How to Mitigate Today's Market Risks and Uncertainty – Larry Swedroe

Pierre Daillie: [00:00:00] This is raise your average.

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Pierre Daillie: Welcome back and thank you for tuning in this episode. We are so very honored to welcome Larry Swedroe. Larry is a well known expert in investing, particularly in evidence based strategies. He was previously the chief research officer at Buckingham Wealth Partners, where he worked since 1996. Beyond his work at Buckingham, Larry has written or co authored over 18 books on investing and personal finance.

Some of his popular titles include The Only Guide to a Winning Investment Strategy You’ll Ever Need, and Think, Act, and Invest Like Warren Buffett. [00:01:00] In this discussion, we get into Larry’s views on forecasting and what investors can do with great effect rather than investing on the basis of any single outlook.

We dive deep into Larry’s wisdom of the many and essential ways and means investors can use in their investing to mitigate most of today’s market risk and uncertainty. Okay, folks, we are on and we’ve got a great show for you today. I’m Pierre Daillie, Adam Butler, Chief Investment Officer from Resolve Asset Management is co hosting with me here.

Larry Swedroe is on the show and it couldn’t have come at a better time. Larry, welcome and thank you for joining us. Where are you joining us from? I’m joining,

Larry Swedroe: uh, from, uh, town and country in Missouri, which is a suburb about 20 miles west of the arch.

Pierre Daillie: All right. Well, Larry, we’ve got so much to talk to you about today.

Stocks are skirting all time highs. Long U. S. Treasury yields have risen back into the force. The [00:02:00] term premium is back again. We’ve got a soft landing consensus, or do we? The U. S. election is next week. It’s, it’s kind of crazy time. Can we begin with your take on markets?

Larry Swedroe: I’m happy to do that, but I think it’s worth, uh, uh, mentioning, uh, the following.

Uh, I spent the first half of my career, uh, in the investment banking world, managing a significant portion of Citicorp’s, uh, assets. international treasury operation. I was a regional treasurer covering the western half of the U. S. And I was, uh, in that role, I was an advisor to some of the largest multinational companies in the world in managing all kinds of risk, interest rate risk, foreign exchange risk, using derivative products, et cetera.

And part of that role was economic forecasting of growth [00:03:00] rates, exchange rates, interest rates, etc. And I was a trained economist. Uh, uh, and in fact, I graduated at the top of my class from one of the better MBA programs in the country at NYU. Uh, and here’s what I learned. Um, when I got my forecast right, I took credit, of course, for my brilliant analysis, and when it turned out wrong, I blamed the fact that there was some surprising event that couldn’t be forecasted.

Uh, and the result is, of course, at the end of the day, you’re a genius because, right, uh, you don’t make mistakes. It’s just unexpected things happen. Uh, eventually you hopefully wise up and figure out that it’s the unknown. You know, expected events that dominate markets and prices because everything that’s expected is already built into prices and by definition, right?

Anything that’s unexpected, you can’t [00:04:00] predict. It’s a surprise. And all of the evidence shows basically that there are, you know, virtually no really good forecasters or maybe an exception here or there. Uh, And Warren Buffett, who everyone admires as one of the greatest investors ever, when he was asked about this question, he said he hadn’t listened to or read an economic or market forecast in 25 years because he knows they’re worthless.

Uh, and another problem related is that it’s an all too human bias, uh, that we tend to give great value to predictions or forecasts or statements that agree with our preconceived notions. And when we hear the other side of an argument, We tend to dismiss it as idiotic, stupid, you know, whatever. And what I learned long ago is you don’t, you tend to learn very little, if not nothing from [00:05:00] statements or forecasts that agree with you because you already know that.

And so you really want to want to do is hear the other side of the arguments, which is what I try to do when I’m writing and researching, you know, finance, you want to listen to the other side. So, you know, I’m happy to give you my forecast and I’ll just close with one last very brief amusing story. I was once at an event where I was, uh.

Keynote speaker, and I, the talk was about why you should ignore all forecasts and stuff, and I presented the evidence on how poor forecasters are. And the first question I got after was, Larry, where do you think the market’s going?

Adam Butler: You know,

Larry Swedroe: uh, and I cracked up. I said, why do you care what I think? I’m happy to tell you, but you shouldn’t care.

So with that said, if you want to ask the question, I’m happy to answer. [00:06:00]

Adam Butler: I have similar stories. I, I always used to tell the Philip Tetlock story, Larry, um, from his earlier works, Expert Political Judgment, what he discovered about the miscalibration and, and, um, you know, worse than random. Uh, guesses from forecasters, both in and out of their own domain, et cetera.

And, um, and I used to laugh and I used to go through why, why systematic approaches are more reliable and, um, you can measure the confidence in those forecasts directly, et cetera, et cetera. And inevitably at the end, you know, I’d get someone asking about. You know, where do I think the market’s going? Or, you know, what do I think about oil here?

Or, you know, am I buying gold here or what have you? You know, it’s just it’s I, I think it, who was it that said, um, some people stumble over the truth and then pick themselves up and walk on as though nothing has ever happened.

I think it’s

Larry Swedroe: probably the best [00:07:00] way, the way I try to answer the question is this way. The, one of the biggest mistakes that people make when thinking about say equity markets and returns is they think about a forecast in a deterministic way. Okay, so they think stocks are going to return, let’s say, for argument’s sake, over the next decade, 6%, okay?

Let’s just use that as a number. Uh, so, the only right way to think about that is, you know, with virtual certainty, stocks are not going to get 6%, right? Uh, that would be a real fluke if you hit it exactly. So, the only way to think about it is you should think about a potential wide dispersion of outcomes, where that 6 percent is the median of a potential wide dispersion of outcomes.

And that means you should expect that maybe there’s a 40 percent chance you’ll get [00:08:00] more than 7, percent chance more than 8, and 10 percent chance more than 9. And the same thing can happen on the left side if that Black swan risk or left tail risk shows up and you need to build portfolios that are resilient.

To every one of those possible forecasts occurring because there are no good forecasts, right? And there’s good research on, uh, expected stock returns and the best predictors we have. It turns out roughly can explain about 40 percent of the next decade’s retirement. And it turns out it virtually doesn’t matter.

Most people look at like the K 10, right? Uh, You know, there’s nothing magical about the CAPE 10. You can use the CAPE 5, the CAPE 7, the CAPE 8. Even one year earnings out is as close to as good a forecaster as the [00:09:00] CAPE 10. And what you need to do, uh, Asness, Cliff of AQR showed in a study he did, that let’s say you forecast a 3 percent expected return.

The potential dispersion is like 6 or 7 percent on either side of that. So you could end up with minus 3 percent real returns, okay? Or you might end up with plus 6, right? And there’s no guarantee it can’t happen outside of that, because those Forecasts assume that the P. E. ratios don’t change, right? Uh, and we know that, uh, risk premiums are regime dependent upon whether the risks show up or not.

So if you get left tail risk, like Russia invading Ukraine or somebody launches a nuclear weapon or whatever else you want to think about, uh, then stock returns are going to be much worse. [00:10:00] So, that’s the only right way to think, and that’s what I do when I make forecasts. I, my view, my job is to think about what risks could show up, and we, I’m happy to talk about that because I think that’s an important topic, and most people don’t plan for it because here’s one of Sweadrow’s favorite expressions, right, that people make the mistake of treating the highly likely as if it’s certain.

