494: Beyond the Headlines: How Retirees Can Navigate Investment Risks with Larry Swedroe

[INTERVIEW]

Casey Weade: Today, we discuss the keys to successful investing, how markets work, how to measure and manage risk, and more with Larry Swedroe. Hey, this is Casey Weade, host of the Retire With Purpose podcast, and my mission here on the show is to deliver clarity and purpose and elevate meaning in your life. And if you go, "Well, that doesn't sound like a financial topic," well, it's not all financial topics. We cover both the financial and non-financial here on the show, week in and week out. And we bring you world-class guests. Today, we are bringing you a guest that we've been excited to bring on the show for some time. We have Larry Swedroe joining us today and I know we are in for a treat.

Larry is a former Chief Research Officer for Buckingham Strategic Wealth and Partners. He has previously been the Vice Chairman of Prudential Home Mortgage. He also held positions at Citicorp as Senior Vice President and Regional Treasurer, and he was among the first authors to publish a book that explained the science of investing in layman's terms titled The Only Guide to a Winning Investment Strategy You'll Ever Need, and that's not the only book that Larry has authored. Over 20 books Larry has authored. Some place it says 18, some places it says 25. But anyway, it's a lot of great content that Larry's put out in the world. We're going to be focusing our discussion on what Larry calls his favorite work and that is Enrich Your Future: The Keys to Successful Investing.

And we partnered up with Larry to give away free copies of that very book. So, if you would like to get a free copy of Larry's book and you've never requested a book from us before, this is your opportunity. All you have to do is text us the word 'BOOK' to (888) 599-4491. And in doing so, we're going to send you a link. Now, when we send you a link, we're going to expect you to do one thing for us in return, and that is write an honest rating and review on iTunes of the podcast. So, go on, write an honest rating and review of the podcast on iTunes. We'll shoot you a link, we'll verify that username, and we'll get you the book for free. With that, I'd love to welcome Larry Swedroe to the podcast.

Larry Swedroe: Thanks for having me, Casey. And the right number of books is 18 but there are three 2nd versions of the books or sequels, if you will, updated so that would make it 21. I have no idea where the 25 would have come from.

Casey Weade: I look around in the internet. You'd never know what to believe. Is it 18? Is it 25? My note's 21. So, we got the real answer here from you, Larry. And it just shows that you're not slowing down. You continue to write, and we don't need to get into what happened with the merger and everything over at Buckingham. But I think it is interesting from some of our listeners' perspectives who are maybe still working, maybe they just stepped into retirement or they went through a major life transition. You're with Buckingham for about 30 years, almost 30 years there with Buckingham. And I'm wondering where you're at today. How do you view where you're at today? Are you retired? Are you living in a phased retirement? What is retirement going to look like for Larry?

Larry Swedroe: It's a good question. Actually, I wrote a book, which was one just before this, called Your Complete Guide to a Successful and Secure Retirement. I'm really proud of that book because I recruited what I would consider to be an all-star team of authors/experts to help me write the book. I put the outline together, recruited an expert, for example, on elder abuse and how older people get taken advantage of, and the scams, and how to protect them. I recruited an expert on estate planning. And the first chapter of that book had nothing to do with investing or finance. It was all about planning a life in retirement because you don't want to retire from life, which sadly is the case.

This may shock your listeners, but it's a really important point to make. If you look at the highest suicide cohort in the population, most people might guess or at least I might guess it might be young, school-age girls because of all the pressure, social bullying, and the media, etc., and we know that's an issue. It's actually recently retired men. That is the single highest suicide cohort. And it's because they've lost the two things that give meaning often to their lives, a reason they get up in the morning so they feel they're contributing, adding value, keeps them interested, and gives them a purpose. And the other thing is that it gives them the social connections we need to stay engaged and feel good about ourselves. So, it's really important.

And that's why I put it as the first chapter in my book. I recruited a friend of mine, Alan Spector, who wrote a wonderful book on how to plan a life in retirement. So, when I was retired at Buckingham, I had a friend of mine said, "Larry, why don't you do consulting?" And he was kind enough. He went out on LinkedIn and wrote a little note saying, "My good friend, Larry Swedroe, is now available to consult with RIAs and investment firms. I couldn't recommend anyone more highly. And within a week I had about seven people contacting me, and now five of those are clients and I'm talking to a few others. Otherwise, I've been on the boards of companies as well. So, I don't want to retire from life. I love writing. I still write for four websites.

If anyone wants to follow my musings, I write for Alpha Architect, Financial Advisor, Wealth Management, and Morningstar or you can follow me on LinkedIn or X. Whenever I write something that gets published, I put it up there, so give you the link. I also put up recommendations for good books. I read about 60 books or so a year and good movies or shows on Netflix or whatever. So, it's not just all about investing.

Casey Weade: It seems like a life of purpose still being lived. And in a recent Transamerica, you know, every year Transamerica does a survey of retirees. And I was recently reviewing their most recent survey, the 24th Annual Survey of Retirement done by Transamerica. And they found that the number one word that retirees use to describe retirement is freedom. So, would you say that since you've left Buckingham that you have a different sense of freedom or more freedom?

Larry Swedroe: Well, I had the last several years at Buckingham with what I was working what I would call semi-full time, slowly backing away from the company. I was spending a couple of hours a day playing pickleball or tennis. When I needed to go see my grandkids at some school performance, I would do that, but I put in whatever time I needed to do my job. If I had to work at night, I did that or over the weekend. So, it's getting my job done but I was already planning and moving into the next stage where I wanted to stay engaged. I love what I do and trying to help people and teach writing, and I'm always learning more. And I made so many good friends over the years. I wanted to stay connected with them.

