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Bogleheads on Investing with Larry Swedroe on his capstone book, “Enrich Your Future”: Episode 69

Post on: April 30, 2024 by Jon Luskin

Larry Swedroe is the head of financial and economic research for Buckingham Wealth Partners. A prolific writer who is the author or co-author of 18 books. His first book, The Only Guide to a Winning Investment Strategy You’ll Ever Need, is in its second edition. Larry’s latest book, Enrich Your Future, The Keys to Successful Investing, is the topic of our discussion in this podcast.

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This podcast is hosted by Rick Ferri, CFA, a long-time Boglehead and investment adviser. The Bogleheads are a group of like-minded individual investors who follow the general investment and business beliefs of John C. Bogle, founder and former CEO of the Vanguard Group. It is a conflict-free community where individual investors reach out and provide education, assistance, and relevant information to other investors of all experience levels at no cost. The organization supports a free forum at Bogleheads.org, and the wiki site is Bogleheads® wiki.

Since 2000, the Bogleheads’ have held national conferences in major cities nationwide. There are also many Local Chapters in the US and even a few Foreign Chapters that meet regularly. New Chapters are being added regularly. All Bogleheads activities are coordinated by volunteers who contribute their time and talent.

This podcast is supported by the John C. Bogle Center for Financial Literacy, a non-profit organization approved by the IRS as a 501(c)(3) public charity on February 6, 2012. Your tax deductible donation to the Bogle Center is appreciated.

Listen On


00:00:10 Rick Ferri

Welcome everyone to the 69th episode of Bogleheads® on Investing. Today we welcome back Larry Swedroe. Larry is the Head of Financial and Economic Research for Buckingham Wealth Partners. He is the author of 18 books, and today we’re going to be discussing his latest book, “Enrich Your Future: The Keys to Successful Investing.”

Hi everyone. My name is Rick Ferri, and I am the host of Bogleheads® on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a nonprofit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at boglecenter.net where you will find a treasure trove of information, including transcripts of these podcasts.

Before we begin, I have one announcement. Tickets for the 2024 Bogleheads® Conference in Minneapolis, MN are now on sale at boglecenter.net. The conference begins at 1:00 PM on Friday, September 27th and runs through noon time on Sunday, September 29th. We’re going to hit the ground running with a full agenda. Lots of great speakers. I hope to see you there.

Today we welcome back Larry Swedroe. Larry is the Head of Financial and Economic Research for Buckingham Wealth Partners. He is a prolific writer who has authored or co-authored many books. His first book was published in 1998, “The Only Guide to a Winning Investment Strategy You’ll Ever Need,” now in its second edition. He was a previous guest on Bogleheads® on Investing, Episode 12, to talk about another book, “The Incredible Shrinking Alpha” and an appearance in Episode 46 to discuss, “Your Essential Guide to Sustainable Investing.” This book, his 18th book, and the topic of our discussion today, is titled, “Enrich Your Future: The Keys to Successful Investing.”

With no further ado, let me welcome back to Bogleheads® on Investing: Larry Swedroe. Hi, Larry. How are you?

00:02:22 Larry Swedroe

I’m doing great, Rick. Hopefully you’re doing well too after your travels.

00:02:27 Rick Ferri

I am. Before we get to today’s discussion, which will be your new book, “Enrich Your Future: The Keys to Successful Investing,” you mentioned in the book that you’re an avid white water rafter. Tell us a little bit about that.

00:02:40 Larry Swedroe

When I was about 30 years old, a friend of mine who grew up in Oregon said Larry, you’ve got to go white water rafting. And I said alright, let’s try. And I grew up in the Bronx and never had done anything like that, but it sounded fun. And we went down a Class 3 river on the American River, a little bit west of Sacramento, and I really loved it. And now I’ve gone on about 50 trips, including big Class 5 rapids all over the country. It’s my favorite pastime.

00:03:12 Rick Ferri

And you do this with your family as well.

00:03:14 Larry Swedroe

I’ve done it with my kids, taking all of them when they were as little as about 7 or 8. I’ve done it with my brother and friends. Whenever I can get somebody to go, I’m happy to join.

00:03:27 Rick Ferri

So today, our discussion is about your book, “Enrich Your Future: The Keys to Successful Investing,” and I want to start out by talking about who you dedicated the book to. You’ve dedicated the book to your grandchildren, and that was a little bit telling for me.

00:03:42 Larry Swedroe

Well, I think the biggest legacy we leave behind us, the way I think of it, is our grandchildren are living messages to a future we will not see. And hopefully we’ve done a good job with our kids raising them and taught them how to be good parents by observing our own behaviors. And I’m so proud of each one of them.

Every day I get joy just from talking to them, whether it’s my kids. Three of them live here in the St. Louis area. The others I get to see few times a week using WhatsApp and to get to see them live, and we try to visit them several times a year. But there’s no greater joy than sitting down with my kids playing a game, reading a book with them, hitting pickleball with them. I’m sure you know with that’s like.

00:04:35 Rick Ferri

Oh yeah. To me, when I read that I said I wonder if this is Larry’s capstone book. Basically, the book that you’ve written to summarize your long career as a researcher and a writer and trying to send the message forward. And was that your intent?

00:04:52 Larry Swedroe

Yeah, definitely. This is the book, personally, is my favorite book, I’ve tried to encapsulate everything that I’ve learned on major topics, how people think about investing. You and I and Bill Bernstein and John Bogle and a few others have dedicated our careers to try to overcome what Wall Street tries to do and convince people that they have the right way to invest.