And the highly likely, if it’s impossible, uh, and so that’s a mistake you must avoid when constructing portfolios.

Pierre Daillie: Yeah. Yeah. Yeah. Well, Larry, I love it. I, I’m not, I, I guess, you know, my attempt to throw you in the deep end didn’t work, but I wasn’t so much getting I’m happy to do it. I’ll give you my

Larry Swedroe: forecast.

I was trained to make forecasts. But most people don’t put much weight on it. I don’t either. Yeah.

Pierre Daillie: Yeah, I, I was just wondering, it’s a [00:11:00] really tricky time, right? I mean, I, I kind of been stuck on, on this, uh, uh, report from, uh, and it’s from September from Brian Chingino at Verdad where he points out that, that the, uh, adjusted market cap of the U S market globally is 70 percent of the ACWI.

And I mean, it’s so, but on a, on an unadjusted basis, 63 percent of global market cap is us stocks, 26 percent of global GDP is coming from the US versus 63 percent of market cap. So, I mean, he points out this huge imbalance. What I was getting at is that we’ve got this very tricky market where, you know, us stocks are overvalued.

To some degree on a CAPE adjusted basis, uh, 36 times versus, uh, Europe and Japan at, uh, 21 and 25 X respectively. And with stocks skirting all time highs and, and bond yields moving back into the fours, it’s a [00:12:00] difficult. Decision making time as well, isn’t it? I mean, I think it’s not so much, you know, asking you, what do you think stocks are going to do going forward?

But what do you think investors should do in this climate? That’s the more difficult question is what are the risks right now? What’s up? And you know, what’s, what’s on your mind in terms of, of how investors can adjust their portfolios for this environment? Uh, based on your thinking, based on the way that you approach investing and your evidence based.

Uh, you know, philosophy. Yeah. Well, you’ve

Larry Swedroe: got about 10 questions in there. Let’s see if we can, uh, try to deal with them, uh, one at a time. So first, you made a statement that U. S. stocks are overvalued or extremely highly valued. Uh, that’s only true if you’re looking at the overall market, but the market is made up of lots of sub markets.

Adam can probably, uh, Jump [00:13:00] in on this. But I think if you look at the value part of the market, the P. E. Ratios are probably about historical levels. Uh, and that actually understates earnings to some degree, although it doesn’t impact as I’ll talk about in a moment, the value stocks as much as it does the rest of the market.

Pierre Daillie: If you strip out You know, the, the top 7 to 10 stocks, you know, and you’re left with the S& P 493, it’s a completely different. It’s a completely different market. That’s

Larry Swedroe: the point I want to make. And it’s not just the seven, it’s basically growth stocks in general are trading, you know, at P E’s probably around the high twenties or thirties.

Uh, but a second point I want to make is this the K 10. Which is or has been the best predictor we have, has problems with it, uh, because you need to make some adjustments, uh, because of changes [00:14:00] in accounting rules. And I wrote about this 10 years ago when, uh, Jeremy Grantham and others were saying that Cape 10 was indicating the market was 70 percent overvalued.

And it went on to go, to have a great decade, ignoring Grantham and John, and, and John Hussman, because they made the mistakes I’m going to talk to you about. Uh, so first is we had changes in how intangibles were treated. And we used, uh, Uh, depreciate them, and now you have to write them off, uh, immediately, uh, and that means your earnings are lower than they would be otherwise, right?

Instead, uh, and that’s impacted how the value premium is treated, uh, because stocks that look like they’re high PEs may not be. If you put those intangibles back on the balance sheet, and then depreciate them. Now that has some issues, uh, because you don’t really [00:15:00] know what the future values of the intangibles are.

Uh, so some people, you know, like really smart people at Dimensional Fund Advisors, they They think you shouldn’t use it, but what they did is they included in their value metrics a profitability measure, which in effect deals with that issue at least to some degree. So that, that’s point one. When I wrote that piece, somebody went and did research.

And I think the Cape 10, if my memory serves, I might be off, but directional will be right. The Cape 10 might’ve been 28 and they estimated Using the old accounting rules, it might be 24 and there are other parts of the world where they do, uh, put the intangibles on the balance sheet and then write them off.

So you have a mix of things. So if the cake 10 is 36, maybe it’s really only 30. If you adjust for that. So that’s problem. [00:16:00] Uh, problem two is the huge mistake. I think that Huff, uh, Huffman and Grantham made was looking at the historical data and saying the average Cape 10 was, let’s say 17 or 16. I think it was at the time and saying now we’re at 28 or whatever the number was at the time.

And therefore it’s. That’s a huge mistake because that data goes back to the 1870s I believe, or 1880s, so you had 140 years of data. And much of that period we didn’t have a federal reserve to dampen economic volatility. help address financial crisis. We didn’t have a financial accounting standards boards to give us more confidence in the data.

So they had a lot more frauds and things. There was no sec, right? All of these things. [00:17:00] Uh, and so investors have much more confidence in the data and therefore probably can accept a lower equity risk premium, right? And the country, right? is dramatically wealthier than it was back in the old days. And there is very clear and logical evidence the wealthier a country gets, That means it has more capital to invest.

That means the equity risk premium is going to be lower. And that’s exactly what the research shows. The wealthier it gets, the lower the equity risk premium gets ex ante. So you know, if 17 was or 16 was a good number as an average, maybe it’s 21 or 22 today. We don’t know what that number is, but it’s almost surely not 16.

I’m very careful, I never virtually use the word overvalued, I will say highly valued and that means I have lower [00:18:00] expected returns. Now having said that, I’ll make one other comment and then we’ll try to address some of the other issues. Uh, Fama famously said that he couldn’t tell when there’s a bubble.

You only know after the fact. I think he’s clearly wrong on that. And the way to show that is when the real yield on TIPS, which is the totally riskless investment for a U. S. investor, okay, is higher than the CAPE, Or the earnings yield on stocks. That’s got to be a bubble that can only be resolved by the tips yield coming down or the PE ratios coming down.

So the earnings yield goes up. And in late 99, early 2000 tips were yielding over 4%. And the earnings yield was like two percent or two and a half. That to me was clearly a sign of a bubble. In fact, we had a, wasn’t quite as bad in 98. I [00:19:00] thought, you know, prices were very high. The CAPE might have been only like in the high 20s then.

Uh, so I, uh, altered my strategy and went to 100 percent value. Now I was two years early and a lot of people would panic and sell because they were proven wrong. Luckily I had the discipline to say the course in the next decade was single biggest premium for value stocks in history. And foreign stocks, again, far outperformed.

And so there’s at least the possibility that that were in that situation or similar today, because at least for those same large growth stocks, because in 99, the U. S. markets were not highly valued. If you eliminated, you know, the dot coms and the large and small growth stocks, that was the speculative bubble.

The PEs of value stocks. We’re in the 11 12 kind of range, which was about [00:20:00] their historical average. And most of the outperformance of growth did not come from earnings. It came from PE expansion, and that’s exactly what we’re seeing today. Now, you can maybe repeat earnings growth. You certainly cannot repeat over and over again PE expansion.

At some point, that will end. So that’s the warning for people today is that we almost certainly can’t repeat the last decade. Right. And one of the most powerful forces in the universe, uh, is that abnormal earnings growth reverts to the mean at a very mean pace. Uh, so by, uh, I’ll explain what I mean by that.

