Larry Swedroe’s Wisdom Helps Investors Profit with 2 Stage Thinking
Following is an excerpt of my recent interview with Larry Swedroe. The full article is published on the U.S. News and World Report Smarter Investor Site:
During this time of investment market turmoil, investors look to professionals for help in weathering the storm. Larry Swedroe, director of research for Buckingham and the BAM Alliance as well as the author of 13 investing books, offers insights and information to help cope with market turbulence and investing. You’ll find out how the ‘Larry portfolio’ might increase your returns and reduce risk. He also touches on secrets from Warrant Buffett’s investing arsenal and advice for millennials. There are pearls of investing wisdom for beginning and experienced investors.
Q 1. Explain ‘two stage thinking’ from your book Think, Act, and Invest Like Warren Buffett. How might this practice help investors, especially in this rocky market?
First, stage 1 thinking occurs when something bad happens, you catastrophize and assume things will continue to get worse. This might play out when you have a bad day, feel a bit depressed and begin to think your entire life stinks. In the investment markets, stage one thinking happens when the averages hit a rough patch, asset prices fall, and you think you’re going to lose all of your money.
Clearly, it’s useful to go beyond stage 1 thinking.
Stage 2 thinking can help you move beyond catastrophizing. In the first depression example, with stage 2, thinking you can reassess your extreme reaction and take action; ie take a walk, plan a fun activity, or get some sunlight. These simple stage 2 thinking strategies will circumvent the possibility of falling into a more serious depressive downward spiral.
When applied to investing, stage 2 thinking is especially helpful during times like the present when the markets start off the year with a tumble. Instead of fearing that you’ll lose all your money, consider Warren Buffett’s stage 2 thinking remedy for market corrections; consider why everything may not be as bad as it seems. Think about previous similar circumstances to disprove your catastrophic fears. For example, during the economic recession during 2008 and 2009 the U.S. lost its AAA rating, there was the Greek debt crisis, Middle East turmoil, the mortgage meltdown, and other bad news. In spite of the negatives, the stock markets have advanced over 200% since 2009.
Use stage 2 thinking to talk back to catastrophic fears and respond with reason. Don’t panic and lock in your losses by selling during a market drop.
Q2. There is a preponderance of evidence in favor of passive investing with index funds. Why are there still so many active managers and investors?
In my recent etf.com article, “Why index Investing Wins” a study by Arnott, Berkin and Ye found, the average actively managed fund underperformed its benchmark by 1.75% per year before taxes, and by 2.58% per year on an after-tax basis. To put the results another way, just 22% of funds beat their benchmark on a pretax basis. After taxes, only 14% of funds outperformed their index. In other words, the risk-adjusted odds against outperformance are approximately 17:1.
Q3. With this type of compelling research supporting an index fund approach, why would investors choose an active manager or fund?
People are ignorant, not stupid. They may not be aware or educated in the current investment research. There’s an inherent conflict of interest between Wall Street and Main Street. It’s not straight forward to understand capital markets and the great number of media outlets and investment firms have a financial interest in making investing seem complicated. These industries’ want to keep investors coming back to buy more magazines and trade more stocks and bonds. Consequently, investors need to take action to educate themselves about investing and take media recommendations with a grain of salt.
Q4. What is the ‘Larry portfolio’?
The Larry portfolio was coined in 2011 when New York Times columnist Ron Lieber wrote about my personal investment strategy. In short, the Larry investment portfolio can be described as a low-beta/high-tilt (to small cap and value stocks) portfolio. The idea behind this unique approach to portfolio allocation is the attempt to reduce black swans, an unpredictable event with extreme negative consequences.
Historical investment returns favor small cap and value stocks. Since 1926 the – S&P 500 returned approximately 10% annualized, bonds in the range of 5% to 6% per year whereas small cap and value stocks returned an annualized average return in the area of 14%. But the drawback to the higher annual returns of small cap and value stocks is greater risk or standard deviation. These specific classes had a standard deviation of 35%, when compared with the 20.23% standard deviation of the S&P 500 from 1926 through 2015.
The Larry portfolio isn’t a fixed percentage asset allocation model, but one that for the stock portion of the portfolio over weights small cap and value stocks and balances out the additional volatility with a large percentage of assets in low risk cash and/or fixed assets. There are several ways I might configure a ‘Larry portfolio’. For example, you could go with 30% stocks and 70% bonds in an attempt to capitalize on the historical outperformance of small cap and value stocks. The 30% would be invested in these risker equity asset classes, yet the 70% allocation to fixed holdings would substantially reduce the portfolio risk.
Continue reading about Larry Swedroe at U.S. News and World Report>>>
Larry E. Swedroe is director of research for Buckingham and the BAM ALLIANCE. Larry holds an MBA in finance and investment from New York University and a bachelor’s degree in finance from Baruch College. 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 since authored seven more books and co-authored six books about investing. Larry is a sought-after speaker and prolific writer, and he contributes weekly to multiple national outlets including ETF.com.