right today,

Larry Swedroe 25:48
you can invest in Clifford's fund for roughly 1% and no carry same thing true. You could have invested in private credit through what are called BDCs, or business development corporations, their typical fees are over 4% because of the high fees. And the carry Cliff waters fund, effectively is about one and a quarter percent no carry. So you're able to capture, as I said, that fund is yielding 11 and a half after fees today, when a high yield fund, the Vanguard is yielding something like six or seven and it's got six years of duration risk. So you've got riskier credits, based on the historical data, you've got 5% or so lower returns, but it's a lot cheaper, and maybe only cost 18 basis points. So some people define as people know the price of everything and the value of nothing, focus only on expense rates, which are important, but they shouldn't be the only criteria.

Andrew Stotz 26:59
So for the listeners and viewers out there who already have the book, just go to the back Appendix A And Larry's got the list there. For the people that haven't gotten the book or that are listening, what would you say? What would be one instrument that you think would be worth somebody who hasn't, doesn't have any alternatives, they have stocks and bonds, you know, maybe a little gold or something like that. But they don't have any alternatives. Where would be one that you would say this one's worth investigating?

Larry Swedroe 27:28
Yeah, well, to me, the most logical and easiest for people to understand is reinsurance. We all know that we don't like buying insurance, and the reason is we know we buy it because we need it in case of a catastrophe, but we not only know we're likely transferring a profit to the insurance company, but we're also praying we never collect it, right? We don't want to collect that premium. We don't want a house to burn down. We're happy to lose money. So how about wouldn't it be nice to be on the other side of that trade, where you're collecting the premium now, that means you have to accept the risk. You know, all risk assets have long periods of poor performance, and that's the investors biggest enemy we've talked about recently. But

Andrew Stotz 28:19
the point, the point is, I think the message from what you've talked about sequence risk is that what we really need to do is do everything we can to protect the downside during the bad time, and then you can survive a little bit better. Now you've got three reinsurance once your pioneer, Stone Ridge, high yield and Stone Ridge reinsurance risk premium. Is there one that you would say that an investor should go and start reading the prospectus and understand it well

Larry Swedroe 28:48
if you need and insist on liquidity, which most investors don't need, at least higher net worth individuals, right? And certainly, if your money is in a retirement tax advantage account in the US, you're not likely taking that money out. Even if you're in retirement, you're probably only taking 345, 6% a year, and the fund provides a minimum of 5% liquidity every quarter. So that's 20% you can get out every at a minimum. Which

Andrew Stotz 29:18
one are you talking about

Larry Swedroe 29:19
that? But this there the the S H, r i x, the high yield fund is daily liquid, but because it's daily liquid, you have similar risk, but you're giving up the illiquidity premium that you would get in the other fund, the S R, R i x, and so you have higher expected return. So I would only own the higher yielding, higher expected returning fund, because I don't need liquidity. But if you needed liquidity, you could go with that fund. Now the Pioneer fund is an excellent fund also, and. It owns some of both of them, so you're getting kind of an in between. I think they jump around their mix, but it might be 75% the illiquid and 25% but it too is therefore only quarterly liquidity.

Andrew Stotz 30:17
Well, I think that's a great, great place to stop this interview, and I think we all got to go back and do our research on understanding funds and ETFs related to reinsurance and see as a starting point for one of many different alternative investments that you mentioned.

