The Scientific Investor: Larry Swedroe

Our guest on this episode was one of the first people to coin and use the phrase evidence-based investing. Larry Swedroe is an investment expert and a prolific author. He is a strong proponent of index funds, factor-based strategies, and the benefits of long-term, disciplined investing. 

In this episode you will learn the following:

• Why trading stocks is much more competitive than people imagine. 
• A behavior in investing that may harm returns more than any other.
• Why patience and discipline are important in investing.
• And tips on how to choose a suitable advisor.

Transcript

LARRY SWEDROE - How to enrich your future

ROBIN: Here at Index Fund Advisors, we are advocates for what is often called evidence-based investing. Our guest on this episode was one of the first people to coin and use that phrase. Larry Suedro is an investment expert and prolific author. He is a strong proponent of index funds, factor based strategies, and the benefits of long term disciplined investing.

In this episode, Larry Suedro explains why trading stocks is far more competitive than most people imagine. 

LARRY: The problem is the competition in investing. Its entirely different. You're competing against what's called the collective wisdom of the crowd. That's been shown to be the best predictor of what is actually the right price.

ROBIN: He pinpoints a behavior that possibly harms returns more than any other. 

LARRY: Simply an all too human trait. To be overconfident. Being overconfident on your investment skills is particularly dangerous because you're likely to take too much risk and that can lead to big problems and you're likely to concentrate in a very few stocks because you know you can pick the future winners.

ROBIN: Larry explains why patience and discipline are so important. They're all long period. 

LARRY: When every single risk asset and strategy in the world is going to underperform. In the U. S. Robin, there are three periods of at least 13 years where the S& P 500 is underperformed, totally riskless, one month treasury debt.

But you have to be there to earn those great returns. 

ROBIN: And he gives us tips on choosing a suitable advisor. 

LARRY: You should demand to see their custodian statement showing you that they are investing in exactly the same vehicle that you're investing in. Now, their portfolio is likely to be very different because their ability, willingness, and need to take risks should be the same.

Uh, and could be very different. But they should own the same vehicle. And if they're not, that's a sure sign.

ROBIN: If you're fed up with financial salespeople and want to find out what the peer reviewed academic evidence tells us about how to invest, you need to watch or listen to this episode. Here, then, is my interview with Larry Swedron.

Larry, you've written many books. On investing over the years, the latest is called Enrich Your Future, The Keys to Successful Investing. I love the quote you start the book with. If you tell me a fact I learn, tell me a truth and I'll believe, but tell me a good story and it will live in my heart forever.

For me, that encapsulates the challenge the likes of you and I have in trying to encourage investors to focus on data and evidence. It's not easy, is it? Our brains just aren't wired like that, are they? 

LARRY: Absolutely. I, somebody, I don't remember who it was very early in my career. told me that quote, uh, and, uh, as, uh, someone whose objective is to try to teach or educate investors so they can make the most informed decisions, not ones that the media or the investment industry want you to make based upon false premises, uh, so I tried to write books.

That would, uh, you know, tell a story, use an analogy to make a difficult concept, easy to understand. And one of the biggest helpers for me early on was my wife. Uh, you know, she's a very bright woman, has a master's degree, uh, in career counseling. But she knows nothing about investing, just in the same way that I think I'm intelligent.

I graduated at the top of my school from one of the better NYU, uh, one of the better MBA programs in the country at NYU. But I know nothing about nuclear physics. My wife and three daughters tell me women is another subject I know very little about. Uh, so there's a difference between intelligence and knowledge, right?

Uh, Uh, so what I try to do is whenever I was trying to communicate a point, I'd have my wife read the, the, uh, analysis and she would tell me whether it worked or not. So a good example early on. Is if you know anything about cooking or baking, you want to make, say a cookie sweet, people would probably guess that you should add sugar, but adding salt, which is not sweet can actually make a cookie sweeter.

So it's how adding an asset class to a portfolio can change the risk of the overall portfolio, so even a risky asset, if it has low or negative correlations. Can actually reduce the risk of a portfolio. So my books are filled with analogies to cooking and gardening and movies and history and sports betting to help people understand what is often a difficult, uh, concept.

ROBIN: Enrich Your Future breaks down into four parts, and you devote the first part to explaining how security prices are determined and why it's so difficult to outperform. This is a huge subject. Many of our viewers and listeners will be familiar with it already, but it's so important we need to spell out these fundamental principles.

Larry, why is beating the market so hard to do? 

LARRY: Well, first of all, uh, trying to beat the market is a very different form of competition than the way most people think of competition. For example, I'm a pretty high, uh, 3 5 level tennis player, so that's like a pretty good weekend player. Uh, if I play a 4 0 player, who's just a little bit better than me, on occasion I will win, but they might win 7 or 8 or 9 out of 10 matches.