So, I accomplished that through my writings. I get emails from people all over the world almost every week thanking me for helping them or asking me a question about something they read in my books. And I return every single email. I try to answer them all before I go to bed at night. So, those plenty of things, plus I've got eight grandkids and a wonderful wife. They keep me plenty busy.

Casey Weade: I'm sure. And one of the things that stands out to me that I see time and time again with so many the most, what I would regard as the most successful retirees, those that are really enjoying this new phase of their life is they've had this kind of transition where they freed themselves up to experiment with retirement. And it seems like that's one of the things that you've done prior to getting to where you're at today. Now, I want to get into your favorite book. We don't want to neglect your favorite book here, Enrich Your Future. And I thought a fun way to get into the content of the book would be to talk about your first published book. So, your first published book was titled The Only Guide to Winning Investment Strategy You'll Ever Need.

And subsequently, you decided we needed 17 more. So, what was missing that we needed 17 more? Was there anything missing? And how do you think about continuing to write these books and how did these things come into your mind where you go, "You know what? That's not the only one we need. We need another one. Then we need another one."

Larry Swedroe: There's actually a funny, amusing, interesting story behind that title. When I sat down to write the book, I did it because I had joined Buckingham a year earlier, and we were trying to explain to clients what today many people call the science of investing or using another term, evidence-based investment, which means you're relying on nobody's opinions about where the market will go because there are no good experts who can predict where either the market will go, the economy will go, individual stocks will go. All the evidence suggests there's no persistence in performance beyond the randomly expected, which means you should ignore past performance of active managers.

So, you should use more systematic strategies similar to index funds. So, I personally don't own any index funds. If you want to have a discussion about the difference between systematic and...

Casey Weade: We'll get into that later.

Larry Swedroe: Index funds. We can get into that a little bit, a little interesting. So, I said to Buckingham, "We need some kind of brochure to hand out to explain this stuff." So, I sat down. I put a 40-page brochure together to explain this science of investment based upon the empirical research. And so, we were able to have discussions with clients in a formal way that everyone could be trained to do. And then I said, "What we really need is to hand somebody a book that they could read. There's a lot of power in the written word." So, I went to the library and bookstores and tried to find the book that could accomplish what I wanted. I didn't actually set out to write a book.

And the only book that I thought that did a good job then is a very famous book, Burton Malkiel's A Random Walk Down Wall Street. The problem with that book, it's about that thick, number one, and importantly, while it told you how markets work to explain this idea of efficient markets and you shouldn't try to pick stocks or time the market, just build diversified portfolios, stay the course, etc., but it didn't tell you what to do with that information really. So, I said, "Okay. I'm going to try to write a book using my 40-page outline that talked much more about the science and new evidence that there were certain characteristics or traits of stocks, which today are called factors like value, which is a trade, a stock being cheap, whether we look at the PE ratio, price-to-book ratio, EBITDA, the enterprise value, lots of different metrics and other factors.

I wrote the book and I called it What Wall Street Doesn't Want You to Know. So, the publisher, when I found the publisher, he said, "Larry, I love the book, but that title just doesn't work." So, I come up with another title. So, I went to the bookstores, gave him like 15 different ideas, and he combined some of the wording from other books and stuff, and he came up with The Only Guide You'll Ever Need to Winning. So, I have nothing to do with choosing the title. You write a book to publish, but the amusing part of the story is this. So, I decided two years later there were lots of topics, there was new research coming out, and I could add on to that first book.

So, I wrote the second book over the next two years, sent it to the publisher again, because they had right of first refusal, and I called it What Wall Street Doesn't Want You to Know. And this time their reaction was, "Larry, I love that title! That's a great title!" And that became the second title. But over the years, I was writing pretty much every week, two to three, sometimes five articles a week, writing about what the academic literature was finding not only from the field of the science of finance but what is called behavioral finance, which looks at all the mistakes we make when it comes to investing simply because we're human beings. So, I would write these articles, and that's what gave me the idea for books.

So, I then wrote The Only Guide You'll Ever Need to Alternative Investments, The Only Guide You'll Ever Need to Bond Investments. And then I wrote several books on the field of behavioral finance, then I wrote a book on financial planning, and then The Only Guide You'll Ever Need for Retirement. I wrote a book on hedge fund investing with a friend of mine who asked me to help write that book. So, I've written all these books basically around I already had the material from all of the articles that I write. I've written now over 4,000 articles over the years. And now it's a matter of putting them together. And the newest book, Enrich Your Future, is a collection of 40 stories that I've written.

When I wrote my first book, I was lucky enough the publisher put me in touch with an English professor at Columbia University who was an agent. He agreed to work with me on that book. And what he taught me, he said, "Larry, you're writing about complex subjects. What you need to do is use analogies or stories to make difficult concepts easy to understand." What he taught me was this: If you tell 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. So, I write stories over the years, and this book is a collection of 40 of my favorite stories, which teach important concepts to investors.

So, if they understand the concept, for example, related to cooking or gardening or movies or history or sports betting, then they can understand that related to investing and they have that aha moment. And luckily, my wife is a very bright woman. She was a career counselor at Stanford University but she knows nothing about investing. So, she was good enough to read my work. And if she didn't understand something, I had to come up with an analogy to help her. Just to give one simple example, so my wife is a wonderful baker, and if you know anything about baking, if you bake cookies, you want to make it sweeter. Most people think you add sugar, but you add a little bit of salt and it makes it sweeter. But salt isn't sweet.

