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In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 15: Individual Stocks Are Riskier Than Investors Believe.
LEARNING: Don’t invest in individual stocks. Instead, diversify your portfolio to reduce your risk.
“Diversification has been said to be the only free lunch in investing. Unfortunately, most investors fail to use the full buffet available.”Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 15: Individual Stocks Are Riskier Than Investors Believe.
Chapter 15: Individual Stocks Are Riskier Than Investors BelieveIn this chapter, Larry reveals the stark reality of investing in individual stocks, highlighting the significant risks involved. His aim is to help investors understand the potential pitfalls of this high-stakes game and why they should avoid it.
Given the apparent benefits of diversification, it’s baffling why investors don’t hold highly diversified portfolios. According to Larry, one reason is that most investors likely don’t understand how risky individual stocks are compared to owning a broad selection of hundreds or thousands of stocks.
Evidence that individual stocks are very riskyLarry notes that the stock market has returned roughly 10% per year over the last 100 years, and the standard deviation on an annual basis of a portfolio of a broad market of stocks has been about 20%. He observes that most people don’t understand that the average individual stock has a standard deviation of more than twice that.
In another study from 1983 to 2006 that covered the top 3,000 stocks, the stock market returned almost 13% per annum, but the median return was just 5.1%, nearly 8% below the market’s return. The mean annualized return was -1.1%. This means that if you randomly pick one stock, the odds would say you’re more likely to get -1.1%. However, if you own hundreds or thousands of stocks, the odds are in your favor, and you’ll get very close to that mean return.
Larry shares another stark example of the riskiness of individual stocks. Despite the 1990s being one of the greatest bull markets of all time, with the Russell 3000 providing an annualized return of 17.7% and a cumulative return of almost 410%, 22% of the 2,397 U.S. stocks in existence throughout the decade had negative absolute returns. This means they underperformed by at least 410%. Over the decade, inflation was a cumulative 33.5%, meaning they lost at least 33.5% in real terms.
In another study by Hendrik Bessembinder of all common stocks listed on the NYSE, Amex, and NASDAQ exchanges from 1926 through 2015 and included. He found:
Bessembinder concluded that his results help to understand why active strategies, which tend to be poorly diversified, most often lead to underperformance. At the same time, he wrote that the results potentially justify a focus on less-diversified portfolios by investors who particularly value the possibility of “lottery-like” outcomes despite the knowledge that the poorly diversified portfolio will most likely underperform.
A diversified portfolio is the way to goThe results from the studies Larry has highlighted underscore the critical role of portfolio diversification. Diversification, often referred to as the only free lunch in investing, provides a sense of security and peace of mind. Unfortunately, many investors fail to fully utilize this powerful tool. They mistakenly believe that by limiting the number of stocks they hold, they can better manage their risks. In reality, a well-diversified portfolio is the key to long-term financial success.
Most professionals with PhDs in finance spend 100% of their time engaged in stock picking and have access to the world’s best databases and teams of professionals helping them. These individuals are unlikely to outperform. So why would an average investor think they have enough advantage over them? Larry’s stern advice to investors is not to play the game. His professional guidance is a beacon of reassurance in the complex world of investing, steering investors away from risky individual stocks and towards the safety of a diversified portfolio.
Investors make mistakes when they take idiosyncratic (unique), diversifiable, uncompensated risks. They do so because they are overconfident in their skills, overestimate the worth of their information, confuse the familiar with the safe, have the illusion of being in control, don’t understand how many individual stocks are needed to reduce diversifiable risks effectively, and don’t understand the difference between compensated and uncompensated risks (some risks are uncompensated because they are diversifiable).
Another likely explanation is that investors prefer skewness. They are willing to accept the high likelihood of underperformance in return for the small likelihood of owning the next Google. In other words, they like to buy lottery tickets. Larry says that if you have made any of these mistakes, you should do what all smart people do: Once they have learned that a behavior is a mistake, they correct it. So, steer away from risky individual stocks and go for the safety of a diversified portfolio.