Uh, because small differences in skill can lead to big differences in outcome. A great example, uh, that I think I used in the book, you might take Roger Federer, who many people consider the greatest tennis player of all time. And when Roger played in the, I think in a Grand Slam tournament, famously, he never lost the first round match.

I'm not sure he lost the second round match. But by the time he got to the quarterfinals, right, you're playing against likely the other seven best players in the world. Because there are eight players left. And when you're So maybe he would lose You know, 30 percent of the time or 25 percent of the time.

And when he got to the semis, he might win only 60 percent and lose 40. And when he got to the finals, maybe one 55%, something like that. So you could see, if you're a top 100 player in the world, that's who's playing in these tournaments, you're obviously a fantastic player. Uh, but the small differences in skill between Federer and the next generation of players, and the next level of players, means that he will win dramatically.

The problem is the competition and investing is entirely different. For example, if you or I were competing, say, against Warren Buffett, or Peter Lynch, or some high frequency trader, they would be able to destroy us, if you will, and outperform likely. The problem is, when we're trying to beat the market, you're competing against what's called the collective wisdom of the crowd.

with each person weighing in. Some people underestimate a value of a particular stock. Some will overestimate the value, but collectively that's been shown to be the best predictor of what is actually the right price. The collective wisdom of crowds. So the first thing you need to understand is that level of competition is much different.

Second thing you need to understand is that the competition is getting harder and harder and harder to outperform something, Andrew Birkin and I. Discussed in our book the incredible shrinking alpha, which I would urge your listeners to read if you think you're likely to outperform Uh, if you go back to the end of world war ii in the US 90 of all stocks were owned by people like me in our individual Brokerage accounts and we were accounting therefore for the obviously the vast vast majority of all the trading. So warren buffett when he was competing And he was buying or selling, the odds were 90 percent plus that I was on the other side or some other individual investor.

He was more sophisticated and he could easily outperform. Today, the percentage of trading done by individual investors is down to around 10%. That means when Warren Buffett is trading, 90 percent of the time, he's trading against the Peter Lynch's of the world, the renaissance technologies of the world, Apollo's and Blackstone's and Blackrock and all these other highly sophisticated traders who have engaged great greatest minds in the world because they can pay them lots of money, uh, and they have access to the best databases and the fastest computers.

You know, they're the competition is now much harder. And what's happened is a third factor. You have to think about that passive investing or indexing or not trying to outperform through stock selection or market timing has gained market share. Now, a lot of people said that would make it easier for active managers to win, right?

Because there is less price discovery is the term. Less trying to find a mispriced security. The exact opposite is actually the truth. And the reason is you have to think about, uh, which investors are exiting the indexing strategy. So, let's take, there are two groups of active investors, ones that have outperformed, either skill or luck.

Uh, eventually over a long period of time, luck likely runs out. So a long enough time, the ones who have outperformed that skill. And on the other side, the ones who have underperformed either bad luck or they're just not sophisticated. Right? Which group of those investors is likely to drop out? It's the ones, of course, that underperform, so you're left with the outperformers, meaning the competition is getting harder.

There are fewer suckers, if you will, that you can exploit because it's a zero sum game even before expenses. You need suckers who you can exploit in order to outperform. So that's become another problem, uh, for, it is there. The last point I would make is this, and this is probably the biggest mistake, besides overconfidence that people make, is they fail to understand the difference between information and what I call value added information.

So whenever somebody is in a discussion with me and they Say I want to buy some individual stock. I say, okay, give me the reasons why I'm assuming you're intelligent You've done your a lot of research not just read some baron's article Uh, which of course means everybody knows everything that's in that article and it should be built into the price But you've done your due diligence And you've read all the research.

Maybe you even got to interview the people at the company. All right. And so you go through a long list. Great management team, great new product pipeline, you know, strong balance sheet, you know, you can go on and on. And I listen, I say, okay, let's for the moment and assume all those things are true and accurate.

Now, tell me, are you the only one who knows these things, or do you think the Warren Buffetts and Peter Lynch's and the money managers at J. P. Morgan and Morgan Stanley and Vanguard, who are also trying to outperform and are spending 100 percent of their time, have greater access to the information than you do?

Better computers and using artificial intelligence now to analyze up. You don't have the resources for If you think a stock that's trading at 50 and you're buying it because you think it's undervalued And it should be worth 60 Do you think all the traders at J. P. Morgan and the others are sitting on their hands watching a trade at 50 when they know it's 60?

