Nine Timeless Lessons from 2024 | Larry Swedroe

Summary

Podcast Summary: Excess Returns - Episode: Nine Timeless Lessons from 2024 | Larry Swedroe

Introduction

In this enlightening episode of Excess Returns, hosts Jack Forehand and Justin Carbonneau engage in a profound conversation with renowned investment strategist Larry Swedroe. The discussion centers around Swedroe's insightful article, "9 Lessons the Market Taught in 2024," which encapsulates timeless investment principles derived from market behaviors in the past year. This summary delves into the key lessons, rich discussions, and invaluable insights shared during the episode.

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1. The Fallacy of Market Forecasting

Key Points:

• Predictive Inaccuracy: Swedroe underscores the persistent inaccuracy of market forecasts, emphasizing that even seasoned strategists fail to predict market movements reliably.
• Warren Buffett’s Approach: Highlighting Buffett’s strategy of avoiding market forecasts, Swedroe illustrates the wisdom in disregarding short-term predictions.
• Confirmation Bias: The tendency of investors to favor information that confirms their existing beliefs often skews their judgment regarding forecasts.

Notable Quote:

“The evidence is very clear. We have no good forecasters.”
— Larry Swedroe [00:54]

Discussion: Swedroe criticizes the prevalent "sell in May" myth and seasonal forecasting strategies, demonstrating through data that such approaches often lead to suboptimal investment decisions. He references historical forecasting errors, including those by famed strategist Jeremy Grantham, to bolster his argument against reliance on predictions.

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2. Limitations of Valuations in Market Timing

Key Points:

• Cyclically Adjusted PE Ratio (Shiller CAPE): Swedroe explains the Shiller CAPE as a tool for assessing long-term market valuations but cautions against using it for precise market timing.
• Correlation vs. Prediction: While valuations correlate with long-term returns, they lack predictive power for short-term movements.
• Monte Carlo Simulations: He advocates using these simulations to understand a range of possible outcomes, enhancing portfolio resilience.

Notable Quote:

“Valuations are the best predictor we have, but they literally the correlation, whether using the current PE or the Cape 5 or the Cape 10 tell you nothing about next year return.”
— Larry Swedroe [02:31]

Discussion: Swedroe emphasizes the importance of diversification and the limitations of relying solely on valuation metrics for investment decisions. He advises investors to prepare their portfolios to withstand various market scenarios rather than attempting to time the market based on valuations.

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3. Patience and Discipline Through Poor Performance

Key Points:

• Long-Term Horizon: Successful investing requires a commitment to stay the course, especially during prolonged periods of underperformance.
• Historical Underperformance: Swedroe cites historical instances where assets like the S&P 500 and large-cap growth stocks have endured decades of underperformance before rebounding.
• Diversification as a Shield: Emphasizing diversification, he argues that a well-diversified portfolio can mitigate the emotional and financial impact of market downturns.

Notable Quote:

“When your horizon is short, diversification is much more important.”
— Larry Swedroe [18:45]

Discussion: Through historical examples, Swedroe illustrates how even the most reliable assets can experience extended periods of decline. He advocates for diversification across uncorrelated asset classes to smooth out returns and reduce the psychological burden on investors during downturns.

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4. Self-Healing Mechanisms of Risk Assets

Key Points:

• Market Resilience: Swedroe explains that risk assets possess inherent self-healing mechanisms that eventually restore their value after downturns.
• Reinsurance Example: He uses the reinsurance fund case to demonstrate how increased premiums and stricter underwriting standards can mitigate risks over time.
• Avoiding Panic Selling: Investors often fail to capitalize on these self-healing mechanisms due to emotional biases, leading to missed opportunities.

Notable Quote:

“Self healing mechanism here… it is when cycles downturn, the risk gets priced higher, which means higher expected returns.”
— Larry Swedroe [28:59]

Discussion: Using real-world examples, Swedroe highlights how market corrections and regulatory changes can reduce risks and enhance future returns. He stresses the importance of maintaining a disciplined investment approach to benefit from these natural market corrections.

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5. Market Unpredictability Despite Clear Insights

Key Points:

• Unpredictable Markets: Even with comprehensive knowledge of economic and geopolitical factors, market movements remain inherently unpredictable.
• Complex Variables: Numerous uncontrollable and unforeseen factors influence market outcomes, making accurate predictions nearly impossible.
• Staying the Course: Swedroe reiterates the importance of adhering to a well-thought-out investment plan regardless of market noise.

Notable Quote:

“Even with a clear crystal ball, markets are unpredictable.”
— Larry Swedroe [40:13]

Discussion: Swedroe elaborates on the multitude of variables affecting the market, from geopolitical tensions to economic policies, which contribute to its unpredictability. He emphasizes that successful investing hinges on a robust strategy rather than attempting to foresee market directions.

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6. Debunking the "Sell in May" Strategy

Key Points:

• Seasonal Strategy Critique: Swedroe dismantles the "sell in May and go away" adage, presenting data that demonstrates its ineffectiveness.
• Risk vs. Return Misconception: He argues that abandoning the market mid-year for perceived lower returns contradicts fundamental investment principles linking risk with expected return.
• Long-Term Premium: Despite seasonal variations, maintaining market exposure yields a consistent premium over risk-free assets.

Notable Quote:

“You have to be pretty dumb to ignore the history.”
— Larry Swedroe [44:00]

Discussion: Addressing the common seasonal trading strategy, Swedroe provides empirical evidence showing that staying invested throughout the year yields better returns than frequently adjusting based on arbitrary seasonal patterns. He emphasizes that such strategies often result in forfeiting significant market premiums.

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7. Reversion of Winners and Losers

Key Points:

• Dynamic Performance: Asset classes frequently shift between high and low performers, negating the reliability of past performance as an indicator of future results.
• Momentum vs. Reversion: While short-term momentum exists, long-term trends often revert, making consistent outperformance challenging.
• Diversification and Rebalancing: Swedroe advocates for a diversified portfolio with regular rebalancing to capitalize on the inevitable shifts in asset performance.

Notable Quote:

“Last year's winners are just as likely to be this year's dogs.”
— Larry Swedroe [47:58]

Discussion: Swedroe discusses how asset classes that perform exceptionally well in one period may falter in the next, reinforcing the unpredictability of consistent outperformance. He recommends a diversified approach to mitigate the risks associated with such fluctuations.