Further readingLarry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
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Connect with Larry Swedroe
BIO: Ava Benesocky is an author, public speaker, educator, CEO, and Co-Founder of CPI Capital, a uniquely innovative real estate private equity firm that helps investors invest in multifamily assets.
STORY: Ava became passionate about real estate when she was young. At 15, she convinced her parents to invest $13,000 in a course by Scott McGillivray on renovating and selling homes. Ava never did anything with the course, which made it the worst investment ever.
LEARNING: If you invest in anything, ensure you’re ready to be committed, take action, and focus completely on it. Beware of shiny object syndrome.
“If you’re ever going to invest in something, you have to take action, or else it’s a total waste of time and money. And what’s the point?”Ava Benesocky
Guest profile
Ava Benesocky is an author, public speaker, educator, CEO, and Co-Founder of CPI Capital, a uniquely innovative real estate private equity firm that helps investors invest in multifamily assets.
She is the Host of Real Estate Investing Demystified with August Biniaz, who was Ep 784.
Ava has been featured in publications such as Forbes, Yahoo Finance, and numerous PodCasts and YouTube shows. Ava helps busy professionals earn passive income through Multifamily Real Estate investments.
Worst investment everAva became passionate about real estate when she was young. At 15, she convinced her parents to invest $13,000 in a course by Scott McGillivray on renovating and selling homes. Ava never did anything with the course, which made it the worst investment ever.
She tried to get it started, but there were so many moving components, and the process was so convoluted that she got scared. It all fell through the cracks. Ava never ended up taking action on it.
Lessons learnedRefrain from being impulsive when buying courses. Take your time and ask yourself if you have time for it. Can you block it off on your calendar? If not, do not get it.
Ava’s recommendationsAva recommends listening to her podcast Real Estate Investing Demystified, where she shares her personal experiences, interviews industry experts, and provides advice on real estate investing and other investment opportunities.
No.1 goal for the next 12 monthsAva’s number one goal for the next 12 months is to continue building a couple of departments in the company and closing on a couple more assets. On a personal level, she will continue taking care of her mind, body, and family.
Parting words“Thank you so much for letting me be on your podcast, and good luck to everybody out there in whatever venture they decide to take.”Ava Benesocky
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Connect with Ava BenesockyIn this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 14: Stocks Are Risky No Matter How Long the Horizon.
LEARNING: Stocks are risky no matter the length of your investment horizon
“Investors should never take more risk than is appropriate to their personal situation.”Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 14: Stocks Are Risky No Matter How Long the Horizon.
Chapter 14: Stocks Are Risky No Matter How Long the HorizonIn this chapter, Larry illustrates why stocks are risky no matter how long the investment horizon is.
According to Larry, the claim that stocks are not risky if one’s horizon is long is based on just one set of data (the U.S.) for one period (albeit a long one). It could be that the results were due to a ‘lucky draw.’ In other words, if stocks are only risky when one’s horizon is short, we should see evidence of this in other markets. Unfortunately, investors in many different markets did not receive the kind of returns U.S. investors did.
Historical examples of stock market risksLarry presents evidence from several markets, reinforcing the historical data that stocks are also risky over the long term.
First, Larry looks at U.S. equity returns 20 years back from 1949. The S&P 500 Index had returned 3.1 percent per year, underperforming long-term government bonds by 0.8 percent per year—so much for the argument that stocks always beat bonds if the horizon is 20 years or more.
In 1900, the Egyptian stock market was the fifth largest in the world, attracting significant capital inflows from global investors. However, those investors are still waiting for the return ON their capital, let alone the return OF their capital.
In the 1880s, two promising countries in the Western Hemisphere received capital inflows from Europe for development purposes: the U.S. and Argentina. One group of long-term investors was well rewarded, while the other was not.