Larry Swedroe 30:35
Yeah, let me just close with this. It's important so stocks have high expected returns because they're highly risky. We saw that in that chart, 73 four collapse, 2933 collapse, 2000 oh two collapse, oh eight and 2022, right? That's not a reason to avoid stocks, right? It's a reason to own them, because if they didn't collapse somewhat frequently, there'd be no risk. You just have to hold on for a few years, and then the risk premium would go away, because everyone would bid up. So it's actually a good thing that stocks, on occasion, collapse. No one likes it when it happens, except maybe Warren Buffet, who likes to come in and buy cheap right? The same thing is true of reinsurance, the fund that I own, first five years performed virtually identical to what we predicted as the median was up about on average 5% or so over T bills the next three years were terrible. Lost a total of about 30% investors panic. The Fund had 5 billion at the start of that period, 1 billion at the end. Now, 1/3 of the drop, roughly, was caused by assets falling in value. The losses. The other two thirds were naive investors fleeing. Instead, I bought more, because now the expected return was much higher. Because what happens after losses with stocks PES go down and the expected returns go up. With reinsurance, it too has what I call a self healing mechanism. Premiums go up, the deductibles go up, the underwriting standards go up, and therefore the risk is down, and you're getting a much higher expect. The next year, the fund returned 44% now every risk asset, every one of the ones I mentioned list in the book, will go through some period of poor performance that gives you the exact reason why you should hyper diversify. Because if you try to guess which one will do, well, be it stocks or reinsurance or anything else, maybe that's the one that sequence risk shows up just when you're starting and you blow up, so you don't want to concentrate your risk. You want to diversify it. And there's no reason to think that the stock market goes down and that's going to cause hurricanes and earthquakes and vice versa, right? So

Andrew Stotz 33:16
the question that I have on that is when the reinsurance funds had their bad years. Were those uncorrelated with the equity market, or were they highly correlated at that moment? Uncorrelated

Larry Swedroe 33:28
because earthquakes and hurricanes don't cause bear markets. Well, think about it, stocks go down about 1/3 of the years. Reinsurance funds go down. Let's say it's not this bad, but let's say it's 1/3 of the years. So what are the odds they'll both go down at the same time, one in nine so that means once every nine years it's going to happen, but eight out of nine years it's not going to happen, right? And what are the odds that they'll reinsurance will go down two years in a row? Well, 1/3 times, 1/3 is one night, right? So, but that means you should expect, you know, once every nine years, you're going to get two bad years in a row, but once every 27 years, you might expect three bad years in a row and that, but it showed up. It can happen. The same thing can happen with stocks.

Andrew Stotz 34:28
And for the listeners out there, it's not so I mean, everything that we're talking about are risky assets, which means that they're gonna have periods where they go down. But what we're talking about when we talk about trying to prevent having this double whammy of your overall portfolio going down and also experiencing inflation and not having a lot of time left for your you know you're not going to be able to regenerate if you're 60 or 70 or something like that. The idea is, if the assets are uncorrelated or low correlation. So then that means that, generally, they're going to go down at different times. So when the market does go down, if you can find an uncorrelated or low correlation asset, what you can see is that if that correlation exists at that time, that you're going to preserve the value of your portfolio a little bit. Of course, you're going to give away some of the equity upside, you know, in the overall long term, but that when we get to this point later in life, and we have to be very careful about sequence risk and light, that diversification really has some value.

Larry Swedroe 35:33
Yeah, the way to think about it is, stocks go up, but they go up like this. When you add uncorrelated assets, your line looks more like this, right? And you ask any 65 year old, or anyone there retirement, and they get to the same endpoint, which would you rather experience?

Andrew Stotz 35:51
He said, That looks like my heartbeat. That's the one I want. I don't want that one that's highly volatile. You

Larry Swedroe 35:57
want the one that's looking like a good EKG, not a bad one.