Let’s say earnings growth is about 6%, three real maybe in three, uh, inflation. If you’re growing at 26, you have 20 percent abnormal growth. [00:21:00] Fama and French did a paper back in the late 90s showing abnormal earnings growth reverts to the mean at about 40 percent per annum. So take 40 percent of 20, you’re eight.

The next year you should expect to grow only 18%. And then next year, maybe, you know, 14 and then boo, but the market persistently analysts and investors alike persistently forecast abnormal earning growth to continue, maybe not at the same pace, but instead of 26, they’ll forecast 25 or 24 when it’s much more likely to be 20.

Even more important, on the other side, low or below abnormal earnings growth tends to revert to the mean faster than abnormally high growth, and that’s because competition leads Supply gets shut down because you can’t earn profits. The other side, of course, high profit attracts lots of [00:22:00] competition, and that’s why if you look at the The best companies with the highest returns each decade are virtually different every decade.

If you can look at the top 10 in the S& P, even something like every decade, 70 percent of them turn over and yet people continue to expect. So just think of stocks like Intel and digital equipment, and you know, we can name lots more like that. That were once part of the nifty 50 and many of them are even gone like Polaroid.

Kodak, you know, and many others. So last, uh, point to get to your, what should investors do? So this is the key question, and I have three key investment principles that I think everyone must follow. This is the way I think about investing. First, the data shows that while the market is not perfectly efficient, We know that there are [00:23:00] lots of anomalies, momentum is a good one, uh, and these anomalies can persist because there are limits to arbitrage like the risks and costs of shorting and borrowing costs, et cetera.

So anomalies can persist, but the evidence shows that that the odds of you outperforming the market after the cost of the effort, once you account for common factors that are identified in the literature, like value, momentum, profitability, quality, investment, uh, term premium, and credit risk, The odds of outperforming are getting closer and closer to zero, which is what I wrote about in my book, The Incredible Shrinking Alpha with Andy Berkin.

And we explain why, uh, that’s the case. 98 book comes out, Winning the Loser’s Game by Alice. Same month, my first book happened to come out. And he wrote [00:24:00] that, He found that about 20 percent of active managers were outperforming on a risk adjusted basis, pre tax. Given that taxes are the highest expense investors face, that means they’re likely to be, you know, 10 percent maybe after taxes.

Just. Uh, 12 years later, a farmer in France, or 13 years later, write a paper, uh, and they find that the number had shrunk to 2%, pre tax, and other papers since then have found the same thing. I don’t know about you, but I don’t like the odds of 50 to 1 against me. So that tells you it’s possible to beat the market, but using systematic strategies are much more likely to achieve your, allow you to win.

to achieve your goal. So that means you should avoid individual stock selection, market timing, what I define as active investing. Okay. But I don’t use any index funds. I [00:25:00] use funds that in, that are systematic, transparent, and replicable. They’re active in defining their eligible universe. But once they define it, There’s no human intervention, even using computers and algorithmic trading to avoid some of the negatives of indexing that can be minimized or eliminated, like front running, uh, and, uh, you know, uh, market impact costs.

Dimensional, for example, only trades, most of the trades are a hundred shares because they’re trying to minimize market impact costs and they don’t care about tracking bands So rule number one. Use systematic, transparent, and replicable strategies. Don’t listen to forecasters, and don’t, uh, engage in any individual security selection or market timing.

If you believe that markets are efficient, There’s only one logical [00:26:00] conclusion I believe you can draw and that is that all risk assets must have similar risk adjusted returns. What do I mean? It doesn’t mean they have the same expected returns because clearly junk bonds should have higher expected returns than treasury bills at the same duration because there’s risk and no intelligent person would do it without taking a risk.

Emerging markets are riskier, etc. And We don’t just care about volatility or economic cycle risk. We’re humans, we tend to care about things like skewness and ketosis, the degree of those fat tails which can tell us how much that withdrawal risk can be. And liquidity risk is an important one for which you could be compensated.

Uh, and so out of that, what it tells you is you should overweight the assets that you don’t have as much exposure to. If you’re in [00:27:00] retirement and you’re not taking more than your RMD, which for a 70 year old is about 5%, you can own lots of interval funds. Which gives you a minimum of 20 percent a year in most cases, because you’re not taking more than that.

And there’s huge illiquidity premiums, which we can touch on if you like. Private credit to me right today and for the last few years has been the best trade in the world by far. Uh, So, now, if you believe those first two things, markets are efficient, and all risk assets should have similar risk adjusted returns, there’s only one logical conclusion you should draw, and that’s you should hyper diversify.

Of course, there’s many unique factors. risk assets, as you can identify, that meet the criteria that Andy Birkin and I identified in our book, which I’m really proud of, because lots of people now quote, although they never give Andy and I the credit, but I, we, I think we were the first ones [00:28:00] to put that in writing.

So it’s that there’s a premium for that. That’s persistent over long periods of time, pervasive around the globe, and asset classes and sectors. It’s robust to various definitions. Uh, so, and it’s implementable, so it survives transactions costs. And lastly, it has either risk based or behavioral explanations for why you think the premium will persist.

And it must meet all of them. Okay, I prefer risk based explanations. Because they can’t be arbitraged away, although premiums will shrink or grow depending on popularity or whether the risks show up. But I’ll accept behavioral ones where I can identify these limits to arbitrage, because we know human behavior doesn’t tend to change much.

So I’m a big believer, at least directionally, with the idea of risk parity. I don’t particularly like that because that assumes [00:29:00] you have the same ability, willingness, to take each of those risks. As a good example, Harvard’s and Yale’s of the world can take much more liquidity risk than a widow living on a pension.

So they can load up on it and earn that illiquidity premium because for them it’s virtually a free stop at the dessert table. It’s not totally riskless, but it’s as close as you’ll get. So you want to identify like a tenured professor Right at Wash U is likely, you know, he’s not losing his job for economic cycle risk reasons.

So he could even take like credit risk in private credit. He doesn’t need liquidity and he can take that cycle risk where others who are less stable jobs So that’s how investors should think the typical investor owns no alternatives That have these unique risks or very little When the Harvards and Yales and Larry Swedro, uh, have [00:30:00] like 50 percent of their assets in alternatives because the typical 60 40 portfolio has 85 90 percent of their risk in one single factor market beta.

And it makes no sense if you believe all risk assets have similar risk of just the return. So things like private credit, reinsurance, long, short, you know, factor strategies, and lots of other things, drug royalties, litigation, finance, I own lots of different things, most of which have big illiquidity premiums, and I don’t need liquidity.

So hopefully, bit of a long, uh, uh, Answer, but I think we got to all of the points you raised there, .

Pierre Daillie: Well, I’m, I’m reminded of, uh, you know, the quote, um, 80% of success is showing up . And, you know, I, I, I, I think, you know, to, just to dive into that just to, just for a moment, you know, it’s [00:31:00] not about. Beating the market, right?

I mean, for investors, there’s so much, historically, there’s been so much focus on this idea of beating the S& P 500, beating the market in general. But the key is not to try and beat the market. The key is just to show up, to participate. Right. And, and, and then, and then the next question is how do you participate and what do you participate in?