So, what is the lesson? When you're investing, you look for the characteristics of a stock individually are not sufficient to understand whether you should invest enough. It's how it mixes with the rest of the portfolio, what the correlation of that either stock or asset class. And if it mixes well, which means it doesn't do well all the time when stocks are doing well and vice versa, that's a very positive attribute. That's called low correlation. So, that's just one example of understanding, in that case, chemistry.

Casey Weade: Well, I think you illustrate one of the challenges that investors have today. I mean, we talk about all these different books. So, which book do we adhere to? Which strategy do we adhere to? Who do we listen to? Who don't we listen to? Do we listen to Swedroe? Do we listen to Bogle? Do we listen to Buffett? Do we listen to Dalio, Ramsey, Weade? And we get a little overwhelmed by it, not just the books, but now we have all of the internet at our fingertips and all of the news at our fingertips. Where do we turn to? Who do we believe?

Larry Swedroe: Yeah. Well, the first thing I try to teach people is you should believe people who are presenting you with not opinions, but facts based upon empirical research. So, Casey, if you're not feeling well for a week or so goes by, kind of little achy, etc., three days you're not too worried. But a week goes by, you decide to go visit the doctor. Doctor puts you through a battery of tests and then sits you down and says, "Casey, here's the results of the tests based upon my reading of the literature," and the doctor pulls out a copy of Men's Health or Reader's Digest and says, "Casey, based upon these my readings, here's what I think the problem is and here's how we're going to treat you. How are you feeling?"

Casey Weade: Men's Health. No good.

Larry Swedroe: Yeah. Well, that's like Barron's Magazine or listen to Jim Cramer on TV. There's no science in most of that stuff. So, you're intelligent. You decide to get a second opinion. You go visit a different doctor. And this time she puts you through a battery of tests, calls you, and says, "Here are the results," pulls out a copy of the New England Journal of Medicine, Harvard Medical Review, and says, "Casey, based upon these tests there and my reading here, the literature suggests there's a 70% chance this is your condition and here's the best way to treat it. If that doesn't work, we're going to try this. If that doesn't work, then we know it might be another problem and we go on until we find this solution. Feeling any better?"

Casey Weade: Took an evidence-based approach.

Larry Swedroe: Right. It's an evidence-based approach. So, in our world of investing, the financial equivalent of the New England Journal of Medicine or Harvard Medical Review or whatever is the Journal of Finance, the Journal of Portfolio Management. And so, you want to have advice that is based upon the results there. And my books, for example, have had as many as 100 or more footnotes citing the empirical evidence. And that should give you confidence in the advice giving you at least the best odds of having success in your financial plan.

Casey Weade: And in some instances, though, do we find that the academic advice doesn't necessarily fit us from a personal perspective? It can be academically correct to be 100% equities in retirement, statistically correct to be overweight equities at retirement. However, that might not be the thing that fits us personally. And I wonder if that's, in Part 1 of your book, if that kind of relates back to what you mean by having your own strategy rather than playing Wall Street's game.

Larry Swedroe: Yeah. So, number one is one of the things I've tried to teach advisors and I've trained hundreds of advisors around the country and how to give good advice is this. There is no right portfolio. There's only the right portfolio for the individual based upon, one, their unique ability, willingness, and need to take risks, which I write about in my retirement book and also the book, The Only Guide You'll Ever Need For The Right Financial Plan, asking lots of questions that help you answer and figure out what's the right plan for you. So, let me give you an example. If I tell you to diversify internationally and own emerging market stocks and based upon the historical evidence that doing so is likely to reduce the volatility of your portfolio, which reduces the risk without negatively impacting the future of them.

But you are subject to what's called tracking error or more accurately, tracking variance risk. What do we mean by that? So, every day if you're paying attention to the markets, you turn on CNBC or Bloomberg and you hear what the S&P 500 did. Now, if you own also some value stocks and small caps and emerging markets and real estate, which I think people should own some of all of those things, but those other assets go through long periods where they will underperform. The S&P has been the best-performing asset class for like the last decade or so, and that causes you because you're subject to this tracking variance or you're subject to recency bias, there's a whole body of evidence showing that investors, retail investors anyway, make the mistake of treating the recent past as if it will continue indefinitely to the future.

So, they buy what has gone up already at high prices, which predicts lower future returns, and then they sell what has gone down, you know, performed poorly at now lower prices, which predicts higher future returns. Casey, you might be shocked to know, for example, that the average investor, all the studies done have shown, underperforms the very mutual funds that they invest in because of that behavior. Peter Lynch once did a little study on his fund versus the investors. This was a period where the fund went up and down and came out okay over the period. But he found that the average investor had actually lost money in the fund because they bought it after it did well, then it had a poor year or so. They lost money, got out, and didn't recover.

So, it doesn't do you any good if you know you're going to be subject to this tracking variance or recency bias. So, I would tell you just own the S&P 500 and sleep at night. The problem with that is this. There's no free lunch in investing. Most people, I think, I would bet even you would be shocked to hear that there are three periods of at least 13 years where the S&P 500 has underperformed totally riskless one-month Treasury bills. From 1929 to 1943, that's 15 years. From 1966 to 1982, that's 17 years. And 2000 through 2012, that's 13 years. That's 45 of the last 95 years. That's almost 50% of the period, which means it got great returns in the other periods, but if you're not there because you can't hang on long enough. Give you one other great example.

