Jason and Larry talk about efficient markets and asset allocation for retirement investing.
Larry Swedroe is the Lead Director and Director of Research as well as a member of the Board of Directors at Buckingham Family of Financial Services. Buckingham is a Registered Investment Advisory firm, currently managing $15 billion in assets, with offices in 25 cities. BAM is also provider of Turnkey Asset Management Services to about 130 financial advisory firms across the U.S. and has approximately $19 billion of assets under administration.
Larry has authored or co-authored 16 books. The latest is Reducing the Risk of Black Swans, 2018 edition, co-authored with Kevin Grogan.
Larry also writes regularly for ETF.com, Alphaarchitect.com and AdvisorPerspectives.com.
If you would like to learn more visit: www.buckinghamadvisor.com
Below is the full transcript:
Announcer: Welcome back America to Sound Retirement Radio where we bring you concept, ideas and strategies designed to help you achieve clarity, confidence, and freedom as you prepare for and transition to retirement. And now here’s your host Jason Parker.
Jason: America. Welcome back to another round of Sound Retirement Radio. So glad to have you tuning in. I’m excited to get into this episode with you. The title is 175. If you’re looking for us online it’s Wise Investing Made Simple with Larry Swedroe. It’s going to be a great one. But before we do as you know I like to get the morning started right and we do that two ways around here. The first one is by renewing our mind and I’ve got a verse that comes to us from Matthew 19 verse 26. “Jesus looked at them and said with man this is impossible but with God all things are possible.” I always love a word of encouragement there. And then I’m going to go ahead and bring our guest on because he has a joke for us. I had one lined up but he said he had one. So I thought I’d do a quick introduction and let him share his joke. So Larry E Swedroe graduated from New York University with an MBA in finance. He’s the author of What Wall Street Doesn’t Want You to Know. Rational Investing in Irrational Times and The Successful Investor Today. Swedroe lives in St. Lewis Missouri where he is principal in the firm of Buckingham Asset Management. In fact, I think he has like 16 books now that he’s either written or co-authored. But Larry Swedroe welcome to Sound Retirement Radio.
Larry: Thanks for having me. Actually the 17th book I’ve just completed will be published at the end of the year called Appropriately For Your Show your complete guide to a safe and secure retirement.
Jason: Oh good because this show our listeners are interested in retirement. So we’re going to dive deep into that. But you have a joke for us. So let’s put a smile on people’s faces before we get started here.
Larry: So John was an attorney 50 years old. Unfortunately, he gets in a car accident, passes away, goes up to heaven. St. Peter meets him at the pearly gates and he’s complaining right away what am I doing here it’s way too early. I’m just 50 and St. Peter says Well we’ve got a new system up here. We’re going by billable hours it says you’re 96.
Jason: A lot of truth in that one. Thanks, Larry. Larry, I’m excited. So for our listeners out there, the way this interview came to be is after we have a guest that really makes an impact for our audience. We will reach back out to that guest and say “Hey, do you know anybody else who would be interested?” And after we had Paul Merriman on the show that was a really popular broadcast and we asked Paul we said hey Paul is there anybody that you think would really be beneficial to have our listeners on to talk about investing and retirement? And he gave us your name. So I’m excited to get into this interview. I want to start out by asking you the question because one of your books has in the title rational investing. So will you take a minute and just share with our listeners when you use a word like rational. What does that mean? What does it mean to be a rational investor?
Larry: There’s actually a definition that financial economists use that there is a rational being as an investor that’s an assumption that is made and how we think about markets. But we know human beings are not perfectly rational. They’re not computers that make decisions based solely on facts but emotions can get in the way. I wrote a book called Investment Mistakes Even Smart People Make and How to Avoid Them. It details 77 mistakes that investors make. If I wrote it today that would be in the 80s because I learned there are other mistakes. And about half of them are knowledge-based mistakes. So people make a mistake because they are unaware it’s not that they’re ignorant meaning stupid but they’re ignorant in a non-pejorative sense meaning like I think I’m fairly smart, I graduated number one from my MBA program. But I’m totally ignorant about nuclear physics that my wife and three daughters tell me women is another subject that I am ignorant about.