And so I think you, you know, you touched on all those three points, which is first of all, don’t try to beat the market, just participate in the market. Secondly, how do you participate in the market? And, and, you know, you explained your rules based investing, evidence based investing, which makes a great deal of sense.

It’s not about just, you know, passively or just, you know, going ahead and buying the S and P 500 and one and done. But then also. What do you participate in? And, and that’s where, you know, the hyper diversifying idea. Uh, comes into play and that’s to distribute your assets among the core, uh, stocks and [00:32:00] bonds, but also to look at alternatives and to distribute.

According to proper risk budget budgeting, as opposed to just saying, I’m going to buy some stocks, I’m going to buy some bonds. It’s by looking at, you know, your different risk premia understanding. First of all, just having stocks and bonds in your portfolio is going to probably equate to about 90 percent equity risk.

Okay. But if you start to add some real assets and liquid alts and long shorts, merger, our event driven credit, things like that, which are uncorrelated, you’re going to get a, a much, much more sort of ameliorated outcome in your portfolio. And, and you can just simply participate because you’re taking into account all.

The forecast, not just a forecast or a view on the market. And, uh, that way, you know, you don’t have to watch your portfolio nonstop, which is what a lot of people do today. You can actually, you know, as, as, uh, Jason Buck likes to say, you can go back to doing the things you enjoy doing. You actually spend more time with your [00:33:00] family and, and, and, uh, you know, just, uh, enjoy life.

As opposed to spending all of your time on your phone, looking at your portfolio. Well, lots of, again,

Larry Swedroe: lots of interesting points you make there. One, just showing up is important, but it does you no good if you don’t stay the course. And that’s another huge mistake that investors make. Again, one of my favorite sayings is, that investors, when it comes to judging, uh, uh, an investment strategy or a mutual fund, they think three years is a long time.

Five years is very long and 10 years is infinity, right? Any good, uh, academic or financial economist will tell you the odds 10 years is likely noise. And yet even professional investors like consultants They, working with endowments and state pension plans, they review the performance of the [00:34:00] managers like every three years.

And it’s insanity because the research shows very clearly, and we know this for at least like 20 years, Uh, that the managers they go and hire go on to underperform the managers they fire, which means they would have been better off doing nothing in the first place. And they would have been even better off if they just used systematic strategies, not try to pick managers who would beat the market.

So, uh, Key number one is that. Second mistake, uh, that’s really important, which addresses this issue of importance of sustained discipline, is this. Every single risk asset I try to teach people will go through very long periods of poor performance. If you doubt that, there are three periods where the S& P underperformed totally riskless T bills for at least 13 years.

29 to [00:35:00] 43, 15, 66 to 82 is 17, 2, 000 through 12, 13, that’s 45 of the 97 years of data we have, almost half the time. Now of course in the other, 55 percent or whatever it is markets got spectacular returns, but it does you no good because Unless you’re there to earn it and what if after 17 years of underperforming t bills.

It’s 83 and you say boy now I’m not gonna own stocks But here’s an even better example people are now focused on large growth stocks, especially and I show them Uh, the 40 year period from 0, uh, from 69 through 08. large and small growth stocks underperformed 20 year treasuries, which is the totally riskless investment for a pension plan with [00:36:00] nominal liabilities.

That’s 40 years. And by the way, each one of these periods of long underperformance, I point out, always occurs after periods of great performance when valuations are high. Which is what we have today. Now, that should tell people there’s at least a risk of that left tail showing up today. So, what, what I tell people is that understanding does not mean you should avoid an acid class.

It means you should hyper diversify so you don’t end up with 90 percent of your risk in the factor that’s getting hammered in that period. And yet investors make these mistakes. I’ll give you two really good examples. I’m sure Adam will relate, uh, to the first one, which is on AQR’s, uh, style premium fund.

So, they come out and it’s long, short. Four factors of, [00:37:00] um, value, momentum, carry, and quality, they call it defensive. So it’s got no beta exposure whatsoever. It has an expected return, historically, based on the evidence, of about 4%, 5 percent maybe, real returns over T bills, and about, in the way it’s managed, it’s targeted to a volatility of about 10.

Now, they can’t get it exactly right. But it’s not likely to be 20. It might be 12 or eight, but they’re targeting 10. Okay. The first five years or so, it virtually matched that return. Then 18 through 20 shows up three horrible years, total losses draw down. I think it was over 30, maybe 33 or 35 percent and investors fled.

Cliff Asness is throwing stuff at his computers and stuff, and then investors [00:38:00] leave. And the next three years, the returns have been, or now a fourth year, have been spectacular. 21, 22, we’re like 25%, 22 percent it’s up again strongly this year. But most of the investors aren’t there because they think three years is a long time.

I point out, so five percent of your portfolio went down 30 percent, so it lost you one and a half. That doesn’t blow up your portfolio. But if 90 percent of your portfolio goes down 40, 50, 60 percent, like stocks have done in 73, 4, in 08, uh, those kinds of things, then that can destroy your portfolio.

Especially if you’re subject to sequence risk. Second example, which I have even more definitive data on, uh, is a reinsurance fund. Now, to me, there’s nothing more logical as an investment than reinsurance, because clearly, bear markets [00:39:00] don’t cause earthquakes or hurricanes, and vice versa. And there’s got to be a big risk premium because it’s illiquid and insurance companies aren’t dumb.

They have all this data. Historically, they got scientists. They’re making estimates, but they could be wrong because the risk shows up. And by the way, if it wasn’t true that every risk asset goes through a long period of poor performance, there’d be no risk. Just have to sit and wait five, six, seven years.

So it has to be true. In fact, the fact that it’s true is why we get big risk premiums because people hate those left tails. They want to avoid them like the plague, that negative skewness with a fat tail means that people are going to demand a big premium. But you only earn it if you stay the course and better yet, rebalance, because now you’re buying when expected returns are higher.

And there’s what I call a self healing mechanism, which I’ll mention, which applies to all risk assets. [00:40:00] So they, uh, Stonebridge comes out with a fund called, uh, their reinsurance fund, S R R I X. And the first several years, four or five years, right 5 percent real expected return. And then it goes through three really bad years, and then it has, uh, up five or six, and then down five.

So four out of the five were really bad. After the first four or five years, of course, money had flooded in. Wow, this is great. Five percent, uncorrelated, real returns. You can’t ask for anything better than that, right? And the fund had five billion. Five years later, it was one billion. Now, about a third of it was from, you know, poor returns, but the other two thirds were investors fleeing.

Last year, the fund was up 44 and a half percent. This year, despite several big hurricanes hitting Florida, the fund’s up 23 percent. Probably will end the year if we don’t [00:41:00] get another major event, which is now. You know, unlikely, but not impossible, like 25%. The average investor has underperformed the fund itself by 5 percent a year.

Now, how do you do that, right? You throw away the good because you think three years is a long time to judge performance. What the only right way to think is to think about the quality of decision based on the quality of the process, that it makes sense based on the evidence and the data, not on the outcome, unless you’ve got a clear crystal ball and it doesn’t exist.

So, the key is getting back to that core principle, since every risk asset is going to go through a long period of poor performance, and we don’t have a clear crystal ball, the only logical thing in my mind is to be a hyper diversifier, and what that does [00:42:00] Is it takes that wide distribution of possible outcomes and it narrows it greatly.