And sadly, our education system has so failed the public that unless you get an MBA in finance, not just an MBA, you probably haven’t taken a single course in capital markets theory. So, investors make so many mistakes, not because they’re dumb, if you will, it’s not lack of intelligence. It’s that they’re ignorant about what the research, the empirical evidence, and economic theory says.

So, I try to come up with a way to help people understand often difficult concepts. And a friend once told me, Larry, if you give somebody a fact, they will learn. If you tell them the truth, they’ll believe. But if you tell them a story, it will live in their heart forever.

00:06:06 Rick Ferri

The book is about 290 pages long and it has stuff with a lot of great information that you’ve learned over the years. I found interesting that you chose Cliff Asness to do the forward. Cliff is the managing principal of AQR Capital Management, who earned his pH. D from the University of Chicago under Nobel laureate Gene Fama. He’s also been a guest on this program on Episode #27.

Interesting in reading Cliffs introduction, in the end he says to be a successful investor, you need to do less, pay less, think about it less, and stay the course. Just buy a diversified index fund. And coming from Cliff, this is quite a statement because he is an active manager.

00:06:54 Larry Swedroe

Yeah. Well, first of all, I think Rick Ferri could have written those exact same words that Cliff wrote and you quoted at the end. And the only thing I would say that’s just slightly different is that I would not define Cliff as an active investor. And here we get into these debates. There’s no real technical definition of what a passive investor is.

So, I like Gene Fama’s attempt to clarify this. Gene said that he defines active management as individual security selection and market timing. So obviously index funds don’t engage in any of that, but none of Cliff Asness’s funds engage in any of that. None of the funds of Dimensional Fund Advisors, Avantis, Bridgeway, the other families that I use and recommend. What they do is they create their own definition of their eligible universe.

So, for example, instead of a Russell 2000 small index, you could say I’ll buy the bottom 5% of stocks. But then they also might add some screens which are based upon the empirical research like don’t buy penny stocks, don’t buy stocks in bankruptcy, don’t buy IPO’s because the research says, even though they’re in an index, they tend to underperform on average.

So, the words I use are we invest in funds that are systematic, transparent, and replicable, which is of course, what all index funds are. But not all funds that are systematic, transparent, and replicable are index funds. So, I think we’re in the same ballpark. We just play it in a slightly different way.

00:08:47 Rick Ferri

Yeah, we might be in the same ballpark, but I think that you’re on the other bench with that, quite frankly.

00:08:52 Larry Swedroe

OK, that’s fair.

00:08:55 Rick Ferri

I’m more on the Jack Bogle side, which is a traditional indexing the total market, the total international, total bond, things that just capture market returns. And by the way, we could debate the semantics of what an index fund is, but there are many people in the industry, many smart people, who basically have told people who read them and have invested with them that they should be buying index funds.

Warren Buffett and Peter Lynch. Don’t try to pick stocks. Don’t try to time the market. You know a lot less than you think you know, and just buy an index fund.

This book, “Enrich Your Future,” is a lot about traditional index funds. You said a minute ago that you could teach better when you write stories, and you wrote a story in the beginning of the book about when you first started learning how to play tennis. And you said that you were a good athlete. But when you went out there to play maybe not very good athletes, you still lost because you made the distinction between being a good athlete and being a good tennis player.

And I thought that was very insightful. A good athlete does not make you a good tennis player. You then parlayed that into investing.

00:10:09 Larry Swedroe

I played some college basketball when I was a kid and I was a good athlete, but I learned that wasn’t necessarily a condition that allowed you to win. It was a necessary condition to be a really good tennis player. You’ve got to be a good athlete. But it’s not a sufficient condition. You have to play the game using the right strategy.

And I was at a clinic at a resort. I took a tennis lesson with a pro, and we were rallying, and he had a tough shot right to my backhand, deep in the corner. And I tried to hit it as hard as I could down into a corner. And I hit a winner against this pro, and I’m feeling great. And he called me up to the net and said, Larry, you know, that shot’s your worst enemy. And I was kind of shocked here. I thought I did a great shot, which it was. And I said, what do you mean? I just hit this shot and won the point. He said, yeah, but the problem is while he as a tennis pro could make that shot maybe 9 out of 10 times, I was likely to make it once or twice out of 10 times.

And therefore, it was playing the loser’s game. You remember those great shots when you know you make them, but you don’t make them frequently enough. And at my level of tennis. And I’m kind of a three, five tennis player (which is a good weekend player), it’s not who hits the most winning shots, but who hits most the losing shots. So, Larry, just focus on getting the ball a little deep on the court with a bit of pace right down the middle. Don’t try to hit winners and you’ll win much more often.

And that’s exactly what happened. All of a sudden, I started to win much more frequently against people I would be losing to, and the same analogy applies with stock picking. We all remember the one stock we hit that became the next Google. We tend to forget the other eight ones that underperform. And the winning strategy, as we all know, the vast majority of people who try to buy individual stocks and time the market end up losing. They’re just playing the wrong game.

00:12:31 Rick Ferri

So, let’s talk about how markets really work. You talk about the point spread between Duke and Army, and a basketball game. Tell me how point spreads between Duke and Army relate to stock market pricing.