Finally, in December 1989, the Nikkei index reached an intraday all-time high of 38,957. From 1990 through 2022, Japanese large-cap stocks (MSCI/Nomura) returned just 0.2 percent a year—a total return of just 6 percent. Considering cumulative inflation over the period was about 15 percent, Japanese large-cap stocks lost about 9 percent in real terms over the 33 years.
Taking the risk of equity ownershipLarry notes that the most crucial lesson investors need to learn from this evidence is that while it is true that the longer your investment horizon, the greater your ability to take the risk of investing in stocks (because you have a greater ability to wait out a bear market without having to sell to raise capital), stocks are risky no matter the length of your investment horizon.
In fact, that is precisely why U.S. stocks have generally (but not always) provided such great returns over the long term. Investors know that stocks are always risky, and thus, they price stocks in a manner that provides them with an expected (but not guaranteed) risk premium.
In other words, stocks must be priced low enough to attract investors with a risk premium large enough to compensate them for taking the risk of equity ownership. Because the majority of investors are risk-averse, the equity risk premium has historically been large.
Things that never happened before do happenLarry warns that investors should never take more risk than is appropriate to their personal situation. It is also important to remember these words of caution from Nassim Nicholas Taleb: “History teaches us that things that never happened before do happen.” With that in mind, you will be well served if you never treat the highly unlikely (a very long or permanent bear market) as impossible.
In addition, investors should diversify their portfolios against risks that can show up and not have all of their assets in any one country or asset class. This is because any of them can have very long periods of poor performance. He insists that having long periods of poor performance is not a reason to avoid an asset class. It’s a reason why investors should diversify.
Further readingLarry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
[spp-transcript]
Connect with Larry Swedroe
BIO: Pritesh Ruparel is the CEO of ALT21, a leading tech company in hedging and currency solutions.
STORY: Pritesh found a good trade and invested 100% in it. His manager later advised him to liquidate that position because it was too concentrated. A day after Pritesh liquidated, a natural disaster occurred, and the spread went from $10 to $250 in an hour.
LEARNING: Put yourself in a position to get lucky. Never decide against your gut. Stay grounded between the highs and the lows.
“The worst thing you can do is to trade on something or to make a decision that you don’t 100% agree with.”Pritesh Ruparel
Guest profile
Pritesh Ruparel is the CEO of ALT21, a leading tech company in hedging and currency solutions. With two decades of expertise in financial derivatives and structured finance, he leverages technology to make financial products accessible and affordable, aiming to save small and medium-sized enterprises (SMEs) millions annually on international transactions.
Worst investment everPritesh’s first trading role was as a market maker in commodity relatives. One summer, he put a ton of analysis into a particular commodity spread trade. Pritesh thought the risk-to-reward looked good, but the trade was not doing anything. Nobody was marking the trade. Pritesh thought this was insane, so he went all in. He had the biggest position possible in that trade and it was 100% of his portfolio.
A manager advised Pritesh to liquidate the position because it was too concentrated. A day after Pritesh liquidated, a natural disaster occurred. The position benefited from this disaster and went from $10 to $250 in an hour. Unfortunately, Pritesh could have earned so much if only he had not liquidated.
Lessons learnedStay grounded between the highs and the lows. Ultimately, you’ll be fine if you make decisions that align with what you believe in. This can give you a sense of confidence and conviction in your decisions.
Pritesh’s recommendationsPritesh recommends building systems, processes, or resources that suit your risk appetite, emotional intelligence, and patience. This can enhance your decision-making and risk management, as it aligns with your personal attributes.
No.1 goal for the next 12 monthsPritesh’s number one goal for the next 12 months is to have repeatable, scalable processes for his go-to-market and use that to make an impact globally.
Parting words“Remember, it’s a marathon, not a sprint.”Pritesh Ruparel
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Connect with Pritesh RuparelIn this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 13: Between a Rock and a Hard Place.
LEARNING: Past performance is not a strong predictor of future performance.