The favorite asset class of today's investors, the cost of the performance of the Mag 7 or FAANG and other stocks like US large-cap growth stocks. This number will shock, I think, your listeners. There's a 40-year period where US large growth stocks underperform 20-year longer-term U.S. Treasury bonds, which is a totally riskless investment for a pension plan with nominal obligations, so not indexed to inflation. They have no risk. Just buy and hold it for 20 years. There's no risk. And for 40 years, you would have underperformed that investment. So, every risk asset, this is an important thing I teach people, every single risk asset will go through very long periods of poor performance. That's not a reason to avoid the asset. It's a reason we diversify. So, we don't have all our eggs in the wrong basket at the wrong time.

Casey Weade: Well, I think you speak to this in the book and saying how it's important not to view the risk of an asset in isolation, and the consideration of how it actually impacts the risk and return of the entire portfolio. I think people understand that. But especially for do-it-yourselfer investors, they go, "Yeah, I get it, but how do I know? How do I actually measure this for myself and really understand how each one of these different assets I'm adding into my portfolio is actually impacting the overall portfolio?"

Larry Swedroe: Yeah. So, one, you want to, again, look at all the historical evidence. You should not invest in an asset unless it has the evidence. Andrew Berkin and I wrote a book, Your Complete Guide to Factor-Based Investing, to over 110 footnotes, citing all the empirical evidence to show you why you should at least consider investing in stocks that have characteristics that today are called value, so things that are cheap, momentum, things that have done well in the recent past, quality or defensive stocks, have meet that criteria what's called the carry trade, so things that pay either higher interest or bigger dividends. That's another factor that has been there as well. So, you have these factors.

And so, you look at the evidence and you want to make sure the evidence meets all of the criteria. I'm really proud that Andy Berkin and I created this list of criteria. It's now often cited, although for whatever reason, people seem never to cite Andy and my book as the original one creating that. But the things you want to look for is there's evidence. You should insist on this. Do not invest unless you see evidence that there's a premium above the risk-free rate. That premium must be persistent over very long periods of time. So, it's not just a lucky 10 or 20-year period when the economies were doing well and inflation was falling. It has to be pervasive. So, it didn't just happen in the US, it happened in course industry sectors, regions, countries all over the world. It's robust to various definitions meaning value.

The original science here was done using price-to-book ratios but that could be a fluke. It could have just happened. So, why wouldn't price-to-earnings ratios or price-to-cash flows or EBITDA-to-enterprise value? Other value metrics also work. So, it turns out that buying cheap under any of those metrics has worked and it's worked in every asset class you can think of in almost every country in the world. It has to also make sure it covers its transaction cost. So, it doesn’t do any good if small stocks, say, outperform by 3%, but it costs you 5% to access that premium in bid-offer spread or manager fees. And there logically has to be a reason for you to believe that that premium will persist.

So, there should be some good economic logic like stocks are riskier than treasury bills, so it's logical to expect they'll outperform. It's not a guarantee. Can't be a guarantee or there be no risk, right? So, every investment before you make it, you need to make sure there's evidence of that premium and it meets every single one of those criteria or you should walk away.

Casey Weade: We've talked about risk quite a bit. And I want to come back to just diving a little bit deeper into risk because you have some really good stuff around really understanding what risk means and risk means your portfolio, what risk means to your retirement. And you have a differentiation that you like to make between risk and uncertainty. Can you take us a little bit deeper into that?

Larry Swedroe: Yeah. Most people think about the stock market and that it is risky, but it's not. We're really dealing with uncertainty 100% of the time with investing because there are no clear crystal balls. So, risk is when you can measure either exactly like with a roll of the dice or the spin of a roulette wheel. We know exactly what the odds of something occurring are. With, for example, buying life insurance, the insurance companies don't know exactly what life expectancies are for a cohort of people, but there's plenty of data that they can have enough confidence that they could predict what is likely and how much margin of error there might be around that. Can't know for certain because, for example, with artificial intelligence, maybe we'll cure all cancers in the next five years but we have science here in these cases.

Investing, because we're dealing with geopolitical risks and all kinds of risks there, there's no way to know. So, people prefer making bets where they can know the risks or at least estimate them well. Once they start to perceive things are uncertain, they hate that, and they tend to panic and sell but they should have understood that in the first place. So, just as one example, say you're a Democratic voter and President Trump gets elected, now your uncertainty level goes way up and the evidence says that, again, here's an example of using behavioral finance. I've written this. There are actually good studies that show that we make bad mistakes because we let our political biases impact our investment decisions.

So, the research shows, for example, if you are a Democratic-leaning voter and your party is in power, so under Obama and Biden, for example, you earn higher returns than your Republican counterparts. And when the Republicans are in power, guess what? The Republican investors earn higher returns than the Democratic investors. And the reason is pretty simple. So, Casey, let's just assume for argument's sake, you lean Democratic and now Bush is elected and we get the events of 9/11 and the markets crashing, you are more likely to say, "Oh my God, he doesn't know what to do. We're going to tank. The economy will go down," where the Republican-leaning investor would say, "I have more confidence the government will get it right," so they don't panic and sell.

Now, if the same thing happened in 2008-2009 when Obama was president, if you were a Democrat, you'd be leaning more that they'll fix the problem, they'll figure out what tax policies and spending to get out. But the Republican voters would be more likely to panic and sell. The research shows that you should ignore your political views because you're likely to make decisions based upon that bias. So, that's just another example right out of the field of behavioral finance that investors can learn from. I would urge all Democratic-leaning investors to avoid panic selling because they're worried about Donald Trump.

Casey Weade: Yeah. Well, we saw that a lot during the previous election as well, especially for the advisor seat. And one of those pieces of advice that we're given as advisors, especially younger advisors starting out in the business, and also a lot of the advice that's given by some of the biggest experts in the world, such as Jeremy Siegel in Stocks for the Long Run, is, "Hey, it's okay. You're uncertain right now, but over a long time horizon, stocks are riskless or near riskless." How do you view that?