Of course, they'd be buying it and the price would be 60. So the answer, you have to ask yourself, what do I know that they don't know? They're smarter than me. They have better access to data. If I don't have an advantage like inside information, and Martha Stewart found out what happens when you try to trade on that, or at least can happen, uh, then it doesn't matter.

It's already built into the price. So knowing a company is a great company. doesn't do you any good whatsoever unless it is mispriced by all the rest of the competition in the market. 

ROBIN: So beating the market in the long run, either by security selection or market timing, is a very tall order. What are the implications then for ordinary investors?

LARRY: Yeah, what I try to educate people is investing is a positive sum game. Minus, you know, because there are risk premiums, it doesn't mean you will have a positive return. But the expectation is, over the long term, stocks have provided, historically, about a 7 percent risk premium to treasury bills. They're, in the U.S., that's their riskless investment. It's not a guarantee that that will happen. In fact, uh, one of the things I try to teach people is that there are long periods. When every single risk asset and strategy in the world is going to underperform. In the U. S., Robin, there are three periods of at least 13 years where the S& P 500 has underperformed totally riskless one month Treasury bills.

15 years from 29 to 43. 17 years from 66 to 82, and more recently, the 13 years from 2000 to 12. That's 45 out of the last 96 years, almost half the time you have to wait at least 13 years just to outperform T-bills. Of course, that means in the other 55 percent of the time or whatever, they got tremendous returns, right?

But you have to be there to earn those great returns. So, one thing is Understand that every risk assets, whether it's growth stocks, value stocks, S and P 500, emerging markets, developed markets, reinsurance, it doesn't matter what the risk asset is. There, it must be true that there will be long periods of a decade or longer that an asset will underperform because if it wasn't true, Well, you have to sit and wait for five or six years and you'll get outperformed.

So the reason you have high returns, especially in risky assets, is there's a lot of risk. It may never show up. All right. A couple of other points I try to teach people is this. Even professional investors who have skill, they are better investors than you are. The problem is they have the disadvantage of costs.

One, you're going to pay them for their skill, so you're paying the expense ratio of their fund. And two, they have trading costs, which are much higher than the trading costs if you're an active investor. When you have success, you have market impact costs, because you're managing a large amount of money.

Today Because there are no more market makers, as there were 40, 50, 30 years ago, who would stand to buy, say, 10, 000 or 50, 000 shares at a price, because there were big spreads of maybe a quarter, half a point, or even more. Today, bid offer spreads are tiny, 1 cent, 2 cent, maybe a bit more for penny type stocks.

But that's only good for maybe 100 shares. Because there is nobody willing and able to take the risk because there's no spread anymore. So the high frequency traders exploit that. And so when you're managing a large amount of money, you have diseconomies of scale. So you have successful active managers.

Retail investors naively believe, despite all the evidence that you and I have written about, that past performance tells you virtually nothing about future performance. They, money rushes in because they believe it does. And then you get this economies of scale. So here's the data. The app, there've been studies done that show the average actively managed fund outperforms by its stock picking by about 70 basis points.

I was a famous study done by a fellow named Russ Wormers around the year 2000 or so. The problem was their total costs, including the fact that they sit on cash. Uh, they have bid offer spreads and their expense ratios. Uh, we're about, uh, I think something on the order of 220. So the net lost about 150 basis point, uh, there.

Now, the individual investor has an advantage because there may be trading much smaller amounts. They don't have an expense ratio. Okay. So when they're buying individual stocks, but now you're disadvantaged because you don't have the knowledge. Of the other players and the stocks that individual investors buy on average go on to underperform after they buy them and go on to outperform after they sell them.

And that's exactly what a rational person should expect because when you're trading, as we said, there's a 90 percent chance on the other side. is some highly sophisticated investor today and they have advantages over you. So that's one reason you shouldn't try to pick stocks and time the market. The last one that I will mention is this.

And this is a shocking, uh, bit of data, I think, for most investors. Uh, Heinrich Bessembinder did investors a great favor in a series of studies he's done. Well, what he showed is. Uh, while the stocks on average have provided a 10 percent return, okay, the median return is well below that. The mean is 10. It costs only 4%.

Of all the stocks that ever been around account for 100% of the equity risk premium, which we said was seven of the 10. What you have to ask yourself, what are the odds that you could pick them and then hold them long enough so it becomes the next Microsoft or Google. Uh, and you got those and you get out before they disappear.

And there are great returns like that many people did earn in Kodak or Polaroid. Those companies are gone. They're bankrupt. These are once great nifty 50 companies. And they're gone, or Enron, right? So their returns went to zero, or actually minus 100 percent over the long term. So, that's the problem. You, here's the data, because the median is below the mean.