Andrew Stotz 36:01
Well, we got to get you onto your next activity. So I want to thank you for another great discussion, and really a great one about sequence risk and thinking about that, as well as sequence risk combined with inflation, that double whammy. Not saying that it will happen. But you know, this is something that we have to put into our thinking. Larry also talked about the Monte Carlo and using Monte Carlo analysis as a way to force yourself really, to look at the distribution and understand what the changes of different factors mean for not only the average portfolio outcome, but also the wide range of portfolio outcomes. So really a great discussion, and I look forward to the next chapter, which, wait a minute. Hold on, ladies and gentlemen, the next chapter. You know, it's a short one, but there's a lot in there. It starts out with Harry Markowitz quote. This is chapter 17. There's only one way to see things, rightly so. For listeners out there, we want to keep up with what Larry's doing. Just follow him on Twitter at Larry swedro, and you'll see his latest work, which some of the latest stuff. I mean, I, I forward all of your latest stuff to my team to look at and think about. I like the one where you talked about the different economic environments and returns a couple of weeks ago. And also you can find Larry on LinkedIn. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedrow, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry's unique because he understands the academic research world as well as the practical world of investing. Today we're going to discuss a recent chapter in his book, enrich your future the keys to successful investing. And the chapter is number 15, individual stocks are riskier than investors believe. Larry, take it away,

Larry Swedroe 00:38
yeah, well, individual stock selection certainly offers the attraction of the potential for spectacular returns. Nvidia would be the latest example. Over the last few years, the returns have been spectacular. The problem with that is not only, as we discussed, that the market is highly efficient, making it difficult to identify stocks that are undervalued, okay, but most people fail to understand that individual stock selection is dramatically riskier than owning a broad selection of hundreds of 1000s of stocks, which is why diversification has been called the only free lunch and investing. So if we think about this, the stock market over the last roughly 100 years has returned, let's call it roughly 10% and the standard deviation on an annual basis of a portfolio of a broad market of stocks has been about 20% okay, what most people don't understand is that the average individual stock has a standard deviation of more than twice that. So you have, obviously, since all stocks got 10% on average, if you own stocks, you got 10% but if you own one stock or even a few, you've got twice the risk and no higher expected returns. So why do people own individual stocks? Well, one is, there's that hope of winning the lottery. And two, I think we can agree that one of the most common human traits is overconfidence. We think we can, you know, do better than the average investor. So what we hope to do here tonight is to show people how bad the odds are and why you shouldn't play that game, unless maybe you have an entertainment account. Take a couple of percent of your portfolio like you might take to a casino or a racetrack for entertainment purposes, but don't put your retirement at risk by buying individual stocks. So let's look at some of the data. There was a study done from 1983 through 2006 and it covered the top 3000 stocks. Okay. During that period, the stock market returned almost 13% per annum. The median return was just 5.1% almost 8% below the return of the market.

Andrew Stotz 03:34
And can you explain median return for those people that may not get that

Larry Swedroe 03:40
the mean is the average return of all the stocks. The median is half the stocks got above and half got below. So half of the stocks underperformed by almost 8% a year. Now here is the more striking thing, the average, or the mean, annualized return, was minus 1.1% so if you just randomly pick one stock, the odds would say you're more likely to get minus 1.1 now here's the way you have to think about stock buying individual stocks, The returns are not normally distributed, like they would be in a bell curve. So if we have a bell curve, and we drew a line down the middle and say the mean would be 10% you would think that half of the returns would be above 10, and half would be below 10. But we just went through an example where the mean was, sorry, the me, the average return was 12 eight, but the median return wasn't 12 eight. It wasn't even close to that. It was five, five. Okay, and. The average compound return was minus 1.1 and you get that because you get a few stocks that return 5,000% okay, so you need that. So way to think about this is, if you own the market or hundreds and 1000s of stocks, the odds are great you're going to get very close to that mean return. In that example, it was 12.8% so fewer stocks you own. Now you look more like a lottery ticket. Now the lottery ticket, the mean return, is minus 50% because the state keeps, typically half of the revenue, but most of the returns are minus 100% so if you buy one ticket, the odds are great you're going to get minus 100% is the most likely outcome, and that's the problem. The other problem we've seen, and we've talked about Henrik besenbaum this work, but he did a study, and he found that less than half of the stocks had a higher average monthly return than one month t bills. So your T bills have virtually no volatility at one month, and you got less return than that, and you're having, you know 20 sorry, you know 40 or 50 times that volatility, right? Even over a decade of a sorry, even over a horizon of a decade, a minority of stocks outperform. T bills, not the market, but treasury bills. Okay, the numbers are so compelling that you really shouldn't try. And we know, as we've discussed many times, that the typical professional investor mutual funds and they underperform after their cost. So you have to ask yourself, outside of the entertainment value, what are the odds that you're going to win that game? Which is why you shouldn't play and why more and more people are abandoning active stock selection. When I started in the business, 28 years ago, the index funds were a few percent of investment strategies. Today, we see estimates of about half of investors are now. So clearly most now we have probably getting very close the majority of investors have given up that hope and taken experience and wisdom over hope by indexing and owning broad market based strategies.