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8. The Inefficacy of Active Management

Key Points:

• Underperformance of Active Managers: A vast majority of active fund managers fail to outperform their benchmarks, especially over extended periods.
• Survivorship Bias: Even studies that control for survivorship fail to show significant alpha generation among active managers.
• Systematic Factor Strategies: Swedroe contrasts active management with systematic, factor-based strategies that have historically outperformed many active approaches.

Notable Quote:

“Less than you would expect randomly throwing dots and picking active managers.”
— Larry Swedroe [50:39]

Discussion: Highlighting extensive research and historical data, Swedroe articulates why active management is often a losing proposition compared to passive or systematic strategies. He details how systematic approaches, which apply academic definitions and factor tilts, can yield superior returns by avoiding the pitfalls of individual stock selection and market timing.

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9. The Superiority of Diversification

Key Points:

• True Diversification: Proper diversification involves owning a range of uncorrelated assets to protect against significant losses in any single area.
• Asset Correlation: Swedroe stresses that if all parts of a portfolio perform well simultaneously, it indicates poor diversification.
• Behavioral Biases: Investors often fail to maintain diversified portfolios due to emotional reactions to market movements.

Notable Quote:

“If some part of your portfolio isn't doing poorly, you're not properly diversified.”
— Larry Swedroe [55:08]

Discussion: Swedroe emphasizes that diversification is not just a risk management tool but a fundamental strategy for achieving consistent long-term returns. He explains that a well-diversified portfolio includes assets that do not move in tandem, thereby reducing the likelihood of severe losses and enhancing the stability of returns.

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Conclusion

Larry Swedroe’s discussion on Excess Returns provides a comprehensive exploration of enduring investment principles derived from market behaviors in 2024. From debunking popular investment myths to advocating for disciplined, diversified strategies, Swedroe equips investors with the knowledge to navigate complex financial landscapes effectively. His emphasis on patience, diversification, and skepticism of active management offers a robust framework for long-term investment success.

Final Notable Quote:

“For investors, it's your job to stick to your well-developed plan until you reach your financial goals.”
— Larry Swedroe [63:33]

Key Takeaways:

• Avoid Market Timing: Relying on forecasts and seasonal strategies often leads to underperformance.
• Embrace Diversification: A diversified portfolio mitigates risks and stabilizes returns.
• Maintain Discipline: Staying the course during volatile periods is crucial for long-term success.
• Question Active Management: Passive and systematic strategies generally outperform active fund management.

For investors seeking to enhance their long-term strategies, Larry Swedroe’s insights offer valuable guidance grounded in historical data and behavioral finance principles.

Transcript

[Larry]

This is something that drives me crazy when I talk to retirees, Larry. I don't have 15 years for value to outperform, you know, Right. I said, well, then you don't have 15 years to wait for the S and P to outperform either. So there is this strategy to sell in May and go away. And it's a myth. And all you have to do is look at the data. If some part of your portfolio isn't doing poorly, you're not properly diversified. I've probably heard tens of thousands of market strategists on CNBC or Bloomberg and they're asked the question about is this going to be an indexer's or an investor's or stock pickers market? I have never once ever heard any one of them say, this is not anything other than an active investor's market.

[Justin]

Hi Larry, thank you very much for coming back on Excess Returns and joining us today.

[Larry]

Thanks for having me. Justin and Jack, always a pleasure to be with you guys.

[Justin]

You wrote an article for Alpha architect's blog titled 9 Lessons the Market Taught in 2024. And I just want to read the opening paragraph. So just indulge me for a second because this is important to get up right up front. And you wrote, every year in the markets provide us with lessons on prudent investment strategies. With great frequency. Markets offer remedial courses covering lessons they taught in previous years. That's why one of my favorite sayings is there's nothing new in investing, only investment history. You don't know. In 2024, investors were provided with nine lessons. Many of them are repeats from prior years. Unfortunately, too many investors fail to learn them. They keep making the same errors. So that is, I think, an important idea to get up front that a lot of these lessons are timeless lessons. There are repeats of things that you've been saying throughout your career in investing, things that you've written about, whether online or in the many books you've written. But I think it's good. We'll walk through each one of these and kind of peel back, try to get underneath the hood a little bit about what you're really trying to get at, you know, if that works for you.

[Larry]

Yep, absolutely. And I've been doing this now for over 20 years and it, it's somewhat easy, although always interesting. When I go back, I look at the prior last few years and I can say, ooh, this happened again. And this one. So you know, it's cut and paste, a lot of it. In that sense, just updating it with the current data.

[Justin]

Yeah. Well, and you know, your first lesson, which is one of the things that we, we've actually talked about in the podcast a couple times, but you know, it really comes to light at the beginning of every new year when the Wall street strategists and analysts make their predictions for where the market's going to end at the end of the year. And you know, your first lesson is no one is very good at consistently getting market and economic forecasts. Right. So just talk about that a little bit to set the stage here.

[Larry]