“If you must invest actively, find active funds that design their strategies more intelligently to take advantage of the problems and at least avoid pitfalls.”Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 13: Between a Rock and a Hard Place.
Chapter 13: Between a Rock and a Hard PlaceIn this chapter, Larry illustrates why past performance is not a strong predictor of future performance.
Academic research has found that prominent financial advisors, investment policy committees, and pension and retirement plans engage top academic practitioners to help them identify future managers who will outperform the market. Such entities only hire managers with a track record of outperforming. They analyze their performance to see if it is statistically significant.
However, research also shows that, on average, the active managers chosen based on outstanding track records have failed to live up to expectations. The underperformance relative to passive benchmarks invariably leads decision-makers to fire the active manager. And the process begins anew.
A new round of due diligence is performed, and a new manager is selected to replace the poorly performing one. And, almost invariably, the process is repeated a few years later. So whenever pension plans interview Larry and he notices this hiring pattern, he always asks them what their hiring process is and what they’re doing differently this time since, you know, the same process failed persistently, causing regular turnover of managers. Nobody has ever answered that question.
According to Larry, many individual investors go through the same motions of picking a manager and end up with the same results—a high likelihood of poor performance.
Doing the same thing over and over expecting a different result is insanityLarry observes that the conventional wisdom that past performance is a strong predictor of future performance is so firmly ingrained in our culture that it seems almost no one stops to ask if it is correct, even in the face of persistent failure. Larry wonders why investors aren’t asking themselves: “If the process I used to choose a manager that would deliver outperformance failed, and I use the same process the next time, why should I expect anything but failure the next time?”
The answer is painfully apparent. If you don’t do anything different, you should expect the same result. Yet, so many investors do not ask this simple question.
Larry insists that it is essential to understand that neither the purveyors of active management nor the gatekeepers want you to ask that question. If you did, they would go out of business. You, on the other hand, should ask that question. You must provide the best returns to yourself or to members of the plan for which you are a trustee, not to give the fund managers or consultants a living.
Break the cycle of repeating past mistakesLarry urges investors to reconsider their approach. The odds of selecting active managers who will outperform on a risk-adjusted basis over the long term are so poor that it’s not prudent to try. However, it doesn’t have to be that way. Investors would benefit from George Santayana’s advice: “Those who cannot remember the past are condemned to repeat it.”
Anyone who insists on hiring active managers should look for a manager with low costs, low turnover, no style drifting, systematic strategies, and broad diversification (i.e., investing in a wide range of assets to spread risk). You are better off trading with a fund that owns hundreds of stocks because that narrows the dispersion of outcomes, which means you’re taking less risk.
Further readingLarry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
[spp-transcript]
Connect with Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 12: Outfoxing the Box.
LEARNING: You don’t have to engage in active investing; instead, accept market returns by investing passively.
“You don’t have to play the game of active investing. You don’t have to try to overcome abysmal odds—odds that make the crap tables at Las Vegas seem appealing. Instead, you can outfox the box and accept market returns by investing passively.”Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 12: Outfoxing the Box.
Chapter 12: Outfoxing the BoxIn this chapter, Larry aims to guide investors toward a winning investment strategy: accepting market returns. He uses Bill Schultheis’s “Outfoxing the Box.” This is a simple game that you can choose to either play or not play. The box contains nine percentages, each representing a rate of return your financial assets are guaranteed to earn for the rest of your life.
As an investor, you have the following choice: Accept the 10 percent rate of return in the center box or be asked to leave the room. The boxes will be shuffled around, and you will have to choose a box, not knowing what return each box holds. You quickly calculate that the average return of the other eight boxes is 10 percent.
Thus, if thousands of people played the game and each chose a box, the expected average return would be the same as if they all decided not to play. Of course, some would earn a return of negative 3 percent per annum, while others would earn 23 percent. This is like the world of investing: if you choose an actively managed fund and the market returns 10 percent, you might be lucky and earn as much as 23 percent per annum, or you might be unlucky and lose 3 percent per annum. A rational risk-averse investor should logically decide to “outfox the box” and accept the average (market) return of 10 percent.