The more stocks you own, the more diversified you are, the odds are that you'll earn the mean. You'll get closer and closer to the mean, which tells you, the average investor, without any sophisticated knowledge, It's highly likely to outperform sophisticated investors that just buy and hold the market in the lowest cost index fund.

Uh, so. 

ROBIN: I know you're a big sports fan, Larry, especially baseball, and you often liken active investing, picking stocks or funds, for example, to sports betting. Why would you say that's a fair analogy? 

LARRY: Yeah, there's several studies on this subject, uh, uh, and they look at a vast variety of sports, not just baseball or, um, I'll mention a famous study, uh, done about basketball.

So basketball now worldwide sports, so hopefully everyone will get the analogy here. It's very often easy. To identify the better team. Okay. In the U S big time betting goes on all the time in college basketball. So a perennial contender for the national championship every year. One of the best teams say is Duke university.

Uh, they're ranked, I think currently as the fifth best team in the country. And let's say they're playing Kansas, who was ranked the number one team. It's pretty hard to know who's going to win. The point spread would reflect that as well, and I'll get to that in a moment. But early on in the season, Duke and most good teams schedule what are called cupcake games.

They, they want to get their teams ready and they want to be able to play a lot of the different players to get them some experience. And so Duke is playing some school called Upstate South Carolina, which has zero chance virtue of winning. They could play a hundred times, they'll never win. So sometimes it's easy to identify who's going to win, Kansas playing Duke, it's hard, sometimes it's easy.

Well, if it's easy to identify a winner because you can identify a better team because they have better athletes, better coaching, better, you know, much taller players, quicker, better shooters, whatever, right? How come we don't know anyone? I you can virtually guarantee none of us knows anyone who's gotten rich betting on sports Although such a person might exist.

It's certainly a rare animal uh, right It's because the you can't bet on duke to beat upstate south carolina. You might have to give 30 points. Now, what do we mean by that? So Duke, if you want to bet on Duke, you give away 30 points and you put up a hundred dollars. And by the way, if you win. You, uh, the bookies take some of the vigorous, all right, uh, so you don't get a hundred dollars, right, back, uh, when, when you bet, right, the bookies are taking some of it.

So there is a bit of a spread just like the casino takes out of every pot on the poker tables as well. So you have to bet a hundred and ten, say, to win a hundred, okay. Uh, so that's one cost, and you could consider that the cost of trading with stocks as well. Alright? But, you have to give away that 30 points.

So let's say Duke ends up winning the game 80 to 51. So Duke won the game, but we have to add 30 points in terms of looking to see who won the bet. And now the other team has 81 points, and if you bet on Duke to win, you lost the bet. Okay, it turns out the point spread is what is called an unbiased predictor.

It doesn't tell you it's Point spread is likely to be 30 points. There's a wide dispersion of possible outcomes there, okay? But a study on the National Basketball Association showed that over, I think they did it over several seasons, like 10, 000 games were played. The average error from the point spread So if you predicted a point spread of 5, let's say that was the Las Vegas betting line, was 5, and it ended up at 10, that was a plus 5 error.

If it ended up at only 2, it was a minus 3. So over 10, 000 games, you add up the errors. The average error was less than one quarter of one point, which is why we don't have people getting rich in sport. It's that collective wisdom of the crowd. Somebody went to Duke, and they're rooting for them, so they overvalue Duke or are overconfident about them, and somebody went to the other school and roots for them.

Or somebody always bets on the underdogs. This is held true, Robin, in every sport. My mother used to love to go to the racetrack. She never bet March 2 on, and you could do that in those days. And she always bet on number three in the first race. Why? Because she had three children, had nothing to do with that.

While my father studied all the charts and their times and everything else, whether they ran better from the inside or outside, or whether they mudders or hard turf, whatever, you know. Here's what the data shows. A three to one favorite wins one out of four races. Virtually identical. The favorites win the most, a hundred to one.

You know, underdog wins roughly that amount. Uh, there is some evidence of a little bit of predictability because people overrate, love to play the really long shot. Okay, so a hundred to one favorite maybe wins only a hundred, one out of every hundred and ten times. But it's hard to exploit them because you still have the cost of that trading.

Same thing applies then. In this collective wisdom of Mark.

MARK: Hi, I'm Mark Hebner. And thank you for watching or listening to Scientific Investor, which is brought to you by Index Fund Advisors. When I founded IFA. com 25 years ago, one of my goals was to educate people about how financial markets work. I wanted them to stop speculating and start investing. And that remains an important part of my mission today.