00:12:47 Larry Swedroe

And I had searched for a long time trying to come up with a story to make it easy for people to understand. And finally, I figured this one out. Anyone who follows sports to any degree, if you’re a college basketball fan, knows that Duke is a logical contender for the national championship every year. They’re usually in the top 25 teams. Army has never come close to winning a national championship and never will.

And yet they play every year because their coach at the time, until recently, Mike Krzyzewski, had played at Army. So, Duke gives them a game where Army could get on TV for their players.

And yet, because everyone knows that Duke is a better team, that doesn’t do you any good in betting. Because if I call Rick Ferri up and say, Rick, I’m going to pick Duke to win, let’s put $100 on the game, Rick’s going to say, well, OK, I’ll do that. But you’ve got to give me 25 points.

Now, for those who don’t know sports betting, what that means is if Duke wins by 24 points, we have to add the 25 point spread to Army’s score. Army now wins the game in terms of the bet. And it turns out that the point spread – which is not set by the bookies as a lot of people think; it’s set by individual investors like you and I who are making bets and setting the price in the same way stock prices are set. Some people are betting on Army. Some people are betting on Duke. And their order and betting will set the point spread.

And it turns out – this will shock people – but a study was done on the NBA (six seasons), and they found that the average error in the point spread was less than 1/4 of one point. It shows you how efficient a market can be even when a group of naive betters, who are often betting with their hearts – maybe they were in the military, so they’ve bet on Army or they watched Ronald Reagan in the movie, so they bet on Notre Dame (win one for the Gipper) or they bet on their college, their home team. Betting with their hearts, it doesn’t matter. It’s the collective wisdom of the markets that sets prices and makes the market efficient.

00:15:13 Rick Ferri

The quarter of a percent spread that was found in the study was the result of looking at literally thousands of games. Of course, every single game is going to be over or under that spread, but in the aggregate the crowd is pretty good at figuring out what the risks are.

00:15:30 Larry Swedroe

Yeah. So now we have to look at the analogy here. What’s the analogy? I’m sure everyone would agree Google is a better company than Ford Motor. It has much higher earnings, much higher return on equity, much faster growth of earnings. But you have to ask yourself, what do I know that the market doesn’t know? Everyone knows whatever you think you know about Google. Certainly, Warren Buffett and all these hedge fund managers with PHD’s in nuclear physics and math. And they’re spending 100% of their time trying to outperform.

They know much more than you, have more powerful computers, and so they have set the price in the PE ratio. I’ll just make this up, but Google might be trading at 40 times earnings and Ford Motor is 7. Well, what’s the analogy? Google is Duke and Army is Ford. And that point spread works in exactly the same way that the point spread does. It equalizes the risk adjusted odds of outperformance.

00:16:34 Rick Ferri

Let’s get into what drives the market’s return. And here you spent some time talking about nominal and real economic growth, earnings growth, interest rates and other factors.

00:16:47 Larry Swedroe

Yeah, the first thing is people should not make the mistake of confusing information with value-added information. In our previous example, the information that Google is a better company, has a better balance sheet, faster growth of earnings. That’s information. It’s not value-added information because everyone knows it. It’s in the PE ratio.

The same thing is true about stocks. What sets stock prices? The expected growth in earnings and the discount rate we use to discount those future expected earnings plus the safe rate of T-bills. So, we take if T-bills today are 5% and we apply to a Ford Motor a 10% cost of capital, we would discount their earnings at 15%.

And whatever the earnings are, we’re going to get a 15% rate of expected return. Now the stock price is going to be low because we’re discounting it at a very high rate. Google on the other hand, is going to be impacted by the same three things, but we’re going to view them as a safer company and probably apply a lower discount rate. Maybe we apply a 7% discount rate. So, what happens is we would take the 5% risk-free rate, add 7% is 12%. Whatever the earnings are, they’re going to be faster growth. It’s just going to mean that faster earnings growth is going to give you a higher stock price today, but your expected return is now 12% because that’s the rate you discounted those earnings at.

So, what determines stock prices is not the growth in earnings rate at all. That’s true of companies. That’s true of countries or industries. So, the fastest growing industries don’t necessarily provide the highest rate of return. What matters is the discount rate investors apply. And if you think it’s a safe investment, you’re going to apply a low discount rate, which means you get a high price and a low expected return.

In the book I use the story of comparing great companies and high returning investments. Great companies are on average lower returning investments because they’re viewed as less risky. And the riskier companies typically have lower growth in earnings, but the market recognizes they are riskier here and therefore applies a higher discount rate, and you get the higher return.

00:19:32 Rick Ferri

When I was talking with Eduardo Repetto from Avantis, he was describing that exact methodology and how they go about picking value stocks where they’re looking for where the market is using a high discount rate.

00:19:46 Larry Swedroe

That’s exactly what Avantis does. They’re not index funds because there’s no exact index to replicate, but they choose, say, the 30% of the cheapest stocks relative to some metric.

So, index funds are doing exactly the same thing in many cases, unless you’re talking about total market funds, they’re often creating their own universe and they just happen to call it an index where Eduardo Repetto’s Avantis fund, there is no index. But they look at two things. One is the cheapness of the stock, but then they might add what Warren Buffett would call the type of stocks that he liked to buy, he’s looking for cheap and profitable companies.

And they combine those two metrics. So, they are looking for companies that are both cheap and are historically higher profitability. And we know the research shows that profits tend to persist, although the grade of growth of profits tends to decline towards the median over time. But there is some persistence in earnings growth.