Yeah, yeah, maybe a good place to start is referring to a book I wrote long ago called Think, act and Invest Like Warren Buffet. And to me, one of the great ironies in investing is if you ask investors who they think was the greatest mutual fund or fund manager investor of all time, probably two names come to mind, right? Peter lynch and Warren Buffett. Right. Those would be the two names. You would think that not only would you listen to their advice, but you would follow it. Right. And yet investors tend to do exactly the opposite. Peter lynch said he never tried to time the market. He was a hundred percent invested in stocks. Buffett has told people that you shouldn't try to time the market, but if you can't resist, buy when everyone else is panic selling and sell when everyone else is greedy. But Buffett also said this. He said recently, I haven't looked at an economic or read a market forecast in over 25 years. That's because he has said they have no value. They only make withermen look good. So that's the setting here. Why do people listen? And what's really dangerous, Justin, is this. There's an all too human trait I know you guys are familiar with. It's a human problem called confirmation bias. What do we mean by that? When we hear an idea that confirms our preconceived notions, we think, that's brilliant. Now I better act on it. And we hear an idea that goes against our preconceived notions, we tend to think that person doesn't know what they're talking about and they ignore it. So when you hear forecasts, it becomes very dangerous. When you hear somebody who is espousing say negatives and you're worried about those negatives, for example, a Trump presidency, for example, the threat of tariffs or the war in Ukraine or whatever. So that's important for investors to keep in mind because the evidence is very clear. We have no good forecasters. That's what basically all the research pretty much shows, at least when it comes to the stock market. The only value I have seen in forecasts is looking at the fact that they show a very, very wide dispersion of possible outcomes. We ended 2023, I think, at roughly 4770. 20. Analysts looking at the following year from the leading Wall street firms predicted anywhere from a down 12% to an up 13. The average was for a gain of 2. Well, we know the S and P itself went up 25%, 23% with the index. When the average was 2, the average was only off by 21%, which is more than double the historical return to the stock market. If you tried to be wrong, you likely couldn't get it by that much. And here's one other interesting thing I pointed out, which is why I'm always looking at each year uniquely. Amazingly, you would think if the analysts were able to predict what the S&P 500 companies would earn, they would get the forecast of the market almost dead right. They were within a dollar of the actual earnings, at least currently, of 243. And yet they missed it by a dramatic amount, with the average error being, in this case, 21%. Avantis created a chart which anyone can look on the article. It's there. In the last seven years, the consensus forecast, the least it was off was by 14%. I think that pretty much covers the spectrum there. Let me add just one other person because he's pretty famous, gets quoted all the time, been a perennial bear since 2013 at least. But Jeremy Grantham of GMO, he became known as a guru because he did accurately forecast the 2000 bubble burst and the 2008 crash in the market. Of course, no one ever went back and looked at other forecasts he made that may have been wrong. Pigs will fly before those, you know, happen. And Wall street likes to anoint. The media likes to anoint, you know, heroes of the moment. Well, in 2013, Grantham warned investors that the market was going to crash. It was 75% overvalued. He repeated that, you know, several years later. Of course, the market went on to ignore him. In fact, Grantham's GMO predicted over the seven years beginning in 2013, the S& P would earn, sorry, would lose almost 1% a year. It actually gained almost 11. So it was only off by 12 percentage points a year. Imagine the poor investor who was concerned in 2013 about the market and its high PE ratios, maybe the K10. And listen to Grantham. Confirmation bias bails out. And this is one of the great decades ever.

[Justin]

It's It's a good point that, you know, someone can come out and get one call out of maybe 15 years. Right. And you know, they get put up on a pedestal and they get brought out to investors and, and you know, and then, and then their hit rate, their accuracy rating is just terrible. So I think the, the bottom line is forecasting is, is, is really, really difficult. And there's a lot, I think important things for investors to recognize about that when they hear these, these types of forecasts.

[Larry]

Probably the most famous one is Elaine Gazarelli. You guys may not be old enough to remember Elaine, but she correctly forecasted the October 87 crash and she got a big promotion that gave her huge money to run. A few years later, of course they fired her because her performance. Terrible. She went on and found another fund that did terrible and then she disappeared. That's the more common outcome that we see.

[Justin]

Well, and I think the second lesson somewhat bleeds into this, although a little different and that is valuations can't be used to time the markets.

[Larry]

Yeah. So there's a lot of good research on this. It really isn't new. Robert Shiller, one of the things he may have won a Nobel prize for, besides all of his work on the field of behavioral finance is he came up with what now is called the Shiller Cape 10 or the cyclically adjusted PE ratio. The idea behind it goes back to Warren Buffett's mentors who said, Benjamin Grant, we shouldn't look at one year's earnings because you could be in the near the end of a boom in the economy, earnings are going to be high and not sustainable and you could be in a end of a bear market caused by a recession and no one expects those earnings to stay down that low forever. So he came up with the idea that we should take a cyclically adjusted. He didn't specifically state 10 years. And in fact, while Shiller used 10 years, which seems to make sense, long cycle research after that looked at 5, 6, 8, all are about the same. They all have about a 40% correlation to future returns. And even the current PE is pretty close to that as well. So what it tells you is valuations are the best predictor we have. But they literally the correlation, whether using the current PE or the Cape 5 or the Cape 10 tell you nothing about next year return. The correlations are virtually zero. So you cannot use them to time markets even at 10 years. A study Cliff Asnes did say the valuations were very high, a Cape 10 of over 25. Okay. Now if you invert that 25, you get 4%. And the way the Cape 10 works, that's the best predictor we have of the next 10 years real return to equity. So you have to invert it. We get now an earnings yield 25. 1 over 25 is 4%. So that would be the best predictor we have. However, you have to take 6% or so, maybe even 7 on either side of that to get all of the possible outcomes that have occurred in the past when the Cape 10 was that high. So you could still end up with maybe a plus 12 or 13% real return, or you might end up with a minus 3% real return. Well, both of those likely have happened, so you can't time it. So what do you do with this information? What you should do, number one, is treat any forecast as a median of a wide potential dispersion of outcomes and make sure your portfolio can live through and withstand all of the possible outcomes, including the left tail. So that's really important, number one. And number two is to make sure you can stay the course, you know, with that because, you know, behavioral problems are the worst. So what I tell people to do is because you can only treat it as a median, what you want to do is run a Monte Carlo simulation and then see what the odds of success are based upon all those possible outcomes. So when 2008 came, the bottom 5% of the outcomes we ran for clients included the 2008 Great Financial Crisis. So our clients at least should have been well prepared. They were listening in our discussions and made sure their portfolios could handle it. And we have discussions around what plan B you were prepared to execute if that worst case actually showed up. Might be cutting down your expenses, plan on working a little longer, getting rid of the second home, whatever it might be. So those are the key lessons from this.

[Jack]

It's funny, like, looking at a range of outcomes is such a great way to look at things in investing, but people hate it. Like end investors hate that stuff. Like going back to what we were talking about before, they love like The Merrill lynch one year forecast for the S&P 500 of what it's going to be, even though there's no accuracy whatsoever to that. People for some reason like that better than like, here's a range of things that might happen. Let's be prepared for all of them.

[Larry]

Yeah, people like to deal with certainty, but investing is even about is is not about odds. We don't know the odds. It's not like rolling the dice when we know what the Odds are of rolling a 711 or a snake eyes. The best we could do is estimate future returns and think about a wide possible dispersion because there is so much uncertainty about what the future holds, we don't know what the risk premium will be. And while a Cape Town gives you a correlation of 0.4, the rest of it is explained by changes in economic and geopolitical regimes which nobody has the ability or shown the ability to forecast.