In all the years Larry has been an investment advisor, whenever he presents this game to an investor, not once has an investor chosen to play. Everyone decides to accept par or 10 percent. While they might be willing to spend a dollar on a lottery ticket, they become more prudent in their choice when it comes to investing their life’s savings.
Active investing is a loser’s gameActive investing is a game with low odds of success that many would consider a losing battle. It’s a game that, when compared to the ‘outfoxing the box’ game, seems like a futile endeavor. Larry’s advice is to avoid this game altogether.
In the “outfoxing the box” game, the average return of all choices was the same 10 percent as the 10 percent that would have been earned by choosing not to play. And 50 percent of those choosing to play would be expected to earn an above-average return and 50 percent a below-average return.
In his book The Incredible Shrinking Alpha, Larry shows that the odds are far worse than 50 percent. Today, only about 2 percent of actively managed funds generate statistically significant alphas on a pretax basis. If you would choose not to play a game when you have a 50 percent chance of success, what logic is there in choosing to play a game where the most sophisticated investors have a much higher failure rate? Yet, that is precisely the choice those playing the game of active management are making.
Larry adds that research has shown that even the big institutional investors, with all their resources, fail to outperform appropriate risk-adjusted benchmarks such as the S&P 500. In addition to their other advantages, institutional investors have one other significant advantage over individual investors—their returns are not taxable. However, if your equity investments are in a taxable account, the returns you earn are subject to taxes. The incremental tax cost of active funds further reduces your odds of success.
You don’t have to play the game of active investingLarry’s advice to investors is to avoid trying to overcome abysmal odds—odds that make the crap tables at Las Vegas seem appealing. Instead, he suggests outfoxing the box and accepting market returns by investing passively. Larry quotes Charles Ellis, author of Investment Policy: How to Win the Loser’s Game:
“In investment management, the real opportunity to achieve superior results is not in scrambling to outperform the market, but in establishing and adhering to appropriate investment policies over the long term—policies that position the portfolio to benefit from riding with the main long-term forces in the market.”
Further readingLarry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
[spp-transcript]
Connect with Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 11: The Demon of Chance.
LEARNING: Don’t always attribute skill to success, sometimes it could be just luck.
“Just because there is a correlation doesn’t mean causation. You must be careful not to attribute skill and not luck to success.”Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 11: The Demon of Chance.
Chapter 11: The Demon of ChanceIn this chapter, Larry discusses why investors confuse skill with what he calls “the demon of luck,” a term he uses to describe the random and unpredictable nature of market outcomes.
Larry cautions that before concluding that because an investment strategy worked in the past, it will work in the future, investors should be aware of the uncertainty and ask if there is a rational explanation for the correlation between the outcome and strategy.
According to Larry, the assumption is that while short-term outperformance might be a matter of luck, long-term outperformance must be evidence of skill. However, a basic knowledge of statistics is crucial in understanding that with thousands of money managers playing the game, the odds are that a few, not just one, will produce a long-term performance record.
Today, there are more mutual funds than there are stocks. With so many active managers trying to win, statistical theory shows that it’s expected that some will likely outperform the market. However, beating the market is a zero-sum game before expenses since someone must own all stocks. And, if some group of active managers outperforms the market, there must be another group that underperforms. Therefore, the odds of any specific active manager being successful are, at best, 50/50 (before considering the burden of higher expenses active managers must overcome to outperform a benchmark index fund).
Skill or “the demon of luck?From probability, it’s expected that randomly, half the active managers would outperform in any one year, about one in four to outperform two years in a row, and one in eight to do so three years in a row. Fund managers who outperform for even three years in a row are often declared to be gurus by the financial media. But are they gurus, or is it just luck? According to Larry, it is hard to tell the difference between the two. Without this knowledge of statistics investors are likely to confuse skill with “the demon of luck.”