Larry: So half of the mistakes are just lack of knowledge. We just don’t have that wisdom if you will to make good decisions. The other half are behavioral errors and things like we are overconfident of our abilities. We make the mistake of recency. So we buy things that have gone up recently and sell things that have done poorly. Exactly the opposite for example what Warren Buffet tells you to do which is the buy things when they’re low and sell when they’re high. And the book covers about 40 of those mistakes are behavioral ones and there’s a whole field of behavioral finance now that delves into this issue about why we make mistakes simply because we’re human beings.
Jason: I was looking through one of your books and you talk about asset allocation being an important component of having a good starting point for building a portfolio. Asset allocation usually the conversation comes up between how much do you want to have in stocks and how much do you want to have in bonds with bonds being the tool that we would use to de-risk a portfolio or reduce volatility. Given that we’re in this rising interest rate environment the bonds have been falling for 30 years. Bill Gross is saying hey the bond bubble has burst. The party’s over. Can that still be a starting point for a discussion about asset allocation? Can we still have this discussion saying hey how much do we want in bonds and how much do we want in stocks given where we are at in the economy today? Do you think that’s a good starting point?
Larry: Yes. Let me expand on in a little bit. First of all the answer is yes. That should be your starting point because the asset allocation determines virtually all of the risk and the return of your portfolio. But within stocks, we want to talk about how you allocate between the US and international and emerging markets, not just stocks. And the average investor makes a very bad behavioral error called home country bias. Doesn’t matter where you live in the world you tend to be overconfident about your country thinking it’s going to have higher returns and it also has less risk. Which makes no sense. So US investors have about less than 10% typically of their investments internationally. That’s also true of Japanese investors and similar types of numbers for French or German or UK investors. So that’s a problem. I think you should be 50% US and about 50% international with about one-quarter of your international being emerging markets. And that’s not because I have any particular insights but that’s how the global markets allocate capital.
Larry: So about half, the equity market is US. So I don’t think I’m any smarter than the collective wisdom of the market. So that’s one thing. Within bonds, it’s a little bit different. We believe based on the receipts that you should only invest in very safe bonds. So if a taxable investments US Treasury is FDIC insured CDs and municipals only triple-A and double-A rated municipal bonds. And within that, they not only have to be triple A and double A but they have to be either general obligation or essential service revenue bonds meaning you don’t want to buy a hospital bond or a stadium bond. And the reason is they could very easily lose their triple-A ratings. And I wrote about that. I have a book called The Only Guide You Will Ever Need For the Right Financial Plan. It actually walks investors through stocks versus bonds. International versus domestic, emerging markets. Value versus growth. Small versus large and why you might want to own more of one or less depending upon your personal situation and ask specific questions that you can answer to help you figure out the right answer. Let me … One last thing, Jason, just on this question of bonds.
Larry: There have been people screaming about bonds being overvalued for a decade and people would have listened to them would have missed out on further bond rallies. I think there is no evidence of anyone having any skill in predicting bond returns. And the fact that you believe rates are going up, well the fact is the market believes it also that’s reflected in the fact that the Treasury bill rates are at 2% and the 10 year Treasury is at 275 so that’s telling you by the way that the market expects rates on average to go up. And by the way a five year CD today you can get three and a half percent. So you’re giving up a substantial premium if you listen to people say just keep that money very short. And evidence shows Bill Gross or anybody else there are no gurus who can predict rising rates and their impact on your investment.
Jason: I want to ask you about that Bill Gross and kind of this the efficient market hypothesis. Before I do though, you just mentioned something that some people say it should be a concern and that if you can go out and buy a five year CD at three and a half percent with no risk to principle, your FDIC insured or buy a 10 year Treasury that’s paying 2.7%, how does a rational logical investor say I’m going to buy the 10 year Treasury at 2.7.