You'll find a wealth of high quality content on our website, on our app, in my book, and on our YouTube channel. Please take a look and share our videos and articles with others you think would benefit. And together, we can help change the way the world invests.

ROBIN: There's a human tendency, isn't there, to attribute good outcomes to good decision making. But as you've said many times, good investment outcomes are often, perhaps even usually, down to luck. If genuine skill among fund managers is so rare, why do you think so many investors, and indeed so many financial journalists, under the impression that you can identify that skill?

LARRY: Well, it is certainly possible. We all agree. And you know, you said that these professionals aren't skilled. I actually said exactly the opposite. They are highly skilled. The problem is the competition is people with equal skill to them and the collective wisdom of the crowds makes it difficult to overcome that.

The question is why do individual investors believe they can either outperform by predicting who will be the future great managers, so you hire them based on your past performance. So let's touch on that and then we'll come back to the other issue of overconfidence. So studies have been done, many of them.

on pension plans, endowments, uh, that have tens of even hundreds of billions of dollars in some cases. And they not only can hire great managers, okay, they hire world class consultants, uh, you know, like Russell, uh, Frank Russell, well known name and others to help them like Goldman Sachs is in that business.

And to help them identify SEI is another name, you know, there are tons of these consultants that get paid to identify the future. Now I think Robin, you and I can agree the people they hire, like those at SEI Russell are smart. They probably have MBAs, PhDs in finance, highly skilled in math. They certainly would never recommend a fund manager without doing a tremendous amount of due diligence.

Checking their track records, right? Making sure it wasn't just a lucky period, right? Uh, and look at, you know, upside risk versus downside risk, you know. Did they avoid the really bad periods but sacrifice a bit on the ups? You could think of a million metrics. And you can be sure they've all thought of that.

The studies show that the funds they recommend go on to underperform the very funds that they fired. And what I try to point out is this. This is what Einstein supposedly said is the definition of insanity. Because I asked him, what are you doing differently this time? To identify the future manager outperform that you didn't do last time, because obviously those things didn't work and you keep hiring and firing managers, the turnover rate is very high, looking at three and even five years of performance.

And the answer is, I always get this, never once did I get an answer that here's what I'm doing, they would go like this. Not there was no answer. And so that's a real problem. Why do people ignore that? The only logical answers are twofold. One, they're unaware of the evidence. So obviously anyone who's now either read my books or your articles or listened to this podcast no longer has that excuse.

But the other is this. It's simply an all too human trait to be overconfident. Uh, it doesn't matter. All kinds of studies have been done. For example, famous study done on drivers and they asked them, are you a better than average driver? And 80 to 90 percent say yes. Now, the interesting thing in one of these studies, the drivers that participate in the study were in the hospital having just been in a car accident and still 80 to 90%.

So it doesn't matter if you ask people, are you a better than average lover? They'll 80 to 90 percent will say yes. Obviously, you can't be more than 50 percent overconfidence is actually a very good thing for life. If you weren't overconfident, just think there'd be no new businesses started because we know something like 90 percent of them fail, they go bankrupt pretty quickly often, right?

So it's good. We wouldn't have all this innovation and great company successes. Right? And imagine, Robin, if you got up, you know, in the morning, looked in the mirror and said, I'm dumb, ugly, stupid, and nobody likes me. Well, the suicide rate would be high. So, it's okay to be overconfident and think everyone likes you and you're handsome and, you know, and really smart.

It makes you feel good about yourself and able to get through life in a much better way. But being overconfident On your investment skills is particularly dangerous because you're likely to take too much risk and that can lead to big problems. And you're likely to concentrate in a very few stocks because, you know, you can pick the future winners when we just discussed before how extremely difficult it is to do that. 

ROBIN: In the book, you borrow a phrase from Charlie Ellis, the loser's game. You explain how traditional investing is like a game that the fund industry wants you to play, but warn that you're highly unlikely to win. What do you mean by that? 

LARRY: Yeah, so first of all, uh, Ellis, when he used that term, wasn't saying, and I don't say, that the people who are playing the game are losers.

It's a loser's game, meaning the odds of winning are so low, it's not prudent to try. It doesn't mean you can't win. You could get rich by taking your IRA or in the U. S., your bank account, and go to the racetrack and bet on the horses, or go to the casinos. Or buy lottery tickets. It's certainly possible to win and get rich doing that.

But, obviously, sophisticated people leave that to a small entertainment account, if they do it at all, because it's not financially rational. It may be emotionally or psychologically rational, because you enjoy, you know, going to the racetrack or trying to pick the horses, but you wouldn't try to, you know, retire, uh, using that as an investment strategy.