Larry Swedroe: Jeremy Siegel is so wrong on that. It’s not even debatable. He’s taking one data sample. Okay? If Jeremy Siegel was born in Japan, say, the last 35 years, stocks have had a zero return in nominal returns. Virtually zero. In 1900, Egypt was the fifth largest stock market in the world. Those investors are still waiting for return of their capital, let alone the return on their capital, or investors in Russian stocks, which is one of the largest stock markets in the world.

In the 1880s, there were two countries that were competing for Europe’s capital because they were developing nations. And one of them was the US, and the other one was actually attracting more capital in the US. You have to know which country it was. Very similar geography, good grazing land, lots of resources, highly educated European stock of people is Argentina. Argentina investors have not done very well for the last 120 years. It cannot be that stocks are riskless, the longer your horizon.

In fact, the evidence is exactly the opposite that the longer the period, the wider the dispersion of outcomes becomes. That means it gets riskier. Now, what he should have said is the longer your horizon, the more likely it is you will get the expected outcome of a premium. That’s true, but it can’t be a guarantee that stocks are riskless. That just ignores reality and the empirical evidence staring you in the face if you look beyond the United States.

Casey Weade: Yeah, this makes me think of the basis of index investing today is kind of just that, right? That over the long term, stay diversified, hold this index fund, everything’s going to work out just fine. And we have in the drivers of investor behavior in your book, you talk about the herd mentality. I have a great question from one of our listeners in this regard. And you call this kind of going along with the crowd during the financial crisis, isn’t passive investing just a craze? Is it another craze?

And one of our listeners, Jim, says now that the majority of assets are invested in passive investments, has passive investing run its course? And you could also speak to this in regard to the risks of the S&P being overweighted to the Magnificent Seven or the Magnificent Eight, or however you want to look at it, and different sectors.

Larry Swedroe: All right. Well, we’re going to try to correct a few misconceptions, well in those questions.

Casey Weade: There’s a lot there.

Larry Swedroe: So, first of all, indexing does not guarantee that anything is going to be fine in the long term. What indexing does is it guarantees you less the very low expenses that you will get the return of the market over that period. So, you have no manager or idiosyncratic risk there. You’re highly diversified. So, it’s not meaning it’s safe. Okay? All right. It means that you get the return of the market, which virtually guarantees you that you will outperform the vast majority of investors who aren’t indexing or passive because they have higher expenses, trading costs, bid-offer spread, taxes.

All the research shows that today, and this goes back as far as 2011, famous paper by Gene Fama and Ken French, they found that once you adjust for common characteristics, so someone who invests, say, in small value stocks, you shouldn’t compare that to the S&P 500. They’re investing in different things. So, an S&P 500, manager should be benchmarked against an S&P 500 index. Someone who invests in small value stocks should be benchmarked against that type of index.

Once you do that, less than 2% of active managers are generating statistically significant outperformance, which is less than randomly expected. Just like if you flip a coin, you put a thousand people in a stadium and you engage in a coin flipping contest. Heads wins, tails lose. If the 10 rounds, you may have one winner, would you then bet on that winner to repeat? No, because there’s no correlation. Like, if 100 people did it, you’d wonder, did they have a fake coin that was fixed, so they could flip it in that way?

So, 2% of active managers were outperforming on a risk adjusted, and that’s even before taxes. So, if you’re a taxable investor because taxes are the highest expense for them, let’s just estimate that 1% of active managers were outperforming. I don’t know about you, but I don’t like the odds of 99 to 1 against me. So, that should end the debate. And it has nothing to do with how many active or passive managers are.

In fact, Andy Berkin and I wrote a book called The Incredible Shrinking Alpha, which makes the case that the more people go passive investing, okay, like indexing, and we should come back and let’s define to make sure people understand. The more efficient the market can become, the harder it actually gets to beat the market. And it’s very simple to understand why that is the case.

So, Casey, coming out of the World War II, 90% of stocks was held by people like you and me, individuals in brokerage accounts. That number today is about 10%. So, the rest is now managed by professionals, mutual funds, hedge funds, high-frequency traders. Okay? That’s number one. Who do you think has more knowledge and skill, the professionals or the retail investors?

Casey Weade: We like to assume the professionals.

Larry Swedroe: You don’t have to assume it, we know it. In fact, all the research, if you read my books, you see the average individual investor, the stocks they buy go on to underperform after they buy them and the stocks they sell go on to outperform after they sell them. Somebody has to be on the other side of that trade, right? It turns out it’s the institutions. The problem is their expenses swamp the benefit that they get by exploiting the naive individual investors.

Let’s think about this now. So, coming out of World War II, everybody was an active investor. There were no index funds. 1977, we get indexing. By the 1990s, it’s about 10% index. And today, it’s roughly 50/50. Okay? Who drops out of the game of active investing?

Casey Weade: And when you say it’s 50/50, is that 50% of assets are invested in...

Larry Swedroe: Roughly active and 50% passive. Well, let’s define it now anyway. So, passive, I like because there is no good real definition here. Gene Fama, Nobel Prize winner, he said his definition of passive is no individual stock selection and/or market timing. Okay? So, index funds all engage in that type of investing.

However, if you can look at, say, an S&P 600 Small Cap fund and it’s very different than an MSCI 1750 Small Cap fund. They’re both index funds, but they have defined their universities slightly differently. Are they active or passive? I would say they’re passive because the only action occurs in their fund construction rules. Once they define it, it’s run by a computer basically. So, no one’s deciding to overweight the stock of that stock.