Larry: Well you should never do that. That’s irrational. The only time you may want to buy a treasury instead of a CD is because you’re holding that asset inside your 401k plan and your company doesn’t have access to a bank CD so you’ve got to own a mutual fund. That’s one of the reasons why we don’t invest in fixed income mutual funds. We buy individual securities for our client portfolios and we can pick up … It depends on the period. Right now the spreads are pretty high. I’ve seen them as high as 100 basis points currently mention the five-year spread between Treasuries and CDs in the 70 to 75 basis point range. So you have to be really foolish because not only are you giving that up you’re paying if you’re lucky and smart using a low-cost fund like a Vanguard fund may be paying 10 or 15 basis points using some insurance company.
Larry: Their plan and maybe you’re paying 50 or more that makes absolutely no sense. Because the only benefit of a mutual fund are two things. One is easing convenience. While you can go to your bank and even go online and buy a CD so that’s not a problem. The other is diversification which you need with stocks because you don’t want to have the what’s called the idiosyncratic risk of a single company. But you don’t need diversification with CDs because as long as you stay within the FDIC limits there is no credit risk. So it makes no sense for most people to own CDs. So individuals have big advantages over companies who can’t buy their individual CDs.
Jason: I see. For our listeners out there, for people that are just tuning in to the show, they’re listening to episode 175. I have Larry Swedroe on the program. He was referred to me by Paul Merriman. Larry, if people want to learn more about the work that you do what’s the best way for them to connect with you online? How can they learn more about the work you’re doing?
Larry: Well I work … My firm is called Buckingham Strategic Wealth. You can go to our website. Also, I write a regular blog at ETF.com three times a week Monday, Wednesday, Friday. I also write for another website. More technical papers for the geeks of your investors who really want to dive into the academic research. There’s a site called out for architects and they can reach me at my email at lswedroeS-W-E-D-R-O-E@bamB-A-MadvisorA-D-V-I-S-O-R.COM. Always happy to answer questions from readers of my blogs or my books.
Jason: And for our listeners that are driving down the road in Seattle this morning I want to let you know that Larry has agreed for our podcast listeners to give us a little bit extra time so we can dive a little bit deeper into somebody’s subjects but I just wanted to make sure Larry that they knew how to get ahold of you or learn more about the work you’re doing in the event that they’re just driving down the road in Seattle this morning they can’t catch the whole podcast. So before we get into something maybe a little bit more technical like efficient market hypothesis you write about. I want to ask just kind of big picture if somebody is retiring right now today. You’ve got people like Robert Shiller who’s saying stocks are trading this cape ratio as one of the highest levels ever. You’ve got people like Bill Gross saying the bond bubbles over. And people are trying to figure out most of these folks don’t have pensions anymore. So they have to live on the money that they’ve saved. Can they have confidence going into retirement that the markets are going to continue to work similar to the way they have in the past going forward given the market conditions we have today?
Larry: Well that’s a question that requires a yes and no answer. So let’s see if we can explain it. First of all, stocks are riskier than bonds and therefore they should provide a risk premium. The problem for investors today is that their risk premium has come way down and for very good reasons. So stocks are a lot less risky investments today than they were say 90 years ago or even 50 years ago. And there is some simple logical explanations which is why I believe Bill Gross, Jeremy Grantham, Robert Shiller are dead wrong and they’ve been saying this for years scaring off investors that literally last since about 2013. So five or six years going on now they’ve been advising … Jeremy Grantham highly regarded chief investment officer of GMO investments in 2013 told investors the S&P is 75% overvalued. And he’s been repeating this theme for years and I think he’s dead wrong and it’s pretty easy to explain it. I wrote a paper on ETF.com about this. So let’s see if we can help investors here. So think back to 90 years ago there was no SCC.