[Justin]

And Larry, I don't know if you have any specific tools that you like, but just this conversation made me think about and I just googled it. Vanguard has a pretty nice market markets model where they give ranges of returns on a bunch of different asset classes. And actually they just added they have a 10 year horizon and now a 30 year horizon. So if investors are looking for a tool, you know, just Google that and you'll be able to kind of see this concept across many different asset classes.

[Larry]

I've seen the Vanguard stuff and I think from what I their ranges are way too narrow, giving people much.

[Justin]

Yeah, well that's probably true.

[Larry]

They might say US stocks are projected to earn between 5 and 7% when they really should say it's between 0 and 10. One of the biggest problems we have, even experts say a doctor has been giving, they show them an X ray or an mri, let's make it a more complex thing like an mri. And they're asked to diagnose the problem and then they ask them how confident you are in their accuracy. When they were, you know, these are experts in their field. When they were 90% confident they were right, they were on average maybe 65% right. AI does a much better job than the experts, for example, there because they don't make mistakes or far fewer anyway.

[Jack]

So this next one also gets to the long term nature of all this stuff. So your lesson number three was it takes lots of patience and discipline to stay the course through periods of poor performance as all risk assets go through them. So I know people who are value investors have been reminded about that, but anybody who does anything that's active is going to be reminded about that at some point or another.

[Larry]

Yeah, this is probably certainly one of the top and worst mistakes that investors make. It may be outside of recency bias and confirmation bias and overconfidence, it's probably, it certainly is one of the biggest mistakes and frequent. I think almost all investors are, you know, prone to make this mistake. And even supposedly sophisticated institutional investors make this same mistake, or at least more not as often as the retail Investor. When I talk to people, they think that three years of a bad performance for either a money manager or an asset class, they think that's a long time to judge performance. Five years is very long and they think 10 years is an eternity. Any good financial economist would tell you the likelihood is that 10 years is either noise, a random outcome or risk showing up. Now what investors have to understand is your horizon better be at least 10 years, should be longer or you shouldn't be investing in any risk asset. Because it's pretty simple. Let's say that you were guaranteed that stocks would outperform 1 month T bills. They're riskless instruments over a 10 year period. Well, now there's no risk. All you have to do is wait 10 years and you're guaranteed for what happens. What would the world look like Jack, in that environment? What would happen to the PE ratio of stocks? PE ratio would be much higher because there's no risk.

[Justin]

Right?

[Larry]

Right. If right, just think about. I think one reason that PE ratios are much higher than they were historically. I wrote about this in 2013 trying to show why I thought Grantham was likely dead wrong in his forecast because his logic was bad. One reason that PE ratios were higher is the risk in investing in stocks had gone way down from the average which he was looking at, which went back to the 1880s. Now was there any SEC in the 1980s? Was there any FDIC in the 1980s? Was there ANY Federal Reserve? Was there any generally accepted accounting principles? What happened to transactions cost over that period? They had come way down. All of those things that made investing cheaper. So you captured more of the returns. You weren't paying 5% commissions for example, and big bid offer spreads anymore. But the fact that the Federal Reserve was better able to control the economy so the volatility in the economy had gone way down. So the peak ratio should go up. And the fact is the US was a much wealthier country than it was on average over the period from 1880 to 2013 when he was Riley. And the fact is, the wealthier a country is, what happens? Capital is less scarce and when something scarce it gets a bigger premium. So all these reasons were wrong. So now what we learn is that getting back to the main point here, you have to understand that every single risk asset must go through long periods of bad performance. And that's not a reason to avoid the asset class. What is that a reason to do?

[Justin]

Diversify.

[Jack]

So stick with them during when they're down.

[Larry]

Unique assets that tend not to look like the Stock market invested. And if you doubt that, I'll give you the following two examples. There are three periods this shocks most investors. There are three periods of at least 13 years where the S&P 500 underperformed totally riskless T bills. The 15 years from 29 to 43, the 17 years, 17 years from 66 to 82. And near the end of that period, I think it was Forbes ran an article the death of equities. Money was going to end up in coin and stamp collections, said the president of Solomon Brothers, if my memory serves all right. And of course, the next decade was the best ever. Next two decades were the best ever. And then just recently 2000 through 12, they underperformed T bills. Now what's really important about this is people forget what the periods look like just before those three awful periods which constitute 45 of the last 96 years. 95, that's 47% of the period. And that means the other periods you got great returns, but you're not there. But you can't wait 12, 13, 15, 17 years. But think about what was before 1929 through 43. That was the roaring twenties. Stocks were now at an all time permanent plateau. Said Irving Fisher, one who was the, you know, the greatest economists of that era. And then you had the coming out of World War II, you had the 50s and early 60s and the nifty 50 spectacular stock returns. And then it crashed. And then you had Ronald Reagan and the change in deregulation and you had the, you know, dot com era. And we had another great period and we've had a, a really bad bear market from 2002 and then the market again recovered after that. Let me give you one last example which is my favorite. What's the favorite asset class for US equity investors now? The S&P 500 or large cap growth stocks, Right?

[Justin]

Yeah, right.

[Larry]

S and P selling like a 23 pence. The S&P growth index is maybe at 28 or 9. That's the favorite one loves the Max 7. Okay. There's a 40 year period from 1969 through 08 where large cap growth stocks and small cap growth stock growth stocks Underperform 20 year long term treasury bonds, which is the riskless instrument for a pension plan with nominal obligations. That's 40 years. You know, if that doesn't tell you you need patience and discipline, of course you would have missed the next eight period. The best ever for large cap or growth stocks. Right.

[Jack]

How do you think when you manage money for people, how do you think about the balance between teaching people this lesson and then recognizing that some people can't learn it. So, for example, like if I'm adding the value factor to someone's portfolio and that has the potential for 20 years to underperform, I would assume with certain people, you just have to recognize they're not sitting through that they shouldn't be it in the first place. And with other people, you might be able to teach them this lesson. And so how do you think about that balance?