You give up the opportunity to earn that fat tail because you’re not going to earn the highest returns from the best asset class. You give that up, but you get rid of. They’re all of that risk of that big left tail because you are hyper diversified. And if you ask investors which they’d rather run the risk of, and that’s what you have to accept, let’s say, a 60 40 portfolio with a very wide distribution of possible outcomes, or a 30 40 Equity, 30 alts and 30 safe bonds just to pick a number.

And that has a distribution much like this would say the same expected return. Only a fool would take the first and not the second, but people don’t because of tracking variance risk. They’re [00:43:00] afraid they’re going to underperform some benchmark, which you shouldn’t care about because you agree that it doesn’t make sense to concentrate your assets.

Adam Butler: Well, there’s nothing more corrosive to one’s well being than to watch one’s neighbor get rich. Yeah, exactly right. And I think, um, you know, I think it’s worth tugging on this idea of, of tracking error, um, aversion. Because, you know, I think this is the culprit in, in the vast majority of these, um, decisions that cause, Us to constantly observe how, how much underperforms the, the underlying investments that they allocate to.

Right. Right. Um, I mean, how does, how does one deal with this? Right. So you, let’s say you’ve got eight uncorrelated potential return streams, right? You’ve got whatever, you’ve got your cap weighted equities. You’ve got a few of your [00:44:00] favorite, uh, factor strategies. You’ve got your private credit, your litigation, finance, your reinsurance, et cetera.

So now you’ve got a portfolio that, you know, all the constituents have a vol of around 10. Because you’ve got eight and they’re all uncorrelated. Your portfolio has got a ball of five. That’s narrowing your return distribution as Larry was describing. Um, You’ve got all this extra potential risk that a client is willing to take, right?

Like they, they can, they can accommodate 10 or 12%, uh, annualized ball, approximately what you get from a sort of 60, 40 portfolio, right? You’ve shrunk that down to four or five because you’ve got eight uncorrelated return streams in the portfolio. Um, you’ve got the same return or expected return as you would As you would maybe get from or expect from a, uh, [00:45:00] a 60 40 portfolio, why not?

Like, why are people not trying to make more use of this extra risk that people can tolerate, right? You’ve got 5 percent fall. They can, they can tolerate 10. So there’s an opportunity for much higher returns here for many people. Why do people not choose to go that route and how, if they did want to go that route, like it’s a whole you can’t eat shark ratio argument, right?

How can you expand that canvas for those who can tolerate that? More risk given the amount of diversification that they have in the portfolio. Yeah.

Larry Swedroe: Yeah. So One of my favorite lines again is education is the armor that protects you from yourself Uh, so you need a knowledge of history you need a knowledge of finance you need a knowledge of, uh, the things we’ve discussed and understand that three [00:46:00] years is nowhere near long enough and even 10 years is not long enough.

As those example I gave you with 40 years of underperformance for growth stocks. So you’ll have to accept those things. And that’s why it comes back to educating people about what should be your core principles. If you accept that you should hyperdiversify. Then you have to accept that you don’t care what the market does.

Why do you care? Cause your objective is not to beat the market. It’s to achieve your financial goals and the surest way to achieve your financial goals. Remembering that most people objective is not to die rich. But to avoid dying poor, right? It’s that left tail risk, that sequence risk. If you’re unlucky enough to retire in 73 or 2000 or even 08, you could be in trouble.

And that recency bias is going to [00:47:00] impact you. And if you know that, how do you mitigate that? Well, you have to diversify. Right? What I, uh, and, uh, sorry, Kevin Grogan and I wrote a book, Reducing the Risk of Black Swans, which is what most people are trying to do. Get rid of that left tail risk. And we show how to do that.

Who the principles that we show. Okay. I’m just going to make sure the listeners understand the point. Pierre was making that that risk points the way every hedge fund and every bank and insurance company thinks about risk is not how they allocate assets. It’s the risk of the assets times So, stocks, roughly, all diversified portfolios have a vol of about 20.

So, if you’re 60 percent times 20, you come up with 1, 200 risk points. If you’ve got a 5 year bond portfolio, [00:48:00] Which might be typical in intermediate treasury, that maybe has evolved roughly a four. So you, you know, a 40%, that’s 160 points, 160 and 1200 is 1360. You’ve got 90 percent of your risk is in equities, which makes no sense.

When, if you believe these, and what can happen, people forget, uh, actually stocks and bonds are positively correlated, not negative. That’s the long term, it’s slightly positive. Uh, and we know that correlations are time varying. The fact that reinsurance is uncorrelated really means that, let’s say, just to make the math simple, 30 percent of the years are negative for stocks and 30 percent for reinsurance, that means You have a one in nine chance they’ll both be down and poorly, right?

So that means it’s going to happen like once a decade. [00:49:00] So it can happen. And the same thing is true of bonds, right? You get a year like 2022 and those bonds you thought were safe get crushed. So, what I do, and we showed in the book, is by adding other assets, think about private credit as a good example.

Now, clearly, you’re taking a liquidity risk, but for most people, and almost, I would say, every single higher net worth investor. Does not need liquidity for 100 percent of their portfolio, so they could devote at least, say, 20 or 30 percent and more likely even 50 percent to illiquid assets. If they could take tracking there today, you could buy Cliff Waters, um, middle market lending fund.

It’s 11. 5 percent net after expenses. It has no duration risk virtually about 45 days. And the [00:50:00] index on which the fund is based has a default loss of under 1%.

Now, you could go buy Vanguard’s high yield fund, which has more credit risk. About six years of duration. And last I looked, it was about a 7 percent yield, maybe at seven and a half. So you’re 4 percent risk premium. Some of that clearly is illiquidity if not, but you have less credit risk. You have no duration risks, but a bit more economic cycle risk.

So what do you do? Well, I could take some away from my equities where the economic cycle risk is, you know, ten times what it is for this fund. Take some from the bond side, you’ll raise your expected return, you’ll cut your vol, you’ll shrink the tail risk. And the same thing is true adding reinsurance.

Which today, [00:51:00] Stone Ridge is fun. Now, I wouldn’t expect this long term. The self healing mechanism I mentioned, and I’ll explain that now, while I remember. The expected return is about 23%. What happened? When I first invested, the fund had a no loss return of 15%. Now, no one expects no losses. The expected mean loss in that distribution was 8, so you got a 7 percent median.

Could be minus 10 or could be, you know, plus, you know, 15, somewhere in between or even worse. But the mean was 7, T bills were 2, 5%, real great asset to own, right? Well, then you had Bunch of years that were bad. What happened? Premiums went through the roof, as everyone who lives in California trying to get fire insurance or Florida hurricane insurance knows.[00:52:00]

Deductibles went way up. Underwriting standards went up. Construction codes got tougher. So the risks went down and the premium went up and everyone’s running away. Warren Buffett in his reinsurance fund was writing more reinsurance than they ever did and they cleaned up. Same thing is true with stocks and credit risk, right?

What happens? The risk shows up, PEs come down, the expected return goes up. Credit risk, credit spreads widen, yields go up, expected returns go up, but people flee just when the expected return is higher. So that’s why you, You have to be hyper diversified. You can’t be subject to recency bias. You can’t care what the S& P 500 is doing.

Or you will make mistakes. Panic and sell. In my book, and this is what I did with every investor I met with, When I was at Buckingham, and by the way, I [00:53:00] retired in June of last year, so I’m no longer with Buckingham. I am doing consulting for RIAs and one major investment firm. Here’s what I showed them. I might show them they wanted a, let’s say, a 60 40 portfolio.