Larry: The Federal Reserve had not learned about the mistakes it had made in the Great Depression. It actually tightened monetary policy. We actually tightened fiscal policy. Roosevelt raised taxes in the middle of the Great Depression. We didn’t have banks safety where FDIC insurance made the banking system more stable. The banks are far better capitalized than they have ever been and banks are critical to the working of the financial system. And there are other things that are good reasons why the equity risk premium should be lower meaning people are willing to pay more for stocks. Simple reasons are you go back 50 years ago if you wanted to buy individual stocks, you had to pay a 5% commission. On top of that, the bid-offer spreads were very wide for stocks. So that made trading very expensive. And if you bought a mutual fund you were paying maybe an 8% lower. Today you can use the Schwab ETF on the market for three basis points and pay no commissions at Schwab. So if you are then getting to keep more of that equity risk premium so you should be willing to pay more for it. Just think about how much lower economic volatility is today than it was 100 years ago or even 50. We don’t have deep recessions anymore.
Larry: We had the worst recession in the post where and unemployment went to 10% and the Great Depression and was in excess of 25%. We had industrial production collapsing. It is an entirely different world we’re living in where economic volatility is much lower and that makes stocks less risky. So the problem is if and here’s the mistake in my mind that Schiller and Gross have all been making. If you look at the 90 years of data the CAPE 10 has averaged. That’s the Cyclically Adjusted Price Earnings ratio. It is averaged about 16. But for the last 40 years, it’s averaged over 20, okay and there are good reasons why as I mentioned why it could be higher. And of course, interest rates are lower as well that helps support higher stock prices. So the fact that the Cape 10 is higher does not mean in any way that stocks are overvalued. But what it does mean is that stock returns are highly likely to be lower because you’re paying more for that same dollar of earnings. So historically a 60:40 portfolio is a return of about eight and a half percent over the last 90 years. Over the last 50 years, sorry the last 36 years starting in 82 when interest rates started to decline at that point the earnings ratio was only about seven the cape 10 and the bond yields were at like 14.
Larry: So we’ve had a massive tailwind helping stock returns as the Cape 10 went from seven to 32. So people were paying much more for the same dollar of earnings which has to drive future returns then down and bond yields went from 14 to two and a half let’s say. So you can’t get that same expect … We think US stocks are likely to return about 6%. That’s what most financial economists believe not 10 as they return. And bonds are going to return two and a half because that’s what the yields are. So that means US investors in a typical 60:40 portfolio, they’ve been used to getting in excess of 10% for the last 36 years. They are much more likely to get about half of that could be better if things turn out better than expected. Could be a lot worse if Gross is right. And rates shows up and people say well we’re not willing to pay those high prices. But people should only build into their plans US stock returns of about 6% international returns a bit higher maybe seven and a half. emerging markets a bit high about eight and half because their valuations are much lower than the US. So that means they’re riskier. That’s why they have lower valuations but they do up higher expected return.
Jason: I’m loving this conversation. Thank you. And thank you for being warned to spend a little bit extra time for our podcast listeners as well. So for those people getting ready to retire then should they instead of assuming an eight and a half percent return I mean if they’re trying to model a retirement cashless scenario, should they be closer to 5%, 4%? What would you recommend?
Larry: That would depend if they own the US only portfolio and then own the bond portfolio using Treasury bonds or even CDs and maybe a bit higher I would look for 5%. If you are globally diversified in the way I suggest then you could bump that up say 1% because their returns are expected to be higher at side doing. But if you also own small and value stocks more than the market does so you tilt your portfolio to these what are called factors or asset classes, then you can raise those returns even more. My own firm we use very a highly tilted portfolio where the market is about 20% small stocks and about 30% value stocks. We’re about half small stocks and about two-thirds value for our typical clients. I’m even more concentrated than that. My portfolio is almost all small value stocks when the market is only 2% of that. So I have a higher expected return for the equities I own but they are riskier. But-
Jason: Yes. I am so excited because there are so many things I want dive into here and just for our listeners if they’re driving down the road some of the questions that I want to go a little bit deeper on our efficient market hypothesis. I want your help understand that. I want to talk about in the world where everybody is getting smarter and if we assume that indexing and keeping your fees low and that the market’s efficient is the smarter way, what kind of inefficiencies is that creating? And are there any opportunities to capture any inefficiencies based on a world of where everybody just indexes?