Andrew Stotz 07:52
It reminds me of the movie Dumb and Dumber, which came out in 1994 and Jim Carrey, of course, was the lead actor, and he was infatuated with a lady in the movie named Mary Swanson, and she was played by Lauren Holly, and he was standing in front of him. Here he is this goofy, not particularly smart guy, trying to figure out if he had a chance with this woman. And the dialog goes like this, what do you think the chances are of a guy like guy like you and a girl like me, which he got confused because he's not very smart, ended up together, ending up together. And Mary says, not good. And Lloyd, Lloyd, Jim Carrey says, Not good, like one out of 100 and Mary replied, I'd say more, like one out of a million. And he replies after a long pause, so you're telling me there's a chance,

Larry Swedroe 08:56
well, to relate that to stocks bessenbahn, that found that 100% of all the excess returns were earned by just 4% of all of the stocks. You have to look in the mirror and say, What are the odds that you can find that NVIDIA before everyone else discovers it, and it's trading, you know, with some crazy multiple already, and it's already returned the 1,000% the odds are clearly low, but it's possible. And, you know, as woody l Allen said, hope is that thing without feathers.

Andrew Stotz 09:38
So, so this, this one kind of blows your mind, because you know what we're understanding about the market and the opportunity to pick stocks. It really blows your mind. But what, what you've explained is the way that indices are constructed, generally is going to be market capitalization weighted, and therefore, in. Index or passive funds are going to try to track that through a market capitalization weighted methodology. And in a market capitalization weighted methodology, it means that those stocks that are going up massively are going to get more weight than the tiny stocks that could go up massively. But you know, they're not going to get the weight into the index, and therefore, what I believe you're telling us is that by owning that index or passive fund, you are going to capture that average return. But if you're just trying to build a portfolio of 10 stocks or something like that, you may have diversified your portfolio, but the likelihood that you're going to catch that very time tiny percentage of really high performing return stocks is just so low that you'll always, almost always underperform the passive fund would, would that be a correct characters? Yeah,

Larry Swedroe 10:50
that's a good way to think about and Bess and bond have found any, maybe even a more amazing statistic. And of all the stocks over the century a day that he looked at less than 1% accounted for more than half of the wealth accumulated in the month. Mean, you know, so if you think about it, the way I try to teach people to think about this, think about a bell curve, okay, and the mean is your average return. If you own the market, you're guaranteed to get that mean return. Now we don't know what it will be, unfortunately, right, could turn out in the next 10 years, we'll get 7% or 2% or 20% right. We don't know what that number will be, but whatever it is, you're guaranteed to get it. Now think about if you had a chance to own a portfolio that had a taller, thinner distribution for a bell curve. So instead of bell curve being wide, where you could get, you know, really spectacular returns, but also really awful returns. That's owning individual stocks, you have the chance, but it's weighted far more to the left, where you can get really awful returns, more likely and a low probability of getting this spectacular returns. Now if you could own the taller, thinner bell curve has the same average expected return, but you can't get you give up the opportunity to hit that home run owning the NVIDIA only, but now you eliminate the left tail risk, because stocks, on average, go up and they don't lose 100% right? Unless you happen to live in Russia, 1917 but anyway, you know, since the average investor, we know, or not just the average, the vast majority of investors are highly risk averse, the only logical strategy is to choose as the strategy the taller, thinner bell curve, getting rid of the left tail risk as the sacrifice for the small opportunity to hit the home run. And yet, half the investors today are still playing what we would call the losers game of trying to hit that home run.