They didn’t like these alternatives. They don’t maybe understand them. They didn’t like illiquidity risk. And we run a Monte Carlo with a 4 percent withdrawal rate and it shows. There’s 80 percent odds of success. That’s the first mistake that most advisors and investors make. They look at the odds of success.

You must look at the odds of failure because you get a very different answer. Lots of people will say, yes, I’m willing to take that’s 80%. It’s highly likely. But it’s right. I remember I told you don’t make that mistake. If you ask him if they’re willing to be one in five people because it failed to end up eating cat food, they’ll say no way.

So that’s [00:54:00] mistake one. But then I show them take Adam’s portfolio with eight uncorrelated assets

Adam Butler: and

Larry Swedroe: the expected but not certain odds of loss go down to like 7%. That’s mistake number two. So you cut your odds of failure by 70%. Now I tell them, which would you prefer based on the odds? Oh, this for sure.

And then I say, then you must give up checking your portfolio against the market because you told me you don’t want the market and there will be long periods. of your portfolio will underperform, but that’s not your objective to either match or beat the market. That’s the key. You must educate people up front, explain these risks of recency bias, relativity, which has a place in science, but not in investing, uh, uh, and tracking variance.

And by the way, Adam, I hate the words tracking error. It [00:55:00] assumes that there was an error. So I substituted tracking variance, right? There’s no error here. It’s intentional. We don’t want to look like the market So those are the biases you must get rid of if you’re going to be a successful investor Did warren buffett?

Did he look, did he complain that he underperformed in the dot com era when people said he was dead, finished, the world had passed him by? He didn’t care. He knows what he believes is the right strategy.

Adam Butler: So, this always conjures for me E. O. Wilson’s quote, Communism is a great idea, wrong sthesis. Like, it’s, it’s, you know, I, obviously, you know, we, we agree, Larry, right?

Like, more uncorrelated bets, the better. Um, both of us have, have built our, our careers, for the most part, on [00:56:00] this. Assertion, right? Um, but there is some question about whether education is sufficient. You know, all the research from from Kahneman and Fersky and the entire canon of behavioral finance and decision making is rife with.

You know, literature demonstrating that you can educate people up the wazoo, but when the chips are down, they’re going to go with their gut, right? Um, so it’s just, it’s remarkable to continue to, to cling. And, you know, obviously we, we do too, it’s just over, over the years. We have acknowledged that the vast majority of people just don’t have and I also have sympathy for people who who don’t have the fortitude to stick with strategies that have Not given them a good experience over a period of sort of three to five years the human life [00:57:00] And certainly the human investment lifespan is relatively short.

You know, if it takes 10 years to even have a shot to distinguish between something that’s likely to deliver a risk premium and something that isn’t, then you might have four or five of those shots in your life, in your lifetime, right? So

Larry Swedroe: certainly we’ll have them.

Adam Butler: Yeah. Right. Right. So, you know, I have a lot of sympathy, which is why.

Over, over time, I’ve kind of shifted more towards some kind of Pareto optimum between what kind of tracking variants to use your parlance people can tolerate and what might be most effective in terms of maximizing their utility under rational expectations, right? And, you know, I used to do these. Um, very [00:58:00] sophisticated Monte Carlo style, actually, um, far more sophisticated analysis than that.

As I went further and further down the rabbit hole, just in terms of failure rates and, and, and lifetime ROI and all that kind of stuff. And I just realized that people actually, it’s not just that they want to sustain a lifestyle, but they also like sustaining a lifestyle means that you’re able to do the things that your friends are able to do that.

You’re largely kind of keeping up with your perceived peer group, right? So if all your friends, they go out and take on massive mortgages that are profoundly imprudent. Are you going to just sit on the sideline and rant? There’s this huge optionality you’re selling, right? And they, they go on and make a fortune in their levered housing that it’s the same thing.

And you know, if, if all your friends have concentrated equity portfolios that are high fiving each [00:59:00] other at Thanksgiving about their ownership in Nvidia, and you’re in this diversified portfolio chugging along at 4 percent real, this is just, it’s just, it’s Almost an impossible thing to ask of most people.

So, I mean, just purely not stepping outside of the academic, what you understand to be true from a rational expectation standpoint. What has been your lived experience in, in, In both continuing to keep advisors on the straight and narrow and also coaching those advisors on how to keep investors invested in these alternatives so that they don’t get all the risk in those negative time periods and then bail on them before they actually get the reward.

Larry Swedroe: Yeah, well, you’ve got an hour or so worth of questions, and I actually have trained hundreds, if not a thousand, or other advisors around the country in teaching them how do you address [01:00:00] these issues. Yeah. That was one of my roles at Buckingham. So, a few points. One, education is not sufficient. I would agree with that one.

Uh, Because it’s only the necessary condition. Without the education, you have virtually no chance. of success because you’ll succumb to all of these biases almost certainly. So that’s point one. Point number two is you have to have the discipline to stick with whatever the strategy is and it’s education that gives you that discipline.

It’s that armor that can protect you. Uh, but what I trained advisors to do is one, understand There is no right portfolio. I can tell you the right portfolio from a purely academic standpoint, at which you point out, but the right portfolio, even if it’s the 60 40 [01:01:00] standard portfolio, which we here agree, is irrational from a, from a finance standpoint, but it may be psychologically rational for the investor.

And if that enables them to stay the course, then that’s the right portfolio for them. I tell advisors, Never tell a client what to do because if you do, if it turns out right, they will take the credit for listening to your advice. And if it turns out wrong, they’re going to blame you for being an idiot.

Right? So your job is to educate them so they can make the most informed decision and then play devil’s advocate to make sure they understand the risks. So I will point out, for example, well, In that, uh, Monte Carlo example, I said, okay, you’ve decided you don’t want this tracking variance. I’m, we talk [01:02:00] about relativity and all of these things and how hard it is in the last decade, for example, or was just as hard in the 90s and look at what happened and I show them the next 10 years, right?

And how would you have reacted then? Right? And keeping jumping will cause you to end up in the far worst place. Right? So I show them that and I say, You’ll either run the risk of a 20 percent odds of failure, but you won’t care about tracking variance. You won’t care about recency bias, although that’s nonsense, because when international and emerging market and value far outperforms, and some of your friends own that, you’re going to maybe be subject to that and panic and sell.

We know that will happen. So this tracking variance is a two way street. It’s not one way, but more of it is related to the S& P because that’s what we hear every day. All right. So I show them [01:03:00] both. You want the 20 percent or the 7%? Your choice. I can’t tell you what’s right to do. For me, the 7 percent is financially logical.

I could deal with tracking variance. You’re the one who’s going to have to live with the consequences of your decision, and therefore you must make that choice. I cannot tell you what to do. So the bottom line is, if you do all of that up front, And then once a year, remind investors, cause you rerun the Monte Carlo’s and you show them alternative scenarios and you show them when something outperforms, we’re selling and rebalancing to stick with our plan, right?

Every year you talk about what did poorly and we knew that some part of our portfolio did poorly. And if none of your parts are doing poorly, you’re undiversified almost certainly, right? Very rare. It’s [01:04:00] possible that all could do well. In 2022, my portfolio was up slightly when almost everybody I know was suffering significant double digit losses.