Bill Miller, the Legg Mason Value Trust manager, was acclaimed as the next Peter Lynch. He managed to do what no current manager has done—beat the S&P 500 Index 15 years in a row (1991–2005). Indeed, that could be luck. You can’t rely on that performance as a predictor of future greatness. Larry turns to academic research to test if this conclusion is correct.
In one example, the Lindner Large-Cap Fund outperformed the S&P 500 Index for 11 years (1974 through 1984). Over the next 18 years, the S&P 500 Index returned 12.6 percent. Believers in past performance as a prologue to future performance were not rewarded for their faith in the Lindner Large-Cap Fund with returns of just 4.1 percent, an underperformance of over 8 percent per annum for 18 years. After outperforming for 11 years in a row, the Lindner Large-Cap Fund beat the S&P 500 in just four of the next 18 years and none of the last nine—quite a price to pay for believing that past performance is a predictor of future performance.
In another example, David Baker’s 44 Wall Street was the top-performing diversified U.S. stock fund over the entire decade of the 1970s—even outperforming the legendary Peter Lynch, who ran Fidelity’s Magellan Fund. Faced with deciding which fund to invest in, why would anyone settle for Peter Lynch when they could have David Baker? Unfortunately, 44 Wall Street ranked as the worst-performing fund of the 1980s, losing 73 percent. During the same period, the S&P 500 grew 17.6 percent per annum. Each dollar invested in Baker’s fund fell to just $0.27. On the other hand, each dollar invested in the S&P 500 Index grew to over $5.
Belief in past performance as a predictor of future performance can be expensiveAs evidenced by the Linder Large-Cap Fund and the 44 Wall Street Fund examples, belief in the “hot hand” and past performance as a predictor of the future performance of actively managed funds and their managers can be pretty expensive. Larry points out that, unfortunately, the financial media and the public quickly assume that superior performance results from skill rather than the more likely assumption that it was a random outcome. The reason is that noise sells, and the financial media is in the business of selling. They are not in the business of providing prudent investment advice.
Larry concludes that while there will likely be future Peter Lynchs and Bill Millers, investors cannot identify them ahead of time. Also, unfortunately, investors can only buy future performance, not past performance. A perfect example of this apparent truism is that in 2006, Miller’s streak was broken as the Legg Mason Value Trust underperformed the S&P 500 Index by almost 10 percent. The fund’s performance was so poor that its cumulative three-year returns trailed the S&P 500 Index by 2.8 percent annually. This further proves that it is tough to tell whether past performance resulted from skill or the “demon of luck.”
Remember that relying on past performance as a guide to the future might lead you to invest with the next Peter Lynch, just as it might lead you to invest with the next David Baker. That is a risk that a prudent, risk-averse investor (probably you) should not be willing to accept.
Further readingLarry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
[spp-transcript]
Connect with Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 10: When Even the Best Aren’t Likely to Win the Game.
LEARNING: Refrain from the futile pursuit of trying to beat the market.
“Only play the game of active management if you can truly identify an advantage you have, like inside information, but you have to be careful because it’s illegal to trade on it. Also, play only if you place a very high value on the entertainment.”Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 10: When Even the Best Aren’t Likely to Win the Game.
Chapter 10: When Even the Best Aren’t Likely to Win the GameIn this chapter, Larry illustrates why individual investors should refrain from the futile pursuit of trying to beat the market.
It seems logical to believe that if anyone could beat the market, it would be the pension plans of the largest U.S. companies. Larry lists a few reasons this is a reasonable assumption:
So, how have the pension plans done in their quest to find the few managers that will persistently beat their benchmark? The evidence is compelling that they should have “taken par.” For example, Richard Ennis’s 2020 study found that public pension plans underperformed their benchmark return by 0.99%, and the endowments underperformed by 1.59%. He also found that of the 46 public pension plans he studied, just one generated statistically significant alpha, compared to the 17 that generated statistically significant negative alphas.