So that's the, you know, one really big, uh, issue there. The second thing is, again, they don't know the data, Robin, and here's just to be specific. When Ellis wrote his book, he called it the loser's game because when he wrote it in 1998, about 20 percent of active managers were outperforming the market on a statistically significant So, I don't know about you, but I don't like to play games where the odds are 80 percent against me before taxes.

Because taxes are the largest expense for taxable investors. Maybe that 20 was only 10%. However, for the reasons we discussed earlier, uh, trying to beat the market has become more and more difficult because the competition. It's gotten much tougher. The losers are dropping out. Information is much more available.

All of the academics have been publishing studies and papers showing how to try to outperform because there are stocks that have certain characteristics or traits that are called factors that have delivered premiums. So, you know, Warren Buffett famously outperformed the market for his first 40 or 50 years because he bought cheap value stocks that were also higher quality today.

You can't outperform the market by buying those stocks because those papers have been published. And now everyone can buy them in an index type of fund or a smart beta, although I hate that term, fund that gains exposure to all of the stocks with those characteristics without trying to identify them.

By 2010, so just 12 years after Ellis published his book, Uh, Ken French and Gene Fama did a famous study and found that that 20 percent pre tax had dropped to 2%, meaning about one after taxes. So again, 98 percent odds, even if you're a tax advantage investor. Is not a good strategy when you have those odds of winning and other studies have replicated that.

So the winning strategy, if you want to try to outperform the overall market, is to learn which factors or characteristics or traits Have a tendency to outperform. And I wrote a book with Andy Birkin called your, called your complete guide to factor based investor. But I have to point out that those strategies, every one of them, for the reasons I mentioned earlier, go through long periods of underperformance value, which had outperformed, you know, right through the mid nineties.

Right. Ben horribly underperformed and Buffett was criticized. You know, he was a new era and he wasn't investing in these dot com stocks and he far underperformed in the second half of the nineties. And then you had that bubble burst and the next eight years with the biggest value premium in history.

But since then, there's been very little, if any, value premium. So you got 15, 16 years now of that happening. But the same thing is true, I point out. Here's a great example, Robin. I think even this will shock you if you're not aware. 1969 through 08, U. S. large and small growth stocks underperformed 20 year Treasury bonds.

Which is the riskless events investment for a state pension plan or as nominal obligations. That's 40 years where both large and growth stocks underperformed. So the key to being successful is sticking with whatever strategy you're going to do and rebalance your portfolio, not panic and sell. Uh, and abandon this strategy because it's gone through a period of three or five or ten years where it underperformed.

ROBIN: So you can either adopt what we might call the factor based approach, tilting your portfolio towards factors such as size, value, and profitability, which academics have identified as drivers of market beating returns in the past. Or on the other hand, you could simply have a market cap weighted approach and invest in a diversified portfolio of traditional index funds.

Are both of those good options, Larry? Is one better than the other? And is there a case for combining the two in the same strategy? 

LARRY: Well, the way I would answer it is this, in my opinion, based on now 28 years of experience in working with investors and advisors alike, there is no right portfolio except the one that you are most likely to stick with.

Okay, so I just mentioned we've gone through a 15 year period where value has underperformed. Not every year in that period, but over that period it's underperformed, and in the most recent few years it's severely underperformed. So if you decided, because you read my book or, you know, read Warren Buffett and said buy value stocks, Buffett has underperformed the market.

Even on a risk adjusted basis, accounting for factor exposure for the last 16 years. Why? Because the markets become so difficult to beat. Okay, again, so if Buffett isn't likely to win, what are the odds you could do it? That's one thing to keep in mind. So, if you bought a value tilted or a small cap tilted or a small in value tilted portfolio, uh, you know, uh, in the last 15, and now you abandon it, It did you no good.

In the same way, if you did that in 95, watch five years of it underperforming, maybe the largest amount at that point it had ever underperformed, and then you panic and sell, and then you miss the next eight years and say, why did I do that? And you switch again, you end up with the worst of all worlds. So, if you want to put the odds in your favor, then you should tilt to this.

Types of factors or traits that historically, on average, have outperformed. But it's not a free lunch. You have to deal with what's called, in our world, tracking error or tracking variance. I don't like tracking error because it assumes that's a mistake. There's no mistake. You made the decision based on the empirical evidence that over 10 year periods, value will outperform historically about 90 percent of the time.

That's putting the odds in your favor, but it's not a guarantee, okay? Uh, but, if you own, so there you're dealing with that behavioral problem of tracking variance, to accept the fact you're not gonna look like the market, but that's what you want. You made the decision, I don't want to look like the market, I want to own different factors that have diversifying characteristics.