[Larry]

Yeah, that's a great question. So the first thing I do is teach them this lesson and show them, well, you want to invest in the s and P500, and then you want to think of large growth stocks. So I show them the history they don't know. Remember we started off with that expression when Justin did the introduction? So you don't know your history. Tell me, are you. Would you have been prepared to sit through those periods of 13, 15 and 17 years and 40 years for large growth stocks? And if the answer is yes, you would, then you should feel the same way about value or real estate or gold or, you know, whatever the investment may be. Because every single one of them, I could cite very long periods of underperformance. So what is the prudent strategy? There's only one logical one. I can't run the risk of having all my eggs in the wrong basket for 15, 20 years. So what should I do? I should diversify. But that means I have to stop looking at the market, a benchmark that's quoted every day. Because if I want that benchmark, then I can own it. But then I can never complain. When a diversified portfolio protects you, as it did in the 70s, international stocks far outperformed in the 2000s. They outperformed. Value is far outperformed in over very long periods. Every single asset we could point to has gone through both long periods of good performance and bad. And the way you smooth out returns. If you invest in one asset, you're going to go like this. Big waves up and down. If you diversify, you make the waves much smaller, and that allows you to sleep better. And when you run a Monte Carlo analysis which shows you your odds of success, the one with the small waves has much higher odds of success, especially for retirees, because it avoids the sequence risk you face when you're in retirement and in withdrawal, because you can't recover, because you're drawing down your portfolio, that's really critical. Diversification becomes more important the older you get. This is something that drives me crazy when I Talk to retirees. Larry, I don't have 15 years for value to outperform, you know. Right. I said, well then you don't have 15 years to wait for the S and P to outperform either. Right. It's the same answer. In fact, diversification is much more important when your horizon is short. Think about the outperformance of growth of value over say any 20 year period. Probably relatively small, maybe 5% at the most, maybe 6. In any one year it could be 20, 30 or 40% difference. So the longer your horizon in theory, it becomes less important from that perspective because all assets are going to tend to have similar risk adjusted return. Short term you can get much wider divergence.

[Jack]

That benchmarking thing you brought up is so important because we found that no matter how someone's invested where they are on the risk spectrum, The S&P 500 is always the benchmark. And a lot of times it's not the appropriate benchmark and it leads to bad decision making because people are judging themselves against the S&P 500 and they end up making poor decisions with their portfolio because of it.

[Larry]

Yeah. So I always tell people the benchmark should be an index of assets that you have decided you want exposure to, not the S&P 500. Because if you want the S&P 500, just own it. And you could do it for three basis points and then you could stop worrying about tracking variance risk. But you better be prepared. Like today when the S and P is trading at near record levels, not quite.com era levels, but way up there. It's you know, like a multiple standard deviation event from the average of the P E ratios of the last 25 years.

[Jack]

So the next one we talked about periods of underperformance for risk assets and this next one gets it. Sort of the answer to that. And your lesson number four was risk assets with poor performance have self healing mechanisms. So can you explain that?

[Larry]

Yeah, this is the antidote to the problem is to teach people this lesson and they fail to remember it. This is why Warren Buffett tells people to buy when everyone else is panic selling, because he recognizes it. I feel good. I think I can't be a hundred percent certain, but I feel good. I think I coined that phrase a self healing mechanism here. So what do we mean by that? So from, if you think about the period from 29 to 43, in that period we went through a great depression. Right. All right, so what happened to the PE ratios?

[Justin]

Went way down.

[Larry]

It went way down. And if the best Predictor we have is the inverse of the PE. So say it went down from 30 to 8. Well, at a 30 PE, you're predicting 3% real returns as the median. And at 8, you're predicting 12 and a half, which is way above the 7 historical, roughly. So you should be loading up. But of course, that means the market thinks things are really risky. That's why you're getting high expected returns. So it's difficult for people to do. Same thing happened after, you know, 99, March 2000. PE ratios went way up. Predicting low returns. Yeah, we got that. And then PE ratios collapsed. By the end of 20, 2002, they were much lower. And again, same thing happened after 08. PE ratios collapsed the end of World War II when nobody wanted to own stocks. I mean, literally no one wanted to own them. Okay. PE was like 6 when everyone should have been jumping for joy. You know, we did win the war. Our industrial production was not damaged, Just how to be converted. And it was a great time to own stocks. And so that's an example, and the best examples I have that of that is why you need to own that. It is looking at, you know, the same thing is true on value stocks. Right, Right. What happened is. But what was. Do you remember the last period before this decade or so when value underperformed and Warren Buffett was called the dummy? He's an old fogy and he doesn't get this new era.

[Jack]

Oh, yeah, late 90s.

[Larry]

The late 90s. Right. Okay. And value far underperform. So I'll just give you a rough number. Let's say the P. E of growth stocks is normally, say 16, and value was 12. Let's say the market was 16, value 12, and growth might have been 18. Well, by the end of 99, the growth was trading at 40 and value was trading at roughly about the same 12. So while the market was vastly overvalued or highly valued, at any rate predicting future low returns, especially for growth stocks, the spread between value and growth had widened so much that it was predicting the largest value premium in history. And that's exactly what we got over the next eight years. Then the spread narrowed, and then growth went on to outperform, putting us right back to where we were virtually at the end of 99. And today value is trading almost something like the 90th or so percentile in cheapness, which is not a guarantee that it will outperform. But the best we could do was learn from history and put the odds in our favor. So that's the Key here.

[Jack]

Do you think with the rise of passive investing, it's slowing down the healing mechanism? So if more and more people are buying stocks and not caring about the valuations and driving up the prices of those bigger stocks, does it mean it's going to take longer for this healing to happen?

[Larry]

No, I don't think that drives up the price of the big stocks at all. Remember, money's coming in proportionally. So if a stock is 1% of the index, 1% goes in and they buy the same stocks, their pressure isn't there. That's not what causes concentration. What causes concentration is active managers who are making bet. Right. Remember, if you're passive, you're just buying the pro router share of the market. That's what's there. Let me give you the best example I could think of of the self healing mechanism and the ignorance and the shortsightedness of individual investors. So there's a fund run by Stoneridge called S R R I X. It's a reinsurance fund. So when it came out, and originally, I think in late 2013 or so, we estimated based on historical data and the current premiums available, that the fund would provide about a 4 to 5% risk premium over risks for its one month treasury growth. Now that's a spectacular return for an asset that should be totally uncorrelated, right? Because stocks and bonds don't, when they have bear markets, that doesn't cause hurricanes or earthquakes. And almost certainly the reverse is also true. Hurricanes don't cause bear markets. Right. So the ideal thing is you get an asset with a nice fat premium and it's uncorrelated. Everyone should love that. And the first four years or so it provided about that greater return and money flowed in and the premiums of course, began to shrink a little bit as everyone loved this asset. The next three years were really bad because of the California fires that happened up in Marin county and just north of there in the wine country. And we had some bad hurricanes and the fund lost like 30%. And the next two years it made six and lost six. So you had five poor years there roughly, but three really bad. Now, after the first few years, money piled in. The fund grew to 5 billion. At the end of 2022, the fund was down to 1 billion. Now, about a third of it was due to performance. The other two thirds was naive investors fleeing thinking this three years is a long period, you know, bad performance, ignoring 150 years of history for reinsurance investments. Okay, so what happened in 2023? Premiums went way up. Okay. Deductibles went way up. And guess what also happened to underwriting standards? Did they get tougher or easier?