00:20:59 Rick Ferri

And even if there’s a consistency in earnings growth, people will eventually discount that earnings growth by a lower number and therefore cause the value stock to rise in value, and that’s the whole idea, I believe.

00:21:11 Larry Swedroe

Yeah, exactly right. Here’s the interesting thing, Rick. And I don’t have a good explanation for it. Clearly, I think you and I could agree that more profitable companies are less risky. They’re less likely to suffer in a recession and go bankrupt. So, you would think they would get lower returns. That the market would adjust. But it turns out that that’s not the case, and more profitable companies have delivered a bit of a premium return over the long term. And I think it’s mostly due to investor misbehavior.

So, individual investors, particularly small retail investors, tend to favor these lottery stocks hoping to hit the home run. Gene Fama and Ken French wrote a paper about tastes and preferences leading people from an economically rational perspective to misprice them. But from a psychological perspective, you know, it may suit their taste to make these bets and they overpay. And that drives prices too high for these lottery-like stocks.

I think this will shock even your listeners, Rick. But companies that are small growth with high investment and low profitability, they’re in indices if they are listed. They have underperformed Treasury bills over the history. So, some people like Avantis and Dimensional will screen out those stocks. This is an anomaly. I don’t know if it’s going to persist, so I do invest using both of those metrics: profitability and value. But I want to make sure I’m buying a cheap profitable company, not an expensive profitable company.

00:23:08 Rick Ferri

One fascinating research study that has come out in the last couple of years talks about how the stock market gets its return. And I’m not talking about earnings. I’m talking about returns of the individual stocks within the market. The author was Hendrik Bessembinder from Arizona State University, who studied the stock market from 1926 to 2019 and found that very few stocks actually created the performance of the market.

00:23:37 Larry Swedroe

Yeah, this is I think as powerful example in the empirical research findings of why you shouldn’t try to pick stocks. Bessembinder’s research, which I think is one of the most important pieces of information that we can have to make investment decisions because it shows just how difficult it is to find the few stocks that are going to outperform. What he found is if you took the 4% of the stocks with the best stock returns, then all the other stocks provided no return above the risk-free rate, which is one month Treasury bills. Now, someone could say I just have to buy those 4% of stocks.

The problem is almost no one is able to identify that, and here’s the way I try to explain that. If you owned all the stocks, you got basically a nice 10% compound return. If you bought 1 stock, the average return was well below that.

That median return, meaning half of the stocks perform much worse than that 10%, and as you add diversification, you move closer and closer to the average. So, the more stocks you own, you increase your odds of getting that average return.

I think of it as a bell curve. You want to get that middle, that high point getting you the best odds of success. There’s been since studies that went even further back to 200 years and have found exactly what Bessembinder found both in U.S. markets and international markets.

00:25:19 Rick Ferri

The study was really fascinating. It opened my eyes up how few stocks give you a better return than T-bills. It’s really difficult to outperform the market unless you own those 4% of stocks, but this probably helps explain the conclusion that Fama and French came to when they did their study on luck versus skill in the mutual fund marketplace.

00:25:41 Larry Swedroe

Yeah. So, what they found was that once you adjusted for exposure to their common factors that explain return (meaning size and value, profitability, etc.) less than 2% of active managers were generating statistically significant alphas. And that’s even before taxes. So, for taxable investors where taxes are the highest expense more than the trading costs, typically more than the expense ratio even of active funds, the odds are probably 1%. You don’t want to be playing that losers game where you have a small odds of success, and that’s where people with far more experience, talent, computers, resources, and everything else. They don’t win. What are the odds that I’m going to win when I don’t have any of their advantages?

00:26:36 Rick Ferri

You wrote just because some investors are smarter than others, that average will not show up because the market is too vast and too informationally efficient. And then you went on to say, don’t confuse efforts with results. High efforts do not equal high value. So, explain all that because there’s a lot there.

00:26:58 Larry Swedroe

Yeah. So, we wonder why there isn’t this persistence of performance when we see it almost everywhere we look in the world. Babe Ruth, the best hitter maybe of all time, only 25 or 27 years old. You can have pretty high degree of confidence that next year he’s going to also be a great performer. And so why can’t the great stock pickers like Warren Buffett continue to outperform?

By the way, Buffett has not outperformed the S&P 500 (or Berkshire hasn’t) since 2008. So, and I have 16 years where the prior 50 years he had dramatically outperformed. Why isn’t he able to outperform now?

There are two big reasons. One is the game of baseball is very different than the game of investing. Babe Ruth, if he was facing some great pitchers who on the All Star teams and other games he would face the pitchers on the worst teams and maybe their 4th or 5th starter or some reliever who comes in and pitches. Now imagine if Babe Ruth were actually facing a pitcher who had Sandy Koufax’s curveball, Randy Johnson’s fastball, Greg Maddux’s change up, etc. That’s the way the market is. It’s not a game of one-on-one where Babe Ruth is facing a pitcher one at a time.

In investing, you’re facing the best investment in the world every day in their collective wisdom. So that’s the number one reason. It’s a very different game. You’re not competing one-on-one, where small differences in skill set make a big difference. The second reason is this. Markets are the most efficient because they learn. Let’s say we learn that value stocks outperform and an academic publishes the research and everyone learns about it. Well, then if there’s not a story 100% for risk there, then the market will arbitrage it away. Money will flow in until the anomaly goes away.