Larry: First of all we’re far away from that world today. We’re not even at 40% of the entire market is index so that whole argument everything’s index doesn’t hold up. I wrote a book for your listeners who are interested in this quiescence a fairly short read maybe three hours. You know maybe a hundred plus pages. It’s called The Incredible Shrinking Alpha and explains pretty simply the trends that they look like this. When I wrote my first book when Paul Merriman and I were first getting in this business and writing about this and that was the beginning of the trend towards passive investing. My book in 1998 was one of the first books that talked about passive investment. At that time 20% of all active managers were outperforming on a risk-adjusted basis. So measuring apples to apples and doing so in a manner that we could say was statistically significant meaning we could look at their returns and say this isn’t likely a result of the luck. That’s pretty bad odds right because that’s even pre-tax and that’s the highest cost of active managers for taxable accounts is taxes.
Larry: So maybe 10% or beating the market after taxes. I don’t know about you but I don’t like making a bet with my retirement money with 90% odds against me. So I’ll explain that yes, it’s possible to win the game of active investing but the odds are greatly invested that’s playing a loser’s game just as the like you couldn’t win a roulette at the casinos in Vegas. But the odds are against the game itself. You Shouldn’t want to take your retirement account there. However today for the reasons I outlined and there are four themes we could spend an hour alone on those, today Jason that percentage has dropped from 20% to 2%. It means you have a 1 in 50 odds of outperforming even before taxes on a statistically significant. It’s difficult and one of the reasons is fairly simple. What investors don’t understand is it’s a different competition. Let me explain this way. I’m about 35 ranked tennis player. Some a good weekend player. If I play against one notch above me Foro player-.
Jason: Larry, hold on. I need you to hold the story until we come back because we’re going to have to go to a break here in just a minute. You’ve been listening to Episode 175 with Larry Swedroe. Find this episode online. Larry, we’ll be right back after this.
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Jason: All right Larry, we’re back. For our podcast listeners, so you were just getting ready to share a story about being a tennis player and had something to do with odds I think.
Larry: Yes has to do with the market in general. It’s actually one of 27 stories in my book. Why is investing made simple that takes difficult concepts of investing makes them easy to understand. So here’s one of the worst mistakes that investors make. They think that knowledge is a relative thing when it comes to investing. So if I’m investing and I know more than you I can outperform and beat the market. That is nonsense and it’s easy to understand why people think that. So I’m a 35 player I play against the Foro player just one notch above me. They’re going to win 95% of the time maybe even more than that. Roger Federer really is only slightly better in the scheme of things than the player who’s ranked 10th or 15th in the world and he wins 90% of those matches if not more. So small differences in skill when you’re playing one on one can lead to big differences in outcome. But that’s not who you are competing against in the market. You’re competing against the collective wisdom of the market. You’re competing against Warren Buffet and Goldman Sachs and all these hedge funds.
Larry: It’s their collective wisdom that setting the prices and that is a much more difficult competitor. And one of the reasons why it’s gotten harder to beat the market is there is the individual investors the dumb retail money who is dropping out of the game. In 1945 coming out of World War II individuals own 90% of all the stocks in their brokerage account. So Warren Buffet had easy pickings. When he’s trading 90% of the time he was competing against people like you and me. Today that is completely flip. More than 90% of the trading is done by sophisticated institutions. So if you’re trading the odds in 90% the person on the other side is some sophisticated hedge fund or Warren Buffet or Goldman Sachs who is the sucker at that poker table, Jason, so that’s the problem that investor … They think they have a competitive advantage and any individual investor who thinks that is a fool or a legend in their own mind.
Jason: Efficient market hypothesis I think you just pretty much explained what that is but would you just wrote briefly explain that phrase, that term because it gets used a lot and what does it mean to the average person out there?