[Justin]

I would say they got tougher. Obviously they got a lot tougher with the fires. Yeah.

[Larry]

You want to buy reinsurance, you want to buy insurance in California on a home. Okay. Right. You were not allowed. If you were in a fire prone area, you couldn't have a tree within 30ft of your house. No two trees within 30ft of each other, no brush for another 30ft. Uh, you know, and in Florida, if you want hurricane insurance, you had your roof, had her, and the windows had to withstand 140 mile hour winds. Deductibles went way up, et cetera. The fund, the risk has gone down. Right, because the deductibles went way up and the underwriting standards went up and the premiums, home premiums went up like 60% in California. Went way up in Florida. In 2023, the fund earned 44 and a half percent. Now 2/3 of the investors weren't there to earn it the next year. It's still on 33%. If we get a normal hurricane season this year, I would estimate the fund is going to earn something north of 20% because the money had flown out. Ross Stevens, who was the chairman of Stoneridge, did a little study and he found the average investor in the fund had underperformed the fund by over 5% a year simply by selling after periods of bad performance, missing the great returns and buying after periods of good performance. Right. And that same thing happens with stocks. It happens with credit risk. Think about the self healing mechanism in credit. You get a recession, you get credit losses, defaults. What happens to credit spreads, Jack?

[Jack]

They widen out.

[Larry]

What happens to covenants? Do they get looser or tighter? They get tighter, they get tighter. So the risk goes down. You're getting paid more for that risk. And what tends to happen, that self healing mechanism occurs. But investors panic and sell, subject to recency and all kinds of other biases, failing to understand the self healing mechanism. Right. Okay. And they miss out on those returns. The same thing happens, say in mining stocks. What happens to precious metals prices? They go way down. Mines shut down, no supply. Guess what happens to prices go way up and then. Right, but they're not there. But now what happens? Price goes way up. And guess what? Now you get people opening new mines, investing, and five years later you get excess supply. You get the self healing mechanism in every single asset class. It doesn't matter what it is. And that's what investors fail to understand. So the key is have patience, have discipline. Don't invest in an asset class unless you're prepared to stay with it. And if you had reinsurance or any other asset, say it's 5% of your portfolio, it's down 30%, so you lost 1.5%. It's not the end of the world. That's why you diversify and don't put all your eggs in one basket.

[Jack]

I really like this, this next lesson, because I think a lot of people think if I told you what's going to happen in the economy and I told you what's going to happen around the world, you could then tell me what's going to happen with the stock market. And it doesn't really work that way. So your lesson number five is even with a clear crystal ball, markets are unpredictable.

[Larry]

Yeah, that's one of my favorites. We consistently see this, you know, all of the time, is that if I gave you a clear crystal ball, it wouldn't help you. Now, we know the market went up 23% or the S&P went up 23% that you know, last year and the total return was 25. But let's say you had that perfectly clear crystal ball and it allowed you to see what was going to happen in the future. What would you have seen? And then ask yourself, would you have bet the market would go up, let alone 23%? You would have seen that there was no resolution to the war in Ukraine and even North Korea was going to be sending troops. The conflict would go on approaching three years. We'd have escalating conflicts in the Middle East. Israel is going to end up directly attacking Iran, Syria and Yemen, threatening spreading this regional conflict. Interest rates will remain much higher for longer as inflation proves stubborn. The manufacturing sector, nobody talks about this. I'm willing to even. I'm not sure I'd bet whether you guys know, but. And you're in the markets. But the manufacturing sector has literally been in a recession. So throughout the year, we've never been above 50 in that index. Consumer delinquencies have skyrocketed. Office vacancy rates skyrocketed. San Francisco to a record 35%. Similar Chicago. Six out of the ten. Sorry, six out of the top 25 office markets saw vacancies increase by 5% in one year. Office properties were selling down 10% and there wasn't a lot of activity. If people actually tried to sell, it probably would have gone down more. The budget deficit would skyrocket to six and a Half percent pushing seven. Here's one you may not be aware of. I bet your listeners aren't is that foreign investors have been significantly lowering their holdings of dollars, mainly for geopolitical reasons. You're Russia, you don't want to be holding dollars in banks like in Belgium where Belgium is holding 300 billion of Russian money because it could get confiscated. So they're diversifying to hold Chinese yuan, maybe Bitcoin. Certainly gold is benefited the percentage of foreign holdings. If US dollars as their central bank reserves is down about 10% in a decade and yet the dollar went up, how would you bet on that? Right. And the Fed begun cutting interest rates in September, cut them 75 basis points. How many people would bet that the 10 year would have gone up 1%? I doubt a single, maybe one economist might have forecasted that.

[Jack]

Certainly not me.

[Larry]

I wouldn't have said that. So that shows you. Here's what really happened. Ask yourself, would you have been able to ignore all of that and follow Buffett's advice just to stay the course?

[Jack]

I love this next one because you hear this all the time. You hear this idea of sell in May and go away and then people will cite the data to show, you know, much better returns for the market in the period, you know, November to May and way worse returns from May to November. So you should just sell from May to November. Why is that wrong?

[Larry]

Yeah, well, you might as well follow astrology. That's number one. And I've even seen astrologists on CNBC and stuff like that. I think it was a guy named Arch Campbell or something like that, I forgot his name, who used to appear fairly often on cnbc. So there is this strategy to sell in May and go away. And it's a myth. And all you have to do is look at the data. Now, there's usually a reason for a myth because anecdotal evidence might support it. And when I dug into the data, I did find that yes, stocks actually perform better in the period from November through April than they do from May through October. The annualized premium for stocks is about 7% total on average for a year over T bills. But it's about ten and a half annualized from November through April. And it's only about three and a half or so less than that from April through, sorry, May through October. But there's still a 3.2% premium. So if you sell not only especially if it's a taxable account, you have that, but you gave away a premium of 3.2%. So the data makes it clear you have to be pretty dumb to ignore the history. But even worse is the complete illogical. What's the most basic principle of finance? It's that risk and expected return. Not people get that wrong all the time. They say risk and return are related. That must be wrong, right? Right. It's risk and expected return are related. Well, if you think you should be out of the market from September, from May through September, it's because you think stocks should have lower returns. It must be that you also think they're less risky. I dare anyone to explain to me why t bills are riskier than stocks from May through November or May through October. It, I mean it's completely illogical. The data doesn't support it. And Justin and Jack, you and I could make a lot of money betting that come end of April or early May, we'll hear on CNBC or Bloomberg about this sell in May. It's the wrong seasonal strategy and asking people to comment on it. Right.