Now, in the next few years, No, it didn’t do as well, but I still, I was achieving my goal and I didn’t care. So that’s, uh, what’s key. Let me address another key point, Adam, that you made. Larry, I’m 65, I don’t have 30 years to wait for the value premium or reinsurance or whatever. I hear that kind of argument all the time.

And I say that’s exactly the wrong way to think about it. And I show them a chart that shows the odds of negative returns over various horizons. And no matter what the asset is, beta, which is the market premium, size, value, quality, insurance, whatever. At one year, beta is about a [01:05:00] 70 percent probability of positive returns, right?

I mean, it’s a 30 percent odds of failure. At five year, it may be is a 20 percent odds of failure. At 10, it may be 4%. And at 20 years, it’s 3%. It’s never zero. But the longer the horizon, the lower the odds get. But It doesn’t matter what your horizon, you’re always putting your odds in the favor with a diversified portfolio.

Because I show them, if you just naively, so I can’t be accused of data mining, just equal weighting these, say, eight atoms asset classes, the odds of failure are much less, you know, like maybe one fifth what they are, of the odds of failure with a market beta strategy. And so I show them, you’re wrong. The shorter your horizon, it’s more important to [01:06:00] diversify because over 20 years, or 30 years, the dispersion of outcomes narrows.

In any one year, stocks can be down 50 or up 30. Over 30 years, maybe they’ll be up 5 or up 12, or, you know, something in that range. Or in Japan’s case, 0, for 34 years, right? So, the shorter your horizon, we have to accept the wider the dispersion of possible outcomes, which means it’s more important to hyper diversify.

The shorter your horizon. So that’s one of the other things. Last point I’ll make, Adam, is this, and it has one of my favorite stories. One of the worst mistakes investors make is they judge the quality of a decision based by the outcome, not by the quality of the process, right? Um, Adam, I imagine you’re a sports fan, NFL, maybe you follow [01:07:00] football, if you, or Pierre, if you are a football fan, you know, maybe the most famous play in football, or one of them, happened in a Super Bowl, uh, when Seattle was driving for the winning touchdown, with a few seconds, like a minute left, and they’re inside the 10.

like on the seven yard line or something like that. And they have the best running back and one of the best offensive lines in football. And everyone’s in the announcer saying, just give the ball, the, the, this Marshawn Lynch, this great running back and, you know, run out the clock and you’ll get that touchdown.

Of course, he, Russell Wilson, froze a pass and gets intercepted, a great play by the defense, and everyone is lambasting the idiot coach for calling this play. So the sabermeticians went to work and did analysis. And they found that fumbled the ball three times during the season in those kinds of situations.

Russell [01:08:00] Wilson had never in that year thrown an interception in that part of the field. The right play, based on the evidence, was clearly to throw a pass which nobody expected, except this one defender who made a brilliant play. Same thing is true. When you own reinsurance and you get three bad years, You shouldn’t judge the quality of your decision by the outcome.

It’s just that the risk showed up and you knew it would show up at some point. It just so happened. Maybe it was the first three years and you never got the, and then you panic and sell, and then it goes up 44 and a half percent because of the self healing mechanism. So that’s the key. Investors must accept before the fact that you cannot judge the The quality of decision.

Robert by the out, Robert Rubin said famously this, I think it’s one of the smartest things that anyone can say, says [01:09:00] you can have bad decisions like taking your IRA account and buying a lottery ticket or take it to the racetrack and you’re, you win. and think it’s a brilliant decision. Or you can make very good decisions and get poor outcomes because the risk shows up.

But if you continuously over time make good decisions, your odds of success are infinitely higher than if you make series of poor decisions. So that’s really key. Do not judge the quality of a decision by the outcome, but ask yourself, and you should, you should. Did I do something wrong? Did I miss something in my analysis?

That’s certainly possible. Or I learned new information.

Adam Butler: Yeah, the, um, last 10 or 15 years in markets, I think are a really good example to highlight right [01:10:00] where, you know, those who have, have always been long and strong S and P 500 cap weighted index investors. Have been vindicated time and again for the last 15 years.

And it’s just very difficult due to this self attribution bias that you highlighted at the very start, where if something goes right, I assume it’s because of my genius. If something goes wrong, it’s because of exogenous factors beyond my control. Right. And so we’ve got just every, you know, with the possible exception of, of 2022 and some of 2023 just got this constant reinforcement that the simplest possible allocation strategy into cap weighted S& P has been the smartest call anyone could make.

And each time that that decision is validated, that attribution bias [01:11:00] grows stronger and the inclination to be receptive to Uh, The education about the long term probabilities are, you know, diminished, right? So I would agree. This is, this is definitely maybe, you know, again, and as you highlighted, going back to the late nineties was another period where education is, is just very, very difficult because all the lessons that the vast majority of people have learned have been the wrong lessons in terms of what to do prospectively.

Obviously they ended up from a resulting standpoint, being very smart decisions retrospectively. Right. Um, At hindsight capital, it’s always a banner year. Um, but you know, prospectively the lessons that you’ve, um, described here today are obviously the ones that, that, that make the most sense. I do want to credit some [01:12:00] reality to the fact that people do care about how they.

Our position relative to their neighbors and their peer group and and that that does need to be a consideration and as you say There’s no perfect portfolio and like my friend brian portnoy likes to say um when you diversify You’ve all always got you’ve all you’re always got to say you’re sorry, right?

Because there’s always going to be something in the portfolio that is disappointing you and that’s the nature of diversification and what you need to live with when you take the decision to diversify right So, all awesome points.

Larry Swedroe: Yeah, so I’ll make a few other points. One, to make this point Go ahead, Pierre.

Pierre Daillie: Yeah, I just wanted to add to, you know, while we were, while I was listening to your, you know, to your points, I was thinking also, you know, so much of, so much of our conversations are Peppered with the lexicon that causes the problem, I think, right. I mean, we’re always [01:13:00] talking about underperformance, outperformance.

We’re talking about performance, you know, they’re, they’re like, like, well, like we’re running a race, you know, like we’re talking about a race. I think, I think among, you know, knowledgeable investment professionals. That conversation is taken, you know, those, those terms are used, you know, more properly. But when you’re, when you’re, when you put that in the context of the, the retail investor, the layperson, you know, those words have much more.

More weight, much more gravity and, and, you know, it goes to, you know, what Adam was saying about, you know, your neighbors, you know, if your neighbors are high fiving each other and you’re in a, you’re in a, you know, 4%, 4 percent real returning portfolio and your, your neighbors are high fiving each other about NVIDIA, um, You know, you’re going to feel inadequate, right?

You’re just going to, you’re just going to, you’re going to start to feel like maybe even angry, like, [01:14:00] what, what am I doing in this diversified portfolio? But, you know, so there, there again, is that, that always that relative distinction that we’re always making about everything. And I think that that causes a lot of problems, right?

I mean, that’s causing, yeah.

Larry Swedroe: Investors are their own worst enemy. They look at the worst enemy in the mirror every day. But. Just to make the point that education done properly and persistently, not once, but persistently, works. When I was at Buckingham, we built highly diversified portfolios, and we’ve been adding, and I’ve been adding more alternatives as the market is You know, created new innovative products with much low cost.