A good example would be there was an anomaly called the January effect. Smallest cap stocks tended to outperform in January. Publish this paper, Rick Ferri, a smart guy, he says, “hmm, I’m going to exploit this. I’ll buy it in December.” But Bill Bernstein may be a little smarter, he says, “I’ve got to beat Rick to that. I’ll buy him in November. And Warren Buffett buys it in October, and the effect is gone.

So, the very fact that we publish information and discover anomalies causes these inefficiencies to go away. So, Buffett had been writing for 50 years in his annual letters, telling people the kind of stocks he bought. The academics went and reverse engineered it as the words I would use and said, let’s see if we could find the traits of stocks that Warren Buffett bought. If we can identify them, can we buy an index of those stocks? Just buy them all, don’t have to buy the five or eight or ten that Buffet bought. Can we get the same returns?

And that’s exactly what has happened. And so now everyone knows this. And now the funds of companies like Dimensional Fund Advisors, Avantis, Bridgeway, they all buy these stocks, they put them in their construction rules, and Buffett can no longer outperform.

One last thing, Rick, on this issue, go back 70 years or so, 90% of all trading was done by retail investors. So, when Buffett was competing and he traded, the odds are 90% there was a naive retail investor on the other side. And he was likely to win that game. He had more skills. Today, 90% of the trading is done by big hedge funds, Renaissance Technology, the Goldman Sachs, Morgan Stanley’s of the world. They pay all these high-powered mathematicians, have all these high-speed computers, all the latest artificial intelligence.

So, when Buffett’s trading 90% of the chance is he’s trading again with them, he doesn’t have any advantage over them and that’s another reason why he can’t outperform anymore or hasn’t been able to. The markets are naturally becoming more efficient over time and making it more and more difficult for active managers to win that game.

00:31:48 Rick Ferri

Well, let’s get on to another part of the book about behavioral finance. People who are trying to outperform. Trying to pick the hot manager, trying to pick the winning strategy, trying to pick the individual investments, believe that they can do it. One reason you pointed out earlier, most have never received a formal education on capital markets. So, when we don’t have training on something, we tend to believe what we hear in the media. Because the media promotes that type of mentality in a lot of ways by pointing out the outperformance of this strategy, the outperformance of that person, or how this fund has done so well. And of course, highlighting advisors and fund managers who bought NVIDIA five years ago, or at least they said they did.

And even if they did buy it, they’re not going to tell you about the other fifty stocks they bought that didn’t go up. The media has these people on to talk about their winners, not their losers. So, people get the false belief that it’s easy to do this and it causes a lot of behavioral problems.

00:32:53 Larry Swedroe

You have to remember whose interest they have at heart. The media, they need you to tune in so they can sell their advertising time so they can make money. And indexing is boring. That’s why you and I and Bill Bernstein don’t appear on CNBC very often because we’re going to tell people basically to tune out CNBC.

00:33:14 Rick Ferri

Yeah. I think that last time I was on CNBC was probably 15 years ago and it had to do with the proliferation of ETF’s that really didn’t have anything to do with indexing.

00:33:25 Larry Swedroe

Right. And the active management community, the investment firms, except for a few exceptions like Vanguard, they need you to believe that they can identify the winning stocks and in and out of the market, so you’ll pay their high fees. Which the evidence shows, yes, it is possible to outperform. Even Fama and French found, as we said earlier, 2% of the funds that have delivered persistent outperformance.

So that holds out the hope. And everyone – we know this is just a human trait; it doesn’t matter whether it’s are you a better than average driver or a better average lover – or we all are over confident in our skills. 90% of us think we’re better than average at everything. So, we think, yeah, most people fail, but I’m going to succeed.

And the media plays on that. And they play on this idea, how it’s easy to beat the market. And you and I and Bill Bernstein and John Bogle, we have the investors interests at heart. The media and active management have their own interests at heart.

00:34:34 Rick Ferri

It is interesting though, when you talk with people, especially in a bull market, when they bought something that has gone up, they attribute it to skill, not luck. I recall back in the late 1990s I was working in the brokerage industry during the internet bubble. After work, we went over to a bar and we were talking with some people in the bar, this woman said to me. Oh, you’re in the investment business. Well, I’m a full-time investor. I just quit my job and I trade internet stocks.

And I said, oh, what do you like? And she told me the name of the company. And I said, well, where’s that company located? She had no idea. And I said, well, who’s the CEO? She had no idea. I said, who are the biggest competitors? She had no idea. I said, well, what is it you like about the company? And everything was well, it’s going up.

That’s great. Good luck with that. The confidence was just incredible. How they believed that it was their own skill. So, overconfidence is a huge problem.

00:35:30 Larry Swedroe

It’s just an all too human trait that when we do something and it turns out well, we attribute it to our skill. And when we do something that turns out poorly, we say it was bad luck. We never admit our mistakes. That’s true in lots of endeavors. And it’s certainly true in investing. And if you do that, you’re always a genius because you just had bad luck. And that will change, right?

It’s amazing to me that people think they could spend an hour or two a day and outperform world class physicists and mathematicians who have all these resources of high-speed computers, etc. And you think you’re going to beat them? What do you know? That’s what I always ask, Rick. The question that I ask people you might have asked the woman in that bar is, “Okay, you like this stock? Give me all the reasons why.” So, I listen carefully. Say let’s say for the moment I agree with all those things. “Do you think Warren Buffett doesn’t know all of those things? Oh, he does? How about the guys at JP Morgan, Goldman, and such? Well, then, it’s already in the price. Just the same way that Army playing Duke, that point spread reflects the difference in the skills of the team.