According to the study, the likelihood of underperforming over a decade is 98%.
Another researcher, Charles Ellis, declared that active investing is a loser’s game that is possible to win, but the odds of doing so are so poor that it isn’t prudent to try. In Larry’s opinion, it would be imprudent for you to try to succeed if institutional investors, with far greater resources than you (or your broker or financial advisor), fail with great persistence. This should make you feel cautious and less likely to take unnecessary risks.
Wall Street needs you to play the game of active investingAccording to Larry, Wall Street needs and wants you to play the game of active investing. They need you to try to beat par. They know that your odds of success are so low that it is not in your interest to play. But they need you to play so that they (not you) make the most money. They make it by charging high fees for active management that persistently delivers poor performance.
Larry insists that the only logical reason to play the game of active investing is that you place a high entertainment value on the effort. For some people, there might be another reason—they enjoy the bragging rights if they win. Of course, you rarely, if ever, hear when they lose. Investing, however, was never meant to be exciting. Wall Street and the media created that myth. Instead, it is intended to provide you with the greatest odds of achieving your financial and life goals with the least risk. That is what differentiates investing from speculating (gambling).
Further readingLarry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
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Connect with Larry Swedroe
BIO: Andrew Pek is a co-founder of Amiko XR Inc., a groundbreaking company that leverages VR and AI technologies to create immersive, personalized learning experiences available 24/7.
STORY: Andrew shared his worst investment ever story on episode 376: Build Revenue in Your Startup Before You Build Up Cost. Today, he discusses his new business.
LEARNING: Learning can be more immersive, sparking curiosity and excitement.
“Thank you so much, Andrew, for having me on your podcast. It’s great to see you. I am excited about the future.”Andrew Pek
Guest profile
Andrew Pek is a co-founder of Amiko XR Inc., a groundbreaking company that leverages VR and AI technologies to create immersive, personalized learning experiences available 24/7. He is a recognized C-Suite advisor on innovation and human transformation. Andrew’s insights on leadership and design thinking have been featured in prominent media outlets such as ABC, NBC, Forbes, and Entrepreneur.
Andrew shared his worst investment ever story on episode 376: Build Revenue in Your Startup Before You Build Up Cost. Today, he discusses his new business.
Worst investment everMuch of Andrew’s work has involved teaching leadership, innovation, product design, and business development skills. He’s always seeking new ways that technology can engage people to absorb learning and become more engaged—not just a boring, traditional training program, but something that would really involve learners in a more immersive way, sparking their curiosity and excitement.
Andrew and his team successfully prototyped a solution in which learners get an immersive learning experience through a headset and talk to a coach avatar who can teach just about anything.
So, if you’re interested in finance, investing, sales, leadership, career preparation, and just about any topic matter, you’ll find it on the app. This includes job-related skills, general management and leadership courses, and personal development topics.
You can obtain information at your fingertips through generative AI and large language models. What sets the application apart is the combination of artificial intelligence and a VR experience. Through simulations, role plays, or evaluation, learners can master any particular topic or get support in any particular challenge. Unlike mobile device applications, VR experiences significantly reduce distractions, leading to more focused and practical engagement.
The solution is also unique because it is curated and configured to the expert level. You teach the avatar, and the avatar then teaches others. It ingests your content to become a master in your subject and attain the same level of intelligence as you.
Learners who use the solution talk to someone as if they’re talking to you in an interactive, dynamic environment. If something is unclear or learners want to probe further or even get additional guidance or resources, the solution will facilitate that. Learners get videos and information transcripts and don’t have to take notes.
Andrew’s solution is a smart choice for mid-to-large-sized corporations or even smaller corporations that can’t afford expensive training or trainers. It’s a cost-effective solution for those looking to provide any training, such as onboarding new employees. Employees can use the application on an ongoing basis to access courses specific to their job or general management leadership courses, just like they’d access a course library, but at the convenience of their homes.