[Jack]

It was also a disaster last year to do that. Right. It didn't work in your favor at all?

[Larry]

Yeah, the only about the last time it worked was 2022, which is a bear market for the year. And the prior time it worked before that was 2011. So the last 14 years we've had twice where it worked. And yet this myth still persists. I get asked about it, it's the wrong time of year. I'm nervous, you know, the Middle east or Trump is president and terrorists, whatever it might be.

[Justin]

So as we kind of bring it home into the last three lessons, number seven is last year's winners are just as likely to be this year's dogs. And I think you know your point. Yes, we've had two years of back to back S&P 500 being 23 and 24, you know, kind of the best performing, I guess equity class. But you also have a chart in there that shows, you know. No, that's not, that's more of a random thing than anything. And a lot of these asset classes have much more variability year to year.

[Larry]

Well, there is some evidence from in the short term which tends to be an average somewhere in the four to six months there is short term momentum. So you can see from one year to the next you may have an asset class outperform. But remember we just discussed that other lesson, that there's a self healing mechanism and if you get spectacular returns which puts you in the top one or two or three, that means likely the PE ratios are now higher and eventually momentum reverses anyone who's familiar with momentum knows there's short term momentum and then there's long term reversion. And so that's what this chart shows in this case, and I show this chart every year. Sometimes the top performers go right to the bottom and the bottom goes to the top. Sometimes there's repeat. In this example, the number one performer did repeat, but the second worst performer became much better and like the other top performers went way down on the list. So the best thing and the only prudent strategy I think is simply to diversify and then rebalance, staying the course. Because when something does poorly and ends at the bottom of your list, you're going to have to buy more, which is tough psychologically. But just keep in mind that self healing mechanism and eventually you are likely but not certain to be rewarded. And it's just as hard to take chips off the table. But selling high to rebalance and buying low to rebalance is a far superior strategy to what most retail investors do, which is buy high after periods of good performance and sell low after periods of poor performance. That's why all the studies Morningstar does this often shows that the average investor underperforms the very funds they invest in by significant amounts.

[Justin]

Your next point number eight was sort of stating that active management is pretty much a losers game in both bull and bear markets. And I'll let you kind of explain why, but I think the more interesting discussion is how sort of you use or look at these systematic factor strategies in, in that context because sometimes investors might think that those are active but they're really just tilting based on factors. And so you have some interesting data I think on that as well.

[Larry]

Yeah, so we hear, literally I can say in my entire life I've probably heard tens of thousands of market strategists on CNBC or Bloomberg and they're asked the question about is this going to be an indexes or an investors or stock pickers market. I have never once ever heard any one of them say this is anything other than an active investor's market. And every year it doesn't matter what, they underperform persistently, especially over longer periods. Once you look at 10 and 15 year periods. Morningstar and their data, which unfortunately fortunately includes survivorship bias because it only includes the funds that survived the whole period. Okay, 90% plus of the active managers underperformed. In 2011, Ken French and Gene Famer published this study which found that once you adjusted for these common risk factors of size and value, quality, et cetera, only 2% of active managers were generating statistically significant alphas, which is less than you would expect randomly throwing dots and picking active managers. And the market has only gotten more efficient over time since other studies have found the same answer. And I love to put, there's a chart there which I show, you know, how active managers in some years will claim this was a tough year to beat the indexes. And I say what nonsense. Here's the top five or ten stocks. Last year there were five stocks that outperformed the S and P by at least 110% and in one case over 200%. All you had to do was overweight those stocks, you know, and you far outperformed. And there were five stocks that lost at least 49% which means you outperformed the S and P by at least 74%. All you had to do was avoid them or underweight them and you'd outperform. And yet the majority of active managers failed to beat their benchmark. If you look at the data that I show, I looked at Dimensional Fund Advisors and Vanguard's funds. So Vanguard's funds are pure indices. For example, small value might be the S&P 600 or MSCI 1750 or a Chris Small index. They're all a little different but they're just replicating indices. And that leads to some unfortunate dumb trading. And therefore I don't use any index funds at all because you can avoid some of the negatives of index fund like getting front run high frequency traders. And I use the funds that are systematic, transparent and replicable. So it's basically being run by machines. No individual security selection or market timing. They just define their universes differently using academic definitions of the asset class. But that's it. They don't and then basically let the machines run it. And in Both cases over 15 years Vanguard funds had outperformed domestic, I think 80% of the active funds and Dimensional had outperformed 85% of the active funds. And that's with two biases. One I mentioned the survivorship bias. 7% of active funds disappear. So obviously the ones who disappeared did because they had poor performance. So vanguards and DFA's data would be even better. And the other bias is this doesn't include taxes. And we know for active managers, for most of them the highest cost is not their expense ratio, it's taxes. And we see the same thing, you know, internationally there. So the data is there once we adjust for these factors as well.

[Justin]

So the last lesson number nine really stands out when you know You've been working with individual investors and even professionals, I guess, sometimes can fall victim to this. But, you know, diversification, if you're properly diversified, you know, is always working for you is the point you made. But sometimes you like the results and sometimes you don't.