00:36:46 Rick Ferri

I see a lot of portfolios that lack diversification, and sometimes it’s because they get RSUs, restricted stock from the company they work with, and they’ve accumulated the stock rather than selling it. And a large percentage of their net worth might be this stock plus they have their earnings attributed to the company they work for. And then often they have a spouse who’s in the same industry. That the whole financial life is just hanging in the balance of that industry. They may have done well, but I tell them they need to diversify.

00:37:15 Larry Swedroe

Yeah. Well, certainly that tends to lead to the problem of confusing the familiar with the safe. A good example is, Rick, is it any safer to own Coca-Cola if you live in Atlanta or if you live in Houston? And is any safer to own Enron if you live in Houston or if you live in Atlanta? Yet people who live in Atlanta own a disproportionate share of Coke and people live in Houston, unfortunately, owned a disproportionate share of Enron. If you live in Rochester, NY, you owned Kodak and Polaroid. And both of these, once great, the Googles of their day, are basically bankrupt. So that’s problem one.

Another is the old adage, Rick, the surest way to make $1,000,000 in the market is to start out with $10 million and concentrate it in a single stock. That’s the surest way to make $1,000,000 fortune. Start out with $10 million. The problem is it is very rare for stocks that have done great to continue to do great once they get large. And if you look at the 10 largest stocks for example in the S&P 500 at the end of each decade, you’ll find very little persistence. And often these companies disappear.

GE is the perfect example. It was, I think, the largest market cap at one point and people made fortunes owning it and then lost fortunes, concentrating their risk. Diversification is called the only free lunch in investing for a good reason. I urge people to eat as much of that free lunch as they can.

00:38:55 Rick Ferri

So, when somebody has a large position in a single stock, you gave some good advice in the book of how to think about when to sell it. Taxes aside because taxes are an issue here. What you wrote is that if you wouldn’t buy the stock at this price, then you should sell it at this price.

00:39:18 Larry Swedroe

Yeah, the example I use is one I think people can relate to simply. I’m a wine drinker. I belong to a wine club. I typically pay between about $15 and $30 on occasion and might go a little bit higher. So, let’s imagine now a friend comes to me and offers to buy. So, Larry, there’s great wine coming out of France. Got a tip on it. Let’s buy a case, and it’s only $20. I think the price is going to go way up. The crop is great, etc. Ten good reasons why you should do this. So, I say great. And I buy it for $20. Ten years later, it’s now selling at $500.

Andrew, what should I do? Well, it turns out they ask people that question. Many of them will say, well, I’d sell some bottles, save some for my anniversary or birthday or special event. Well, the answer is if you wouldn’t buy it for $500, you should sell it because you don’t think it’s worth $500. The fact that you owned it and bought it for $20 is irrelevant, and the same thing should apply to a stock. If you bought NVIDIA at $20 and it’s $500 and you wouldn’t buy it today, you wouldn’t certainly put 50% or 80% of your money in one stock. Well, then you shouldn’t continue to hold that much stock because it’s just too much risk.

00:40:39 Rick Ferri

Well, I’ll push back on you on the wine example because obviously if you bought it for $20, it tastes a certain way, has a certain quality taste to it, but once it goes to $500, it tastes that much better.

00:40:53 Larry Swedroe

Yeah, it probably does. They’ve actually have done tests on that, and if you’re told the price of wine, you actually think the more expensive wine tastes better, then you do a blind test and that difference goes away. That’s actually a real study.

00:41:10 Rick Ferri

Alright, let’s talk about investing in a portfolio of risky assets. How there’s this belief that if you have a portfolio of risky assets that you have a diversified portfolio that’s going to protect you in a down market. And it’s not always true. I mean risky assets can all go down together. They can be highly correlated in a bad economy.

00:41:31 Larry Swedroe

Yeah. And Rick, that’s absolutely true. And what people forget is that correlations are nothing more than averages over the long term. So, you not only have to look for an asset that is as low correlation or negative, but how does it react when Asset A, let’s call that your individual stock portfolio or mutual fund portfolio, how does that tend to act when the stocks crash?

A good example is high yield bonds. The correlation on average may be low. I don’t know, maybe it’s 0.2 or it’s 0.3. But when stocks crash, they tend to get hit at the same time. Low correlated, but at the wrong time. So, you need to look for assets that tend to do well when your stocks are doing poorly. That’s hard to find. So, you want to look at things that are uncorrelated. A good example would be reinsurance.

Earthquakes and hurricanes don’t cause bear markets, and vice versa. Doesn’t mean you can’t have both going down at the same time, but it’s certainly not expected. In 2022, provided a good example. Stocks and bonds both went down. Reinsurance had a good year. You know, it might have been down, too. But that’s why you diversify across assets that have low correlation. And there’s no logical economic reason why they should correlate and both do poorly or both do well at the same time.

00:43:08 Rick Ferri

A lot of people think that if you’re half in stocks, half in bonds, especially Treasury bonds, quality bonds, that when the stock market goes down, the bonds will save your portfolio. They’ll reduce the volatility. And that’s not really true. I mean, it reduces the probability of a large loss, but it doesn’t eliminate the probability of a large loss.