So my portfolio is more likely not to be subject to huge ups and downs. The other side of it is this, Warren. People think you don't have to deal with tracking variance if you just own the total market. I think that's dead wrong. It's a different kind of tracking variance. So, let's say you bought a Vanguard total market fund in 2000, January 1.

Of course, you read Charles Ellis book, or even my books, or Rick Ferry's, uh, books, and you decide, I just want to own the total market. The next eight years, you dramatically underperformed. And you didn't even own international stocks, emerging market stocks, which slaughtered U. S. stocks. So now you say, what did I do?

I should diversify more. Right? So you have a tracking variance of a different kind. So what you have to do is decide, I don't care about tracking variance. I'm going to buy this portfolio because I think it's the one I'm most likely to stick with. Let me give you one other really great example of this.

So I'm a big believer, uh, in a few, and this hopefully is helpful for your listeners. I think there should be three key core principles that everyone should follow when you build portfolio. One, accept the fact the market is highly efficient. Not perfectly so, and therefore, except for if you want to have an entertainment account, that's fine, you know, don't try to beat the market, invest in strategies using your word and mine, systematic, transparent, and replicable, okay, so they could be active in how they define their universe, because Dimensional Fund Advisors, which has A systematic, transparent, replicable, small value fund.

Well, so does AQR, and so does Avantis, and so does Bridgeway, and so does BlackRock, and so does Vanguard. They just define their universes a bit differently, okay? So they're active in how they do that. So you have to decide how much exposure to these factors do you want. A Vanguard fund will give you very little.

but some exposure. A dimensional fund would give you more. But not as much as a bridgeway fund. No right answer. Each of them will do exactly what they want to do Okay, so we want to we believe markets are efficient so we don't buy individual stocks We don't try to time the market and the reason we do that if the market's efficient now Then all risk assets should have very similar risk adjusted return not similar returns But similar risk adjustment.

So historically, small value stocks have outperformed the market by roughly 3. 5 percent a year. Not a guarantee going forward. You're going to put the odds in your favor by doing that, okay? But that three and a half percent a year is not a free lunch. It's because these stocks are riskier. The volatility is certainly something like 60, 70 percent higher than the market, okay?

They're more subject to downside risk. So, on a risk adjusted basis, small value stocks and the market, or large growth stocks, all have the same expected return. Now, if you believe that, Then you should hyper diversify across as many different unique risks as you can identify. Because they all have the same risk adjusted return.

If you own a total market fund, and you're a typical, say, 60 40 investor with 40 percent in, say, a five year safe bond fund, 60 percent of your risk is not in stocks. It's 90%, roughly. And that's because stocks are much riskier than safe bonds. So you want to diversify. 

ROBIN: Now, much of your latest book is about behavioral finance.

As you like to say, we have met the enemy and he or she is us. Explain why that is. 

LARRY: Well, I wrote, I wrote a book called Think, Act and Invest Like Warren Buffett. Uh, the, I think one of the great ironies in life, uh, and in the world of investing Almost everybody idolizes Buffett, considers him certainly one of, if not the greatest investor of all time.

And yet, they tend not only to ignore his advice. They tend to do exactly the opposite when it comes to stock picking and market timing Buffett has said You're better off owning an index fund they for certainly the average investor and he has left his legacy assets and Directed it to go to an S& P 500 index fund and when it comes to timing the market He says you should never try to time the market But if you can't resist You should buy when everyone else is panic selling and sell when everyone else is getting greedy.

Uh, and but people we know do exactly the opposite overconfidence Taking too much risk paying attention to recency. Whatever has happened In the recent past, they project infinitely into the future. I wrote a whole book, Investment Mistakes Even Smart People, uh, Make and How to Avoid Them. Most of that was on this field of behavioral finance.

We're just human beings. And the biggest role of most investment advisors, I believe, is giving investors the information they need to make informed decisions. that are financially logical, not psychologically logical. Uh, and because we are humans and we're subject to all kinds of these biases. 

ROBIN: For you, Larry, what are the main advantages then of having a good financial advisor?

LARRY: Well, one thing investing or finance is not only about the investment side, there's all kinds of risk management, estate planning, insurance, life insurance, health insurance, annuitization, should you annuitize it, what kind, you've got to integrate all of this into one thing. Well thought out plan. I wrote a book.

Uh, I recruited an all star team of advisors to help write it called your complete guide to a successful and secure retirement that has 20 chapters, including issues related to women, cognitive decline and dealing with it and a good advisor. Should not be one who is only maybe a good investment advisor.

You really want to work with somebody who can integrate all of these things into a plan, but having a well thought out plan can be meaningless. If you're unable to stay the course, number one. And number two, help the investor to stay disciplined, but also recognize when the risks show up, sometimes that can put even a well thought out plan in jeopardy, and you want to think about what actions need to be taken.