You don’t have to pay two and 20 anymore to get hedge fund like strategies, like reinsurance, uh, the fees are generally 2 percent or less private credit is in the low 1 percent private real estate is [01:15:00] in the low 1%. With maybe a not a 20 carry with a 10 carry, so there you’re now able to capture a lot of the premium where before you couldn’t even private equity, which was additionally two and 20 cliff order just came out with a fund with a fees or I think their expense ratio or management is currently 1 percent and no carry there.

Uh, so. That means you should use these things where 20 years ago, or even 10, I wouldn’t have used them. Uh, AQR’s fees are like 1. 1 or something like that, 1. 3, not 2 and 20, right? 2 and 20, at 15%, you’re paying 5%, and I wouldn’t do it, because they’re taking all of the premium. While we were hyper diversified, and it did cause us to lose some clients in the late 90s, for example, and probably in the last decade, our client turnover rate, except I think for one year, [01:16:00] uh, never exceeded 2%.

So that tells you if you do a good job. And one thing advisors could do to address the problem Adam and Pierre, you, uh, mentioned is, Instead of just showing the performance in terms of returns, you draw a line and show here was the return we needed to achieve our goal. And that’s what the objective is.

And now where are we in making progress? Are we ahead or behind? So even if you underperform the market, you still got pretty good returns in the last decade, right? Uh, from a more diversified portfolio and you’re ahead of, or well on your way to achieving your goals. I’ll make one other point, Adam, because I hear this all, value was underperformed for 15 years.

Two points. It’s only true in the U. S. Developed markets, they’re virtually in a tie for the last 15 years. And emerging markets [01:17:00] value is far outperformed, something like 6 percent or something like that. So it’s not pervasive. The second point you have to ask is, How did you get the outperformance? In the late 90s, growth outperformed, Adam will tell you I’m sure, it was not from earnings growth.

It was multiple expansion, which means your future expected returns are now much lower. And that’s what we’ve seen a repeat of now. And valuations do matter. So yeah, you got that great returns because you got lucky and P. E. multiples expanded. If the risk shows up. And you get a recession and or a financial hit or whatever value stocks will probably go down, but their PEs are roughly 10, 11, something like that.

So where are they going to go with the PEs of growth stocks could be in the thirties, forties, fifties, et [01:18:00] cetera. Uh, and they could drop down to 12 or 15, and now you’re down 60, 70%. So you have to always ask how did you get those returns, not just understand that they did get them. And the last point I’ll make is U.

S., king of the world, last 15 years, you could say exactly the same thing in the following story, which is why, again, one of my favorite expressions, again, is The only thing you don’t know about investing is the history you don’t know, because we’ve been there and done that. Instead of 2024 in the U. S., it’s 1990 in Japan.

For the last 20 years, Japan has slaughtered every asset class. The land underneath the imperial palace is worth more than all of California. Uh, Japanese are buying up Rockefeller Center, Pebble Beach. There’s almost no [01:19:00] semiconductor plants left in the U. S., dominating the world. The next 34 years, Japanese stock returns virtually zero.

In nominal terms, I’m not making that prediction about the U. S., but anyone who says that’s impossible, You know, it’s a legend in their own mind. We cannot know the future, and therefore, we need to build a portfolio again to come back to that core principle, which you should always come back to. You need to build a portfolio that’s resilient to all of the possible outcomes, which, you know, you could, if you’re reading Nassim Nikol Taleb, I think he’s brilliant, but it’s hard to read his stuff because he’s telling you he’s so brilliant and on every page.

Uh, But the brilliance is that he always is thinking about what could happen and can my portfolio withstand that risk. In fact, this book came out [01:20:00] Uh, before 9 1 1, and I forgot what page it’s on, he talks about analyzing the risk of an airplane crashing in to a New York office building, you know, so I was taught that early on in my career because I learned that we can’t forecast when surprises happen.

So I, my job in helping both corporations who I advise them, I ran credit risk and interest rate risk. for the largest mortgage company in the country for a decade, uh, and was always thinking about how can I protect myself, including liquidity risk, uh, from those bad things. So I always made sure we had more credit lines than we could possibly need in any situation.

I was hedging the tail risk of rates going way up or way down and stuff. So even though I didn’t think it was likely, I made sure. I was be alive at the end of the day to keep playing the game [01:21:00] and not blowing up. And that’s what investors need to do.

Pierre Daillie: Yeah.

Larry Swedroe: Well, if you don’t have insurance,

Pierre Daillie: you don’t have a portfolio, right?

Uh,

Larry Swedroe: that’s, you know, again, yeah, that’s one of the best things. you could do is teach people that every asset you’re putting in the portfolio is buying insurance against the left tail risk. And what should you do when you buy insurance? Root that you collect or don’t collect on it. You don’t want to collect.

So if it underperforms, it’s okay. I wasted the premium. When your house burns down, Adam, or you lose it in a hurricane, right? Now you say, okay, I’m glad I got the premium, but if it didn’t and your tornado blows through and your house just happens to get missed, right? You don’t think, gee, I’m, I wasted that premium.

Well, that’s the way you, I try to teach people to think about diversification. You’re lucky [01:22:00] the risk didn’t show up. We could have put all of our assets there. Because right now, reinsurance is the highest expected returning asset probably in the world. Because the premiums went up and the risk went way down, we don’t know what next year will bring because there’s still December, January, we’ll have renewals.

The guess is it’s probably going to be similar to last year when the expected return was 23%. The year before it was 33 percent and 70 percent of the money left. Because the risk had gone up. I loaded up, uh, because I was rebalancing, and I even added a little bit more, because I said, I’m, I don’t, you know, move my asset allocation much, but when valuations get to extreme, or expected returns get to extreme, I sin a little, and we’ll go from 5 percent to 8%.

But I won’t go to 0 or 20, because I know the [01:23:00] unlikely is still possible.

Pierre Daillie: If that wasn’t my quote, by the way, that was Nassim Taleb. Larry, uh, what a fantastic discussion. Thank you. Thank you so much for your incredibly valuable time and, and your wisdom and your insight. Well, thanks.

Larry Swedroe: And thank you, Adam.

It’s always a pleasure. Happy to come back anytime. This is my way of giving back. I got lucky in life. I grew up sleeping in the kitchen when I was a young kid in a apartment of bribes. My parents didn’t have a car till I was 10 years old and stuff. I had, you know, hand me down the wear and stuff and You know, only in America could I have lived the dream and make the money that I did and have this successful career.

Uh, when I sold the company I was part of, I wrote a big, uh, seven digit check to the government for the taxes, and I wrote on there, God bless America.

Pierre Daillie: I love that. Fantastic. What an amazing story.

Adam Butler: Yeah, [01:24:00] always awesome to chat, Larry. I had like four different directions that we could have gone here. So there’s, there’s plenty more ground to cover next time.

Larry Swedroe: I mean, we didn’t get to all four. We didn’t get to any of them. Well, this is great to have you back.

Pierre Daillie: Yeah.

Larry Swedroe: Hopefully people benefit, uh, and they got some education and hopefully that’ll help them build more diversified portfolios and be able to resist the all too human biases, including overconfidence.

Adam Butler: Yep. Big exclamation mark on that one.

Pierre Daillie: Larry, thank you again. Thank you so much. My pleasure. Great to see you.

Adam Butler: Thanks, you [01:25:00] too.