There are quant funds, many popular fund family that made quantitative investing popular was Dimensional Fund Advisors run by Gene Farm and Ken French, their research. But there are many others today. Vanguard runs a bunch of them. BlackRock, Avantis, Bridgeway, AQR, all based upon this, and they all create their own rules based upon their research, backed by empirical evidence to define things a little differently.

So, I say what you want to do is invest in something that is run systematically, it’s transparent and it’s replicable. And it may even not trade exactly when an index moves. I’ll give you an example in a moment. It allows a computer algorithm to do the trading to save money.

A recent study on the S&P 500 found that because everyone knows ahead of time what the changes are likely to be, guess what? The people like Ken Griffin in Citadel and Renaissance Technologies, they front run the changes and it costs investors in the S&P 500 about 40 basis points a year. It doesn’t show up in any returns in the index because the index shows the price at the closing prices of the day, incorporating that trading costs. But if you just delayed your trading or traded a bit earlier, you would save that 40 to 50 basis points.

All the active managers know when the indexes have to trade because they reconstitute their indices, so publish date, and they get front run. So, Dimensional, in their fund, what they do instead of saying, buying the S&P 600, I’ll just make this up to make it simple. They will buy the smallest 5% of stocks that have P/E, say, below 12. And then if the stock leaves and no longer has that characteristic, they won’t automatically sell it. They’ll put it into their computer program. The algorithm will try to sell it slowly over time. Almost all their trades are 100 shares at a time, so they don’t have to hit bids, take offer. They don’t move the price.

When an index fund, they want to get that last price on the last day because they’re solely focused on replicating the index or time. So, everyone knows when they’re going to trade, they wait. And in fact, it ends up costing them. So, I don’t own any index funds, but I would say I’m certainly a passive investor. I don’t time. I don’t pick individual stocks or time the market, and neither do the funds that do that. So, that makes a big difference there.

So, think about this. Let’s come back to the example, right? 90% of the money was traded by individual investors in the 50s, 60s, etc. Okay? Warren Buffett is far outperforming. How does he do it? Who’s on the other side of his trades 90% of the time? You and me. Today, 90% of the trading is done by high-frequency traders, Warren Buffett, J.P. Morgan, Merrill, what advantage do you have over them? And so, they’re the ones exploiting the retail, but the retail is only 10% of the trading now. So, they can’t make as much money. So, it’s getting harder. There aren’t enough victims to exploit.

When I got out of college, I was trained to be a security analyst/portfolio manager. Those days, almost nobody had an MBA, let alone a PhD in finance. The whole field of finance didn’t exist, really. Most people don’t know this until William Sharpe and a few other people were given credit for discovering what was called the Capital Asset Pricing Model, the CAPM. That was the first asset pricing model.

So, you couldn’t teach finance. It was finance classes were taught in accounting programs or economics program. I graduated one of the first degrees in finance from Baruch College and then an MBA from NYU. So, who were the people who were doing the security analysis on Wall Street? It might have been an English teacher, or somebody got into the training program in Merrill Lynch and studied stocks or whatever?

Today, virtually everyone who is investing professional money has a PhD in nuclear physics or quantitative math. They have access to the greatest databases in the world, the fastest computers and stuff. What advantage can you gain over them? So, the competition is getting much tougher. You don’t have enough victims to exploit. It’s getting harder and harder. And the percentage of active managers who are outperforming has been persistently declining, even though indexes share or systematic investment share has gone up.

Now, I ask you a question. Think about this. Who drops out of the game of active investment, the people who have been outperforming or the people who have been underperforming?

Casey Weade: The underperformers.

Larry Swedroe: So, as they leave, either because they had bad luck or they were unskillful, does the competition get tougher or easier?

Casey Weade: Should get tougher, right?

Larry Swedroe: It’s tougher. So, as people leave active investing and become passive, the remaining people, although there’s always some new naive people who think they can outsmart the market, the ones remaining are smarter or they got luckier. And over time, it gets harder and harder and harder. And that’s why so few people would be– I urge those who want to learn more about this story, pick up a copy of my book, coauthored with Andy Berkin, The Incredible Shrinking Alpha. Really, you’ll understand. We make the case using analogies to sports and history. For example, in that book, would you say today’s athletes are superior athletes, bigger, stronger, faster, better training, diets, everything, than athletes 100 years ago?

Casey Weade: Well, not even 100 years ago. We saw the first Super Bowl, the linemen versus where they’re at today, they almost doubled in size.

Larry Swedroe: Right. Okay, how come there’s no baseball player who’s hit 400 in over 80 years? And it was done over 20 times before that. Because the competition is much more difficult. The pitchers throw 100 miles an hour, the fielding gloves are much better, all this stuff. Even though the athletes are much better, the competition has gotten harder. And the way you would tell that is you look at the standard deviation of the batting averages.

So, when Honus Wagner was hitting 424, the standard deviation might have been 50 or 60 points. And today, it’s down to like 20. So, there’s not much difference between a mediocre hitter, because the 10th best hitter in the league hits 300 and the average hitter hits 250. There’s only 50 between the average. That’s one hit a week. Where in the old days, the average was still about 240, but someone hit 420. So, there was a bigger divergence in skill. But those players don’t exist anymore. They’re not in the game. Only the best, or the competition’s gotten much tougher. And we use that analogy to explain why it’s getting harder and harder.

Casey Weade: Which works on both sides of the game, which is why so many have jumped on the passive train or the index fund train and we have a proliferation of just the availability to invest in an S&P 500 index fund in our 401(k)s, which we didn’t have 35 years ago. And so, I was just looking at what SPY’s market cap is, the SPDR, S&P 500 ETF, it’s over $0.5 trillion. And so, that makes some wonder, is there more risk in the market today because of this defaulting into buying these 500 stocks overweighting certain equities?