00:43:29 Larry Swedroe

Here’s the problem. Why people believe that is we went through a period from 2000 through 2021 where that was the case. Where stocks and bonds were negatively correlated. But you and I know 20 years is a very short horizon. And when it comes to investing, you need to look at the longer term. If you looked at the longer term, there were six periods where stocks went down and bonds also went down. You have to know this. Stocks can do well when inflation is rising because inflation is going up from a low level.

So, we’re coming out of a severe recession, you don’t want to have deflation. Inflation is going up from 0% to 1% or 2%. The economy is doing well. Stocks soared. But bonds do poorly. That’s OK for your portfolio diversified. But what happens when stocks do poorly because inflation is rising from a high level? Like it did in 2022. It was going up from 2-3% to 5% to 6% to 9% to 10%, and the Fed now has to come in and tighten. So, you get an economic recession, likely, and you get your bonds hit. So, stocks and bonds can go down.

But we hadn’t seen that in 20 years and people tend to forget. What I try to tell people is the only thing you don’t know about investing is the investment history you don’t know. You have to look at the long-term data and see what has happened and plan for both of those events. So, you need, I think, to add assets that are uncorrelated to the economic cycle risks. And luckily, none of that really existed in, I think truly investable form until about the last 10 years.

00:45:19 Rick Ferri

And you’ve got a list of those funds in the back of your book as well. And the fund guide, if people are interested in those alternative funds. But I do want to talk about gold before we jump off of this subject because you said something about gold, which I thought was a good insight. You say, you know, is gold an inflation hedge? And the answer is yes over, say, 1,000 years it is or couple of hundred years, but may not be over 10 or 20 years. 10 or 20 years is not the long term.

00:45:47 Larry Swedroe

You know, even for investors, at the least your age, Rick, you’ve got probably at least the 20-year horizon and I don’t know how anyone can say that gold is a good inflation hedge over that type of horizon when all you have to do again is know your history.

January 1980, gold is trading at 850. 2002 in March, if my memory is correct, it was trading at something like 295, which meant gold fell by about 86% in real terms because inflation averaged 4% a year during that period. You cannot say something is a hedge if it loses 86% of its value when inflation is rising. Now, why is gold a good inflation hedge over the long term? You look at the data someone had the thoughtful idea to do it this way.

And when Jesus walked the Earth, a Roman centurion could buy a good suit of clothing and armor for about the price of an ounce of gold. Well, Rick, you could buy a good suit to go to a conference today, probably for about the price of an ounce of gold. So, you have got 2,000 plus years of data evidence you got a zero real return for investing your money. I think there are far better alternatives than using gold. I’ve never owned any. I don’t recommend it. On the other hand, for people who want, you know, are concerned about geopolitical risk, having a small allocation of gold probably isn’t the worst thing. But be prepared to sit on the sidelines for 20 years of God awful returns and then some event happens, and gold will soar. But you had better be there and waiting those 20 years.

00:47:39 Rick Ferri

I’m going to push back on you here, Larry, a little bit because gold was the best investment I ever made. 41 years ago, I bought 2 gold wedding bands. And they have yielded the absolute best return I could have ever hoped for. I’m sure they have for you also.

00:47:54 Larry Swedroe

Yep, that’s called your marriage.

00:47:57 Rick Ferri

Alright, so let’s move on to lessons for investors. What we want to do with all this and the first thing we want to talk about, is risk. How much risk should you take as an investor. You have always talked about three factors of risk: your ability to handle risk, your willingness to handle risk, and your need to take risk.

Briefly, talk about those three things and then the difference between risk and uncertainty, which you make very clear in the book. And I think it’s a good point.

00:48:24 Larry Swedroe

Ability to take risks. Most people, even most advisors that I have known, look at ability to take risk and look at only one thing, which is your investment horizon. The longer your horizon, the longer you have the ability to wait out a bear market and therefore you could take more risk. However, there is a second factor which is really important, and that’s your intellectual capital or your labor capital. And the younger you are, the bigger that is. And so, what I tell people is if you’re a doctor, a tenured professor, and a CPA working for the government, you’re not subject to economic cycle risk. You can afford to take more stock risk, have a higher allocation. If you’re a construction worker, an automobile worker, maybe a stockbroker, your earnings are more tied to the economic cycle. Then you should own less equities. That’s a really important issue.

Second is your willingness to take risk, or your risk tolerance. You ask people, we’ve seen drops as much as 50%. Not that infrequently. About once a generation. And even the Great Depression was 90%. So, I tell people if you can’t take more than say, a 30% loss, you probably shouldn’t be more than 60% in equities. That’s at least that leg.

And the third leg is your need to take risks. For example, let’s assume you need $100,000 a year to retire to a lifestyle you’re comfortable with. Well, we know you can be fairly conservative if you’ve got 30 times that money. That would be $3 million. If you’ve got $3 million already, why are you taking a lot of risk? Probably should have a portfolio with 20 or 30% equities, all else equal. And then just don’t worry about the rest. The upside is not worth the downside risk. The loss of money, it hurts much more than growing your money.

So those are the three things at each leg of that three-legged stool has to be firmly planted or the stool will tip over when the risk shows up and your stomach yells GMO, which is, “Get Me Out!” Stomachs – I’ve yet to meet one that ever made a good decision.