To prevent the plan from failing. In fact, in my books, like that retirement book, I point out that before you invest, you should always have what I call a plan B as part of your investment policy statement, because we don't know what the future is. You have to think about what left tail risk those black swans might show up like an 08.

And could cause great damage, particularly if you're retiring there when this issue called sequence risk shows up. Uh, which people should, uh, learn and read about. Uh, so you should have, here's what I'm going to do if that 5 percent bottom risk shows up. You don't want to treat the unexpected or the unlikely.

As if it's impossible. If those risks show up, I'm going to cut my spending. I'm going to sell my second home. I'm going to move to a lower cost of living area. I'm going to work longer, whatever it is, you should have that written down. So you're making an informed decision and not in one that's and causing you to be in a panic mode and you're not going to think rationally.

You should demand from an advisor to help you think through what that plan B should be. 

ROBIN: How should people go about finding a financial advisor they can trust? 

LARRY: Yes. So here's the, uh, in my books, I've written a chapter or an appendix on this. Certainly in my retirement book, there's a whole chapter to help people on that.

So anyone can go there. But a few tips. First, you want to make sure that the advisor is giving you advice, not based on theirs or anyone else's opinions, but based on what you and I call evidence based investment. So evidence from peer reviewed academic journals. Imagine, Robin, you're not feeling well. Uh, and it goes on for a week or two weeks and you say, Gee, I better go get a checkup and go to the doctor.

And after putting you through a battery of tests, the doctor sits you down, says, Here's what the results show. And they pull out a copy of Men's Health. And say, Robin, based on what this says here, here's my, what I think. You're not going to feel good. So you being an intelligent person, you go get another second opinion.

This time a doctor puts you through the same test, but when she's finished she says Robin and pulls out a copy of copy of the New England Journal of Medicine. At least in the us That would be like the Bible, right? Uh, and says, based on this, there's a 70 percent chance your condition is this, and we're gonna treat it this way.

If that doesn't work, the next best slot. And now you feel a lot more confident because there's peer reviewed evidence there, not people's opinion. So that's the first thing, demand to see, have them show you the journals that they're citing and the evidence, uh, why they believe that to be the case for their strategy.

Thank you. Second thing you should demand to see, and I always did this with people that I would sit down with, you should demand to see their custodian statement showing you that they are investing in exactly the same vehicles that you're investing in. Now, their portfolio is likely to be very different because their ability, willingness, and need to take risks should be the same.

Uh, and could be very different, but they should own the same vehicles. And if they're not, that's a sure sign. Third thing, never work with anyone who won't put in writing that they are a, in the U S the term is a fiduciary. Uh, and if they're not willing to do that, which means they're required under the law to give advice that is solely in your best interest.

Which means they cannot sell any commission based product because that could influence it. If they're not prepared to put in writing that they are acting as a fiduciary for you. In the US, by the way, if you work for a stock brokerage firm, you know, like your fiduciary responsibility is to your employer, not to the client.

So you have to ask to get it that way. Registered investment advisors in the U. S., their fiduciary responsibility under their guidelines must be to the client. So there's three things that everyone can simply do. 

ROBIN: Larry, we've covered a lot of ground and you've given people a great deal to think about.

Building our future financial security is one of life's big challenges. And it's often tempting when faced with a big challenge to put off thinking about it until another day. What final piece of advice would you leave our viewers and listeners with? 

LARRY: Stop watching CNBC, Bloomberg TV, reading Barron's. Uh, if you're going to read investment books, I've got 18 of them out there.

Bill Bernstein, Rick Ferry, uh, Charles Ellis. These are the kinds of people, books are, uh, uh, Jason Zweig. These are the kinds of books that are out there for people that show what the empirical academic evidence says. For those of you who are interested in keeping up, uh, you can follow my musings on both, uh, X or Twitter and LinkedIn.

Whenever I write a piece that's published, I put it up there so it's easy enough to follow. Make sure you're following the evidence. Not people's opinions don't get caught up in the social media That's likely to lead to very poor outcome 

ROBIN: Larry. Thank you so much for your time. 

LARRY: My pleasure Happy to come back anytime.

ROBIN: That was my interview with Larry Swedroe We're very grateful to Larry and to our sponsor index fund advisors If you'd like to talk to an evidence based financial advisor, just get in contact via the IFA homepage at ifa. com. That's ifa. com. If you enjoyed this episode, why not subscribe? And please leave us a rating.

We love to receive your feedback. That's all for this episode. Until next time. Goodbye.

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