Larry: Yes. So it’s important understand first of all its hypothesis, not a lot and hypotheses don’t have to be right to help us to understand how markets work or how the world operates. So the hypothesis of a fish market says that whatever the prices are whether it’s stock prices or bond yields that’s the market’s best estimate of the right price. We don’t know what the right price is until after the fact. But that’s the market’s best estimate. If that’s true then we should see evidence that passive investors who just accept market prices through things like index funds are outperforming and it’s very difficult for active managers to exploit mis-pricing. And that’s what all the evidence shows. I gave you that earlier. All you have to do is look at S&P produces what is called a speed report card which is showing the evidence what percentage of active managers outperform in every asset class. And the numbers are persistent. It’s over long periods of time like 50 years it’s precisely in the 80%, 90%, 95% range in almost every asset class.
Jason: So but if that’s data don’t we end up in a world where there are no more active money managers. I mean once the word gets out to enough people what you’re sharing here doesn’t everybody just throw the talent on active money management and buy an index fund?
Larry: Well I’ve actually addressed that question in that Wise Investing Made Simple book what happens if everyone index you were certainly on that trend but it’s a very slow trend but I think inevitable as people are waking up. It’s only moving about 1% a year. So but maybe now it’s picking up some when I started I wrote my book 1% of index, sorry individual assets were indexed. Today it’s somewhere in the 15% to 20% range that’s 20 years ago. Institutions have moved a bit faster from about 15% to north of 40% today but that’s not much more than 1% a year. So we’re a long way from that. But what should happen in the world as you get more passive investors is you would get less trading right. And so what happens to trading costs for active investors they’re going to go up right because there’s less liquidity.
Larry: So even if you get less active in the market less trading and there are more people just accepting market price you could argue well maybe they’ll be inefficiencies. The problem is just as those inefficiencies appear it gets harder to exploit them through trading. And the same argument can be made for example you hear this argument that emerging markets are inefficient. We can discover mis-priced stocks. Well, the funds we use have outperformed over 90% of all the active funds in emerging markets over the last 20 years. So that argument doesn’t hold the same thing is true in small stocks where people say there are inefficiencies. The evidence says, in other words, we don’t need a lot of trading for markets to be fairly efficient. Let me … One other thing. Back 50 years ago we only had 100 mutual funds and a lot of active professionals. And even then only 20% were beating the market.
Jason: Wow. So your newest book I think it has to do with black swans. And we talk about markets being efficient but there’s obviously a behavioral component here that’s been identified because if there wasn’t a behavioral component would we still have black swans?
Larry: Yes. Black swans has to do with the meaning. The term is caused by the fact that everyone thought there was no such thing as a black swan till we discovered “Australia” the Aborigines wouldn’t say they discovered it just you found it but it was discovered and there in Australia we have black swans or Black Swan is an unexpected event. So 2008 you could consider that crisis a Black Swan. An oil embargo and 734 a black swan. A world war would be a black swan. You know those kind of things. A Japanese earthquake causing maybe a nuclear disaster that could have gotten worse. So a black swan is an unexpected event that can drive prices down very sharply-
Jason: But that wouldn’t be a logical reason for-
Larry: And so my book is about how to try to protect against that.
Jason: Yes that’s not a logical reason for prices to go down though unless fear is a legitimate element that needs to be planned for. And so if the markets are efficient without fear-
Larry: I’d say pretty simply Jason if oil prices jump from 8000 barrel to say 50 that’s going to have a severe impact negative on the economy will act if you’re an importer as we were in 734 a big negative impact on oil. The 911 that event drove the world into a recession. People weren’t willing to travel, make investments. 2008 when our economy got massively hit as banks couldn’t lend because they ran out of capital and big losses. That’s not behavioral that’s real risk showing that.
Jason: But wasn’t the response behavior.
Larry: I would say that some of the response was a natural reaction that drove the risk up so people demanded a bigger risk premium so prices go down. But many people like my clients they didn’t panic and sell they rebalance and bought wall in the end. You hope markets come back but there’s no guarantee those people did better than the people who are emotionally panicked because they didn’t have a well thought out plan that actually anticipated those black swans knowing they’re going to likely happen. You just don’t know when in what form. But you better build that risk into your plan. In other word your listeners today if they’re say 60 years old they got to live another 25, 30 years plan. They are likely to see another two or three big black swans and they’re planning better and cooperated where they are likely to panic and sell and then you can’t recover.