Most people nowadays are spending time at home or in the office. With this solution, they don’t have to worry about entering the physical space for an immersive learning experience. Unlike gaming, they can do that sitting on their couch without moving around, so you don’t have to worry about getting dizzy when using VR. It’s a much more stationary experience.
If you’re interested in understanding how Andrew’s solution can help your organization, check out amikoxr.com or contact Andrew at [email protected].
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Connect with Andrew Pek
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 09: The Fed Model and the Money Illusion.
LEARNING: Just because there is a correlation doesn’t mean that there’s causation.
“Just because there is a correlation doesn’t mean that there’s causation. The mere existence of a correlation doesn’t necessarily give it predictive value.”Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 09: The Fed Model and the Money Illusion.
Chapter 09: The Fed Model and the Money IllusionIn this chapter, Larry illustrates why the Fed Model should not be used to determine whether the market is at fair value and that the E/P ratio is a much better predictor of future real returns.
The FED modelThe stock and bond markets are filled with wrongheaded data mining. David Leinweber of First Quadrant famously illustrated this point with what he called “stupid data miner tricks.”
Leinweber sifted through a United Nations CD-ROM and discovered the single best predictor of the S&P 500 Index had been butter production in Bangladesh. His example perfectly illustrates that a correlation’s mere existence doesn’t necessarily give it predictive value. Some logical reason for the correlation is required for it to have credibility. Without a logical reason, the correlation is just a mere illusion.
According to Larry, the “money illusion” has the potential to create investment mistakes. It relates to one of the most popular indicators used by investors to determine whether the market is under or overvalued—what is known as “the Fed Model.”
The Federal Reserve was using the Fed model to determine if the market was fairly valued and how attractive stocks were priced relative to bonds. Using the “logic” that bonds and stocks are competing instruments, the model uses the yield on the 10-year Treasury bond to calculate “fair value,” comparing that rate to the earnings-price, or E/P, ratio (the inverse of the popular price-to-earnings, or P/E, ratio).
Larry points out two major problems with the Fed Model. The first relates to how the model is used by many investors. Edward Yardeni, at the time a market strategist for Morgan, Grenfell & Co. speculated that the Federal Reserve used the model to compare the valuation of stocks relative to bonds as competing instruments.
The model says nothing about absolute expected returns. Thus, stocks, using the Fed Model, might be priced under fair value relative to bonds, and they can have either high or low expected returns. The expected return of stocks is not determined by their relative value to bonds.
Instead, the expected real return is determined by the current dividend yield plus the expected real growth in dividends. To get the estimated nominal return, estimated inflation must be added. This is a critical point that seems to be lost on many investors. This leaves a trail of disappointed investors who believe low interest rates justify a high valuation for stocks without the high valuation impacting expected returns. The reality is that when P/Es are high, expected returns are low, and vice versa, regardless of the level of interest rates.
The second problem with the Fed Model, leading to a false conclusion, is that it fails to consider that inflation impacts corporate earnings differently than it does the return on fixed-income instruments.
Over the long term, the nominal growth rate of corporate earnings has been in line with the nominal growth rate of the economy. Similarly, the real growth rate of corporate earnings has been in line with the real growth of the economy. Thus, in the long term, the real growth rate of earnings is not impacted by inflation.
On the other hand, the yield to maturity on a 10-year bond is a nominal return—to get the real return, you must subtract inflation. The error of comparing a number that isn’t impacted by inflation to one that is, leads to the money illusion.
Understand how the money illusion is createdUnderstanding how the money illusion is created will prevent you from believing an environment of low interest rates allows for either high valuations or high future stock returns. Instead, if the current level of prices is high (a high P/E ratio), that should lead you to conclude that future returns to equities are likely to be lower than has historically been the case and vice versa. This doesn’t mean investors should avoid equities because they are highly valued or increase their allocations because they have low valuations.
Further readingLarry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
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Connect with Larry Swedroe
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