[Larry]

Yeah, a smart person, I think it was Bill Bernstein said if some part of your portfolio isn't doing poorly, you're not properly diversified. Right. Because what you're doing is trying to protect the tail risks. No one worries about the good right tail, but we all worry about the left tail, which means you have to own assets that don't look like the S&P 500 because hopefully they are subject to different risks and therefore may not go down at the same time the S and P goes down. Things like reinsurance or real estate or private credit or litigation finance or long short factor strategies. Most of those have low or even no correlation to the S&P 500. So you have to own them if you don't want that tail risk to be as steep as it is, that concentration. But that means you have to accept the fact there will be periods when the S and P outperforms your diversified portfolio. But that's ridiculous to compare your portfolio to the S and P. Because if you want the S and P, just own it and don't look. In hindsight, here's the biggest problem that or one of the biggest problems that investors have. So I write about in my book Enrich youh Future, which is a behavioral finance book teaching people all the behavioral errors. One of the worst mistakes they make is engaging in what is called resulting. For those aren't familiar with the term. I'd urge you to read Annie Pottser's book, Thinking in Bets. So what she points out is in poker you could make a dumb bet and draw to the inside straight and think that's a great strategy going against the odds. And if you keep repeating that, eventually you will go broke playing poker. On the other hand, you can make good bets and lose because the risk showed up. It's not a certainty when you make that bet. The best example of that, which is to show you that a good strategy is, as you know it, before the fact, not after the fact. Should never judge a strategy by the outcome, but by the quality of your decision making. Jack, you were a fan of the NFL. Since we just had a Super bowl.

[Jack]

Yesterday, unfortunately, a Jets fan.

[Larry]

Larry Born, suffering Jets fan. Yes. So the most famous play probably in the history of the super bowl was a pass that was intercepted.

[Jack]

Do you remember the Seattle New England game, right?

[Larry]

Exactly right. So Seattle had the ball with about a minute to go. First and goal, unlike the three or four yard line, I don't remember. And they had the best running back in the league, Marshawn lynch, big horse and a great offensive line. And the announcers everyone saw, they're just going to run the ball three or four times if need be and they'll get their touchdown. That was the logic there. Of course. Russell Wilson dropped back the pass, threw an interception. Guy made a great defensive play. Intercept the ball, Seattle, and everyone's criticizing. So what happens? The saber maticians went to work and actually looked at the analysis of all the historical evidence there. And here's what they found in the red zone there in that area. Russell Wilson had not thrown an interception the entire year and Marshawn lynch had fumbled the ball three times. Clearly the right choice, because no one should have been expecting the pass except the one defender from Seattle guessed right and jumped it. The right call was that Robert Rubin, Secretary of the treasury, said good decisions can lead to bad outcomes and dumb decisions could lead to good outcomes. You could take your IRA account and go buy a lottery ticket or take it to the racetrack and bet it on some horses that wear the color purple jockeys clothes. And you like purple and you win. That doesn't mean it was a good decision. But in the long term, good decisions made thoughtfully should turn give you a much better odds of success than making poor ones. So what you have to do is get the strategy right in the first place, which is diversify across many unique sources of risk that meet your criteria. That there's a premium that's persistent over long periods of time, pervasive around the globe and across asset classes, robust to various definitions. It survives transactions costs, and it's and therefore is implementable. And there are logical reasons why you think it should persist. Is there any reason to think insurance reinsurance companies are dumb and idiots and they're going to lose money forever? Or do they have more scientists than anybody studying the climate and eventually they'll price the risk. We have 150 years of data. Warren Buffett runs one of the largest reinsurers. In the last two years he wrote more reinsurance than he ever did. Why? Because the premiums were met. But yet retail investors ignore it. Discipline is the key to successful investors investing and diversification is the necessary ingredient.

[Jack]

I just have to admit, Larry, the the other weekend with the Trump coin, I was doing a little resulting myself and I was when I Saw that it produced the same return the S and P had since the 1970s from like Friday to Sunday. Obviously not a good thing to invest in in advance, but looking at it.

[Larry]

After the fact, I'm like, no, I.

[Jack]

I probably should have owned some of that.

[Larry]

Yeah, exactly right. You, you cannot judge a strategy by the outcome. That's a, a really bad mistake. And almost all retail investors make that mistake. And that's why they bail out of reinsurance after three years. AQR as a style premium fund, that's long, short factors, long history of the data to show support the logic of these factors. That value should outperform in the long term across assets and so does momentum and carry and quality. And the fund the first three or four years provided about a 4 to 5% real return, just as AQR estimated. The next three years the fund lost 35% and everyone bails out. And the next four years were spectacular returns. Over 20% each year, I believe. Some in the 30s, but most investors weren't there. So the key, if you can't stay the cost, don't invest in the first place. But then you're taking all the risk of putting all your eggs in one basket. You cannot run away from risk. You can only diversify it. So your choice, you want to have better odds of success by diversifying and living with tracking variance or living with huge odds of failure. But now you don't have to worry that you look different than the market.

[Justin]

So I love so many things about this article and this has been great, but you know, the way that you ended it was, was, was, was pretty, was pretty awesome too. And you said, you know, once you have that plan in place, the job as an investor is to act like a postage stamp, because a postage stamp has one, has one job. It, you know, it sticks to the letter until the letter reaches its destination. And you said, you know, for investors, it's your job to stick to your well developed plan until you reach your financial goals. So that's a, that was a great, great way to end it.

[Larry]

One other line that I use you. I think you'll like this one. Do you remember Dirty Harry's famous one line in his movie, points the gun at the. Yeah.

[Justin]

What, what, what is it? I forget. It's unfit.

[Larry]

Go ahead.

[Justin]

Oh, you make my day.

[Larry]

Yeah. And that's when I tell investors, okay, you sign this investment policy statement promising you're going to rebalance when you're going to complain it underperformed. I'm going to hold the revolver and say, go ahead, make my day.

[Justin]

Nice. Nice. Larry, it's always a pleasure. Thank you very much. I know our audience gets a tremendous amount of value from this and you're so generous with sharing your time and just your overall approach to investing. Educating investors is really appreciated from Jack and I. So thank you.

[Larry]

Well, thank you. It's my pleasure. Always happy to come back, guys. We didn't even get a chance to talk about private credit infrastructures. Guess you'll have to have another.

[Jack]

The next appearance. We'll definitely do the next appearance.

[Larry]

All right.

[Justin]

Thank you.

[Jack]

Hey, thanks, Larry.

[Justin]

This is Justin. Again, thanks so much for tuning in to this episode of Excess Returns. You can follow Jack on Twitter at practicalquant. You can follow me on Twitter JJ Carbonell if you found found this discussion interesting and valuable, please subscribe in either itunes or on YouTube or leave a review or a comment.

[Larry]

We appreciate Jack Forehand is a principal at Validia Capital Management. Justin Carboneau is a Managing Director at Life and Liberty Indexes. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of clients of Validia Capital.