Jason: You and I had a chance to talk briefly before our interview here today and you had talked about how using some alternatives may be a way to help people diversify. But one of the big risks are the costs with some of those alternatives you shared with me was a liquidity cost. So they don’t have access to the funds the next day like you would with a normal mutual fund. Will you share with our listeners why you think it might be worth a liquidity premium to diversify your portfolio using some of those alternatives and the risks associated with that kind of investment choice?
Larry: Yes. I wrote a second edition of my original Reducing the Risk of Black Swans book so this one is a 2018 Edition. What’s important to understand here as we talk about this the investments we’re going to discuss have been around for decades and institutions like Harvard’s in the yields of the world have recognized they only spend say 5% a year of their endowment. So some portion of their assets they could invest in illiquid securities or investments and collect a liquidity premium. And for them, it’s not a risk for at least some portion of their portfolios they are not going to use it for a long time. It’s for future generations. Think about someone who’s 30 years old and they got money enough for a 1K plan they can’t even take it out and likely are not going to unless emergency but that money’s not coming out for 30 years and then only slowly even at 65 there RMBs is only 4% a year. So you don’t need at all. So most people who at least have accumulated wealth may be at least a couple of years of reserve money if they get laid off and they get a problem with a house or a car they’ve got funds set aside can set aside some of their investments not all to be in less liquid investments.
Larry: So a good example would be investing in consumer and small business loans that are made by now what are called fintech companies that are disintermediation the banks and lending to consumers and small businesses at lower rates. So instead of a small business the consumer having to borrow from a bank on a credit card at 22% or 24% they can borrow from Sofi or a Lending Club or Prosper a whole bunch of these at maybe 14%. And the same thing for small businesses. So now you can’t put that into a mutual fund because you’re making a three to five-year amortizing loan so you can’t get daily liquidity. So the SCC just a few years ago approved what it called Interval funds and they allow for only quarterly redemptions of 5% per quarter meaning you can get out up to 20% a year. So if you know you don’t need that liquidity, we think this fund will provide equity-like returns in the 6% or 7% range protect you against inflation because the maturity is a very short average of about a year and a half and only has a volatility of about five which is bond like and yet you’re getting equity-like returns but volatility of 20. And the reason you’re getting it is because you’re giving up liquidity. That’s one of the funds I recommend in the book. If we have time I’ll discussed the other which is related to reinsurance.
Jason: I have another question I want to kind of go down a different path here with you offer these alternatives in just into the factors because factor investing this is a term that we hear used a lot. Years ago there were just a few factors. Now I’ve heard as many as 600 factors. What are the factors that are most important to investors? What are factors and what are the most important ones for peoples who has constructed portfolio?
Larry: Great question. Coincidentally I wrote a book Your Complete Guide to Factor-Based Investing.
Jason: You got a book on everything.
Larry: Yes I’m proud of that because it was the first book of its kind really to go into that. And as all my book’s not my opinions we cited 106 academic papers in that book so people can make their own decisions. A factor simply is a trait or characteristics that adds explanatory power to the returns of stocks or bonds or commodities or currencies whatever. So you can think of it as small stocks are riskier than large stocks so there’s a size factor. Value stocks are riskier than growth stocks so there is a value factor. There is a liquidity factor less liquid assets cause more to trade it’s hard to trade him when you trade him you may have a big price impact. So you’re going to get a premium. In the literature, there are 600 factors. I said criteria with my co-author to determine if they’re worth considering. So the first was that I had to have evidence that it was persistent over very long periods of time and across economic regimes. So it wasn’t just a lucky outcome over five, 10, 20 even 30 years. We want to see very long periods. Second, it should be pervasive meaning it didn’t happen just in the US which could be a lucky outcome because we won World War II and the Cold War and our economy is booming it should be pervasive around the globe.