Larry Swedroe: Right. So, let’s take a few of the issues here. There’s a lot to unpack actually there. First of all, the indexing has nothing to do with the concentration. It’s exactly the opposite. Because if you put in $1,000 in the market, you’re going to buy a pro rata share of the weighting of each of the individual stocks. So, you don’t affect the relative price of any of the stocks, right? You’re just buying pro rata. You’re not pushing on one stock and overweighting it, which would drive its relative price up or underweighting another. It’s the active investors who are doing that. That’s what people don’t understand, number one.

Number two, this is not that unusual period, not only in the US, but around the world, you have similar concentrations and that tells you nothing about whether they’re overvalued or not. Now, what you have to understand is this, valuations in the short term tell you nothing about where the market’s going. There’s virtually zero correlation between stocks can have 30 P/Es or 10. It tells you nothing about the next year returns, whether they’ll be higher or lower than average.

However, over the long term, like 10 years, it tells you a lot. Not anywhere near perfect. The correlation is only about 40%. But what we do know today, because you have market cap weighting, right, you could buy the S&P 500. The forward looking P/E is about 23. Okay? If you invert that, you get an earning to you. Let’s round it roughly to somewhere between 4% and 5%. That’s a prediction of what the future real returns, the stocks will be in that index. Okay? Well below the long-term return.

But that tells you nothing about whether it’s overvalued or not. They still may be better investments than investing in T-bills. Okay? Now, but the S&P 500 is not the market. There are lots of markets. The P/Es of small value stocks are trading somewhere around 11 or so. That’s about their historical average, where the P/E of the S&P 500, the growth index is trading of like 30, which is way above its historical average.

So, right now, the market thinks, right or wrong, that large growth stocks are where you want to be and are willing to pay a lot more because they think they’re safer or they’re just creating a bubble, and we won’t know until 10 years from today. But what I would tell investors is you should diversify so you don’t have all your eggs in the S&P 500, because there are those very long periods of underperformance I mentioned, as long as 17 years. And they all occurred when the P/E ratios were around these levels. Like I said, it tells you nothing.

Two years ago, the P/E ratio was very high. And it’s kept going. In ‘97, when Greenspan said the market was irrational exuberant, market ignored him. And the next two years, that’s spectacular time. But eventually, it blew up. So, what you want to do is this. Let me see if I could summarize. This will come in near the end of the hour.

Here’s what I think are the prudent strategies for investments. They should operate on these principles. First principle is based on all the evidence. Markets are not perfectly efficient. They make mistakes, but the odds of your exploiting them are close to zero after all costs and put a time value on your time of investing and trying to figure all this out, right? So, you should invest systematically. Could be index funds. I don’t use them because I think there are negatives. That could either minimize or eliminate it using more sophisticated quant strategies from fund families like Dimensional and Avantis and Bridgeway and others, but indexing is fine.

If you think the markets are highly efficient and you should act that way, then there’s only one logical conclusion, which is you should think that all risk assets, whether it’s real estate or emerging markets or whatever, should have similar risk-adjusted returns, because let’s say, you think, because US exceptionalism which I recently wrote a piece about, is that US large growth stocks are going to outperform. Well, if the market’s efficient, then money would leave emerging markets, go into US stocks, driving their valuations up. You don’t change their earnings, right? You just paid more for them. And now, you get lower returns and you drive down because you sold the emerging market stocks or real estate or value stocks or whatever. And you drove their valuations down. You didn’t change their earnings. So, they expect the returns go up until we got an equilibrium.

It doesn’t mean everything gets the same return, means they get the same risk-adjusted return. So, emerging markets should have higher expected returns because they’re riskier. But once we adjust for that risk, a lot of it being volatility, some of it is liquidity, trading costs are more expensive bills, they have to be roughly the same.

So, why do you want to put all your eggs in one basket when we know that every single one of them, for example, big hard asset today is gold, all right, mostly because people think it’s an inflation hedge. Gold is an awful inflation hedge unless your horizon is very long. And all you have to do is look at the 23-year period, which I think you and I would agree would test any investor’s patience.

January of 1980, it was 850. And in 2003, it was 270. And inflation ran 4% a year, which meant in real terms, you lost 86% of your money. How could anyone claim gold is a good inflation hedge when that actually happened? That’s why you ask for the empirical evidence.

So, coming back, if everything has similar risk-adjusted returns, I want to own some value stocks, some small stock, some emerging market, some real estate. I own things like reinsurance because bear markets don’t cause earthquakes or hurricanes. So, you get a year like 2022 and stocks get killed, reinsurance might do well. Okay?

I own private credit. I own what are called long-short factor strategies. They’re all uncorrelated to the S&P or very low correlation. They’re uncorrelated to bonds. They may not have duration or inflation risk. And I hyper-diversify across them and I just rebalance. That means I’m doing the opposite of what most people, retail investors are doing. They buy after periods of poor performance at high prices, meaning low expected returns. They sell after periods of poor performance, meaning low valuations and high expected.

I wrote a very simple book called Think, Act, and Invest Like Warren Buffett. The great irony, Casey, is people think Buffett may be the greatest investor of all time, right? And yet, they not only ignore his advice, they do exactly the opposite. He tells people never try to time the market, but if you can’t resist, buy when everyone else is panicking, that’s what you do if you rebalance, and sell when everyone else is greedy because the returns are good. That’s what you do when you rebalance instead of chasing recency.