00:50:49 Rick Ferri

But what you wrote, and I thought was really good insight, is during a crisis investors forget about risk and begin reacting to uncertainty. And I said this is really good insight because it’s true. People can learn to handle the day-to-day volatility of the market. Uncertainty, much more difficult.

00:51:09 Larry Swedroe

Yeah, the way to think about it is risk is where we know the odds, like when we roll the dice, we know exactly the odds of rolling the snake eyes. Or an insurance company. When you buy a life insurance policy, they have millions of data points, and they can make a reasonably good estimate of your life expectancy and can price for it. Same thing for hurricane risk or earthquake risk. It’s not a certainty, but there’s a lot of data that gives us confidence that we can get a good estimate of the risk.

Uncertainty is where you have no idea what the odds of something occurring. A good example would be 9/11, COVID occurring, or China invading Taiwan and disrupting world trade. Or maybe creating a third World War. You can’t price that. Investors, as you know, can deal with risk. They can price for it. They can put a discount rate on it. How do you price for uncertainty?

We don’t know how big the losses are and therefore investors hate uncertainty and when risk shows up, people tend to think the world is more uncertain, even though it’s always uncertain. We don’t know what the way the world’s going. We get lots of these Black Swan events like Black Monday in 1987, when the market fell 23% in one day. Or an oil embargo, or Russia invading Crimea, COVID etc. They happen with great frequency, much more than people think. And that leads to them having too big an equity position in my experience.

00:52:55 Rick Ferri

So, then you come up with your, basically the basic advice for investors which gets back to knowing how much risk you have the ability to take, the willingness to take, or need to take. Which is your allocation between risky assets and non-risky assets. So, call it stocks and risk-free rate or quality bonds. So, your stock side you recommend, no surprise, a diversified portfolio of global equities in an index fund.

Your definition of it, or my definition of it, which we discussed earlier, was a little bit different. And bonds, again, either use some quality bond index funds or in your case you wrote that you could use individual bonds, but if you did this you would want to use only the highest quality individual bonds rather than trying to take credit risk. And then finally stay the course. Just adhere to the asset allocation. Adhere to the plan that you put together for the long term. So, this is very “Bogleheadish”.

00:54:06 Larry Swedroe

Exactly. Those are John Bogle’s own words. They are Warren Buffett’s words. He says don’t try to time the market, but if you do, what should you do? You should buy when everyone’s panic selling. When there’s blood in the streets. And you sell when everyone’s greedy. And Rick, you do that all the time for your clients without thinking of it that way. Because what are you doing? You’re rebalancing the portfolio to restore it to its asset allocation that you wanted, not allowing the market to dictate your allocation.

So, when stocks are outperforming and you want it to be 50% stocks, you’re at 60%, Rick doesn’t say anything other than, well, I’m supposed to be 50%, so let’s sell even if we have to pay some taxes. There’s only one thing worse than having to pay taxes. And that’s not having to pay them. So, we do that.

00:54:58 Rick Ferri

I’m going to finish this interview with one final question about your book. And I’ve read all of your books, all 18 of them. This one had a little bit different flavor to it. In my opinion, it was more mainstream. As I said before, more “Bogleheadish”. And I’m just wondering, in your old age, if you’re just trying to make things simpler for yourself, your family, and also all other investors by just sticking with the basics.

00:55:35 Larry Swedroe

So let me answer it this way. First of all, John Bogle I think was the one who said it, is investing is simple. It’s just not easy. And it’s not easy because of all the emotional issues and the behavioral mistakes we make. Either we get too greedy when the markets are doing well, or we panic and sell when the markets are doing poorly.

What you want to do is have a portfolio that you have confidence in. You understand all the investments because when the markets do poorly, your stomach is going to get stressed no matter how disciplined you are. That’s my experience. You’re going to question yourself. And if you don’t have a strong belief system that says this is the right portfolio, you’re likely to panic and sell and be subject to recency bias.

Good example, you could understand reinsurance is a great investment, a very logical, but it goes through three bad years, it’s down 25% and so you panic and sell. Instead of now being a buyer because risk premiums have gone way up. A disciplined investor will rebalance and buy more. So, I think the key point that I was trying to make, I kept it simple, but told people I think there are these advantages, but only if you’re willing to put in the time, learn about them, and become confident.

The same principle applies, Rick, I’m sure you would agree to owning emerging market stocks. We both agree you should own a global portfolio, but don’t own them if you’re going to bail out when emerging markets underperform for 10 years. It’s exactly the same principle. So, keep it as simple as you need to so that you can stay the course.

00:57:26 Rick Ferri

Those are great final words. Well, Larry, thank you so much again for being our guest on Bogleheads® on Investing. And good luck with the new book.

00:57:33 Larry Swedroe

Thanks very much, Rick. A real pleasure. And by the way, I’ve read all of your books too.

00:57:38 Rick Ferri

Oh, thank you. Alright. Well, thanks Larry. This concludes this episode of Bogleheads® on Investing. Join us each month as we interview a new guest on a new topic. In the meantime, visit boglecenter.net, Bogleheads.org, the Bogleheads® Wiki, Bogleheads® Twitter, the Bogleheads® YouTube channel, Bogleheads® Facebook, Bogleheads® Reddit, join one of your local Bogleheads® chapters, and get others to join. Thanks for listening.

About the author 

Jon Luskin

Board member of the John C. Bogle Center for Financial Literacy


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