Larry: So it has to meet that criteria. It’s even better if it exists across asset classes. So value is buying what’s cheap and avoiding what’s expensive. You could do that in bonds you could do that in commodities and currencies as well. So that’s a second criteria. It should be implementable meaning you could have a big premium because something’s illiquid so the premiums say is 5% and request you six to capture it doesn’t do you any good. So it has to survive costs. It has to also have what we call an intuitive risk-based or behavioral explanation for why you think it will persist. Otherwise, it might be a lucky random outcome. I think most people know for example intuitively small companies are riskier that should have a premium that’s logical, stocks are riskier than bonds it should have a premium. In the book, I provide all these explanations. And there was one other factor or criteria which is robustness. Robustness means it’s a test that you didn’t get lucky in your choice of metric. So value is usually measured having a low price to book value. But there are lots of other value metrics you could use. Low price to earnings, cash flows, sales, eBide etc. Why should a work only and price to book? Maybe it was lucky.
Larry: So we tested against these other criteria and guess what it holds up. So we find that the criteria that the five factors for stocks that have the strongest evidence so we think you can limit it to them are the market itself. That’s called market data size meaning small stock’s value profitability sell more profitable companies tend to do better and there is really you want to avoid the unprofitable company. And then the other is related to its poor quality. So it’s kind of profitability plus it doesn’t have a lot of debt more stable earnings. And again there it’s not you need to own the high-quality companies you have to avoid the really junk companies. Though it’s all you need on stocks the rest are either redundant or don’t meet their criteria and in bonds, you only need one, the term premium because there is very little evidence that you get rewarded for taking credit risk on the corporate side with bonds. So we in our portfolios own no corporate credit risk whatsoever. You can do better owning bank CDs. That’s 90 years of data. So that’s age of the money manager fee on part of it. So [inaudible 00:43:00] those six.
Jason: So now I want to transition to a couple of last questions here before I let you go. I know you got a busy schedule there but the next question is what’s been one of your favorite books you’ve read recently? Besides one of the ones, you’ve written.
Larry: My favorite book recently was the Librarian of Auschwitz which is based on a true story there and then another one would be The Happiness Advantage. I’ll give you two one a novel based on history and the other a behavioral thing that I think will help people find happiness.
Jason: Wow that’s great. Thank you. And then … So what do you do in your spare time when you’re not working or thinking about efficient markets and how to construct portfolios?
Larry: Well I like to take walks with my wife. I’m an avid reader so far this year I’ve read 45 books and I love spending time with my grandkids.
Jason: All right. And then as you think about the legacy that you hope to leave, what … And one of the cool things about a podcast is it’s something that can live for a really long time. So Larry as you think about the work you’ve done and the impact you’re having on the world, how do you hope people remember you?
Larry: Well I think the thing I feel most grateful for having written 17 books and I’m all over the Internet and people email me all the time. I get emails from people all over the world. My books have been published now and I think six languages Dutch even and Jack and Indonesian, Chinese and Japanese. And is that I get emails from people all over the world. I never go to bed before I at least answer them. It may be tied up that I’ll get to you tomorrow. And I get people who I been helping. I get these beautiful thank you letters you’ve helped my life. You’ve helped us achieve our goals. I will never know these people but knowing that I help them is the reward in and of itself. And that’s what I feel most proud of and there’s good research on this by the way. We are actually made happier by the act of giving.
Jason: That’s awesome. That’s awesome. Well, hey I just want to say thank you. This has been a really fun interview for me. I’ve learned a lot. I’m sure our listeners have learned a lot. Well, one more time will you tell our listeners how to find out more about you if they want to research the work you’re doing?
Larry: Well again the company is Buckingham Strategic Wealth. You can check us out our website. You can just Google my name you can set up a Google alert if you’re interested in my musings and you’ll get to my blog post whenever they’re up and know that I’m always happy to answer emails from listeners.
Jason: Awesome. Larry, we’ll include a link to your website from our site. Thank you so much for being a guest today.
Larry: My pleasure. Happy to come back any time.
Jason: Thanks, Larry.