Casey Weade: Well, we’ve unpacked a lot and I think we could probably sit here for another hour, but I know we’re running out of time, but there is one thing that I really wanted to touch on before we bring things to a close, because this is something we talk about with clients and families we’re working with all the time. You talk about and you advise, determining the right amount of risk involves balancing three factors – ability to take the risk, your willingness to take the risk, and the need to take the risk.

Now, we use an acronym CAN, can I take the risk? That is C-A-N. Do I have the capacity for the risk? Do I have the attitude for the risk? Do I have the need for the risk? Now, what I wanted to ask you though, is how you weight these different factors, because you could have the capacity and you might not have the attitude, you don’t have the need, or you don’t have the capacity, but you have the need. How do you actually weight those different factors?

Larry Swedroe: Very simple answer to that question. You don’t weight them at all. What you do is think of those three as a three-legged stool, and each leg of that stool has to be firmly planted on the ground. So, if you have the capacity, but you don’t have the need or the ability, you weight that as the determining factor. If your need says, I only need to be 30% stocks, you can decide, then that’s all the risk I want to take. But you could decide, okay, I also have the capacity and the ability, so I could go higher. But if you don’t need all three, always choose the lowest one.

Now, sometimes you have a conflict. Someone has the capacity and the need. They want to retire at a certain lifestyle, but the stomach acid won’t let them do it anyway. So, then what I tell them, you have a choice. You can lower your goals or go out and buy a 10-year supply of Maalox and commit to sticking with your asset allocation through high and low. I mean, that’s the kind of thing that you have to make a decision on.

But let me close, see if I can end with this very important thing. There’s a book called Thinking in Bets. I forgot the author’s name, Annie something. Wonderful book about poker, using that analogy. What she teaches people is they make the horrible mistake of engaging or what is called resulting. YTou know NFL, we just watched the Super Bowl, right?

Casey Weade: Yeah.

Larry Swedroe: So, the most famous play in Super Bowl history, do you remember what it was?

Casey Weade: No.

Larry Swedroe: Seattle Seahawks/New England game. The Seattle’s got a first down and goal to go on like the four-yard line or three-yard line. They have the best running back in the league, Marshawn Lynch. Big front line like the Eagles did. Everyone in the house is expecting, they’re just going to hand the ball off to Marshawn Lynch three times or four times and will get a touchdown and win the game. Turns out the quarterback drops back the pass and throws an interception, they lose the game.

All the people engaged in resulting saying, what an idiot, it was dumb. Turns out the sabermetricians went into the data, and they found that in similar situations during the season, Marshawn Lynch had fumbled the ball three times and Russell Wilson had never thrown an interception in that game. So, what were the odds, right, when everyone’s expecting them in particular to run? And England was probably stacking their defense, but one guy came up and made a great play or Wilson made a bad pass. That’s called engaging and resulting, judging the quality of a decision by the outcome.

So, you, listen to the saying, Larry Swedroe tells you to diversify and own some reinsurance. Okay? Well, the first three years that there was a reinsurance fund run by Stone Ridge (SRRIX), it earned virtually identical to what we expected, which was about a premium about 5% over Treasury bonds. Okay? So, something like 6% or 7% a year, right? Great asset. Totally uncorrelated to stocks. You should love that. Half the volatility of stocks.

Next three years, what godawful. The risks showed up. Big fires in California, Northern California, and then big hurricanes in the southeast. Fundless like 35%. People engaged in resulting, dumped the fund. The fund had grown to $5 billion because everyone loved it. At the end of this period, it’s down to $1 billion, at the end of 2022. Of course, premiums went up, deductibles went up, underwriting standards were up. The last two years, the fund went up 92%.

The average investor in the fund underperformed the fund by 5% a year because they engaged in recency bias and resulting. Didn’t listen to Buffett. They tried the time instead of rebalancing. As an investor, I bought more after it kept going down. I actually outperformed the fund because I owned the most I ever did just before I went up 92%. And now, I’m selling a little bit to take some of those chips off the table.

Same thing was applied. International stocks. Why do I want it only done poorly for 10 years? Value stocks have done poorly. All the principles apply. Nobody has a clear crystal ball. Don’t look at that. Don’t make the mistake. Either a strategy is right because the decision-making process was right and good, or it was wrong because the decision-making process was bad. Casey, if you went out and took your IRA account embedded at the racetrack and you happened to win, you got rich betting on some longshot, was that a good decision?

Casey Weade: We see this in gambling all the time.

Larry Swedroe: Yeah, but if you engage in resulting, that’s what you think. And of course, the next time you do it, because you’re going to repeat it, maybe then you go broke, right? So, good decisions can end up with bad outcomes because risk shows up. It doesn’t mean the decision was bad and you should stick with the strategy over the long term. And bad decisions can get lucky and get good outcomes, it doesn’t mean the decision was good.

Casey Weade: Well, I would say, education is going to be your best defense against all of these things that Larry’s talking about. And I want to get you the education at your fingertips. We partnered up with Larry, as I said, to give away free copies of his book. So, we’re going to bring it to a close, but there is a treasure trove of valuable information in this book. So, get it for free. Just go over to iTunes, write us an honest rating and review on iTunes. Shoot us a text with the keyword “Book” to (888) 599-4491. We’ll verify that username and we will send you a free copy of Larry’s book.

Larry, thank you so much. I truly appreciate the opportunity to engage in this conversation with you. I’ve learned a lot today, and I look forward to learning so much from you over the coming years.

Larry Swedroe: Thanks. There are 40 great stories in that book. I’d be happy to come back and share some of those stories.

Casey Weade: Thank you, Larry.

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