Andrew Stotz 13:26
And one last thing for me is one of my guests on episode 667, his name is Sri, and he was the one that introduced me to Besson binders research originally, and I went through it and saw it. And what he was, you know, what he saw was a great opportunity, because he said, I have the skills to find that small number. I don't need to worry about 20,000 stocks around the world. I'm just going to focus on 100 that fit the parameter. Then bring that down to the 20 or so that I'm going to hold in my portfolio. And I'm going to, you know, be able to outperform as a result of that. What would you say for the expert that's listening to this and thinking, Yeah, this, this just tells me that, you know, I'm going to use my skills to get into that little space, yeah? Well,

Larry Swedroe 14:13
you the first thing I would say is look in the mirror and see if you see Warren Buffett. We know the vast, vast, vast majority of professionals who have PhDs in finance and spend 100% of their time engaged in this activity have access to the best databases in the world and have teams of professionals helping them, and they have been typically, highly unlikely to outperform what makes you think you have enough of an advantage over them? What advantage of any do you have over them? The answer is almost certainly none. And. Therefore you shouldn't play the game. Now it's possible you know, you have some inside information that gives you what you think is an advantage, even then, I'd be careful to think, are you really the only one who knows that? Is that not embedded already in the stock price? Perhaps not. But remember, it's also illegal to trade on that. Yeah,

Andrew Stotz 15:22
and it just, there are some people in the markets that focus on these tiny little niches where they figure out something in this little niche that causes this particular stock to go up by 10 times. Now that stock's never, maybe ever going to be one of these super large cap stocks like Nvidia. But, you know, they, they, they went into a space where nobody you know was but that's not what we're talking about here. When you talk about these small, tiny number of stocks that are outperforming, you're talking about large cap stocks that are getting bigger and bigger and bigger. Well, once

Larry Swedroe 15:53
they were small, and then they become large, right? And

Andrew Stotz 15:56
when they become large is when they're having that impact. And what I'm saying is that, what's the chance that an individual sitting in Chicago has some kind of competitive advantage in a company like Nvidia? Very, very unlikely, compared to building some kind of uniqueness in a tiny little niche of the market?

Larry Swedroe 16:14
Yeah, and, you know, look, the evidence is very clear. It's possible to win. That's what attracts people. That's what attracts people to betting on sports, even though they know. The average person you know gets taken to the cleaners, and many people end up in bankruptcy and even committing suicide because they've lost fortunes. You know, one of the worst things I you know that happens is countries legalize gambling now you got companies that are exploiting addictions that people have, and you see more bankruptcy, more credit card defaults, more mortgage defaults, because people get addicted, and they start off thinking they're smarter, better, and then they get hooked, and it's a loser. Well, the stock market is no different. They've actually run tests where they're wire your brain and people who are online trading like this, it's exactly the same part of your brain that's reacting when people are at the roulette wheel or at the slot machines or at the racetrack and they're gambling. No difference at all, but people don't recognize them.

Andrew Stotz 17:26
A great book that I read many years ago that illustrated that was your money and your brain by Jason's

Larry Swedroe 17:32
wife's book, yeah, excellent book, great book, by the way. Yeah.

Andrew Stotz 17:36
Larry, I want to thank you again for another great discussion about creating, growing and protecting our wealth, and I'm looking forward to the next chapter, chapter 16. All crystal balls are cloudy. For listeners out there who want to keep up with all that Larry's doing, make sure to go to Twitter at Larry swedro, and you can find him also on LinkedIn. This is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. I.