Episode: 154
Originally Aired: December 22, 2015
Topic: The Incredible Shrinking Alpha with Larry Swedroe
The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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TOPICS COVERED:
- Guest Introduction: Larry Swedroe, Author, MBA in Finance & Investment
- What is Alpha?
- Active versus Passive Management
- Considering Premiums
- Advice for the Do-It-Yourselfer
- How to Choose the Right Advisor
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1. Guest Introduction: Larry Swedroe, Author, MBA in Finance & Investment
Dan Weinberg: And welcome to The Lange Money Hour. I’m Dan Weinberg along with CPA and attorney Jim Lange. Active versus passive investing: it’s been a hot topic in recent years. Well, tonight, we welcome a guest who believes there really should be no debate at all, noted author and nationally-recognized investment expert Larry Swedroe has spent years using scientific analysis to show that passive investing through index funds, and other passively managed funds, is the best path to prosperity. Larry is director of research for Buckingham Asset Management and the BAM Alliance. He’s authored fifteen books. His latest is The Incredible Shrinking Alpha, and he’s made numerous appearances on TV, sharing his ideas with viewers at NBC, CNBC, CNN and Bloomberg Personal Finance. Now, tonight, you’re going to learn what Alpha is, whether active money managers are likely to succeed in today’s environment, and whether those using a passive investment strategy should get some help or go it alone. We also welcome your specific questions for these two experts, who have a wealth of knowledge to share with you, so please give us a call at (412) 333-9385. Now, let’s say good evening to Jim Lange and Larry Swedroe.
Jim Lange: Welcome Larry!
Larry Swedroe: Thanks for having me, Jim. Pleasure to be back.
Jim Lange: And congratulations on a great book. I’ve always liked your books, but The Incredible Shrinking Alpha is terrific. Now, I have kind of an early version. Is this available on Amazon right now?
Larry Swedroe: Yes, it is. It has been since January.
Jim Lange: Okay. So, again, The Incredible Shrinking Alpha, just a great book, by Larry Swedroe, and it is particularly appropriate for investors who are trying to get the most out of what they have with the highest degree of safety. So, the name of your book is The Incredible Shrinking Alpha. Can we start out with a simple question and just say what is Alpha?
Larry Swedroe: Sure. It’s an important question because Wall Street wants to mislead you often. So, Alpha, we define as returns above the appropriate risk adjusted benchmark. So, a simple example that I’m sure all of your listeners will follow, is if you invest in, say, junk bonds, and they’re clearly much riskier, and you’re in a higher rate of return than I do if I invest in treasury bonds, and you claim Alpha, that’s either lying, or, at the best interpretation, would be misleading. Now, if your portfolio of junk bonds that you selected outperformed a junk bond index, then you might be able to claim that that’s Alpha because you outperformed an appropriate benchmark. So, if you’re investing in stocks, and Jim, you invest in emerging markets and I invest in U.S. large cap stocks, you’re taking more risk, and if you outperform, that’s not Alpha, but if you outperformed an emerging markets index, that would be Alpha, and you can look at this thing in the right way, which is if you invest in small cap stocks, then you benchmark it against a small cap index, against value stocks, against the value index, etc.
Jim Lange: All right. Well, let’s take the most well-known index, which is probably the S&P 500, and a lot of times, people make that analogous to the Vanguard S&P 500. What would be the equivalent of, say, outperforming or, I think you’re going to try to make the case saying that it’s very difficult for a comparable fund, or a comparable…even using active money management, to outperform the S&P, particularly after fees?
Larry Swedroe: Well, it’s actually been very easy to outperform the S&P 500, over long periods anyway, and all you had to do was invest in small cap stocks or value stocks. Small cap stocks have outperformed the S&P by about two percent a year, large value stocks also by about two percent a year, and small value stocks by more like four percent a year, just rounding there. So, if you’re comparing yourself to the S&P 500, that’s only being appropriate if you invest in stocks that are similar to those in the S&P 500, which are basically more large cap and more growth-oriented types of portfolios, the stocks that are in the S&P 500. So, if I’m running a fund and I’m an active manager and I’m deciding that these 250 stocks within the S&P 500 are going to outperform the other 250, so I’m just going to buy the top 250 winners and exclude the 250 that I think will underperform, and I actually outperform, that is truly Alpha. But if I invest in small cap stocks or emerging market stocks and outperform, that’s not Alpha.
Jim Lange: Okay. By the way, you just said something that I think should be of tremendous interest to viewers, and let me make sure I understand that. If you were in small caps, whether it’s a small cap index, and let’s even assume a small cap index, although it could be a collection of small companies, you could expect a greater return? When I say ‘small companies,’ I don’t mean mom and pop grocery stores, but maybe like a billion dollars as opposed to a hundred billion. You’re saying that you could expect a four percent greater return than the S&P 500?
Larry Swedroe: No, sorry.
Jim Lange: I thought it was about two-and-a-half, right?
Larry Swedroe: Yeah. So, here’s the long-term data. If you go back to 1926, basically, the market and the S&P, meaning the market being all stocks and the S&P 500 have had very similar returns, partly because the S&P dominates the total market. Currently, it’s about 80% or so of the total market. So, 500 of the roughly 3,500 stocks make up 80% or more of the total value. If you bought the smallest stocks, and you might think of them, roughly speaking, as the smallest 10% of all stocks on the market, they’ve actually returned about 12%, large value stocks have also returned about 12%, and small value stocks closer to 14%. Again, I’m just rounding here.
Jim Lange: Okay, but by the way, I think that this is critical information because I would say that nine out of ten people, maybe even more, they come into my office, and if I like them and they like me, we actually analyze their portfolio, and virtually all of them would be significantly underweighted in small cap, in emerging markets and in value, and if I understand what you’re saying right, if they had a heavier emphasis on value, on small and on emerging markets, at least given historical returns, that they would likely, over a long period of time, have a greater return, and if I also understand you right, you’re saying, “Hey, that’s not Alpha. That’s just a greater return because they’re investing in different asset classes.”
Larry Swedroe: Well, let me take it just a step further. I think people have to consider not just return, but risk. There’s a reason small and value companies, and especially small value companies, have historically had, over the long term, higher returns. That’s the general view. A traditional financial theory says it’s because they’re riskier. So, just as one measure of risk would be volatility, which we can look at as the standard deviation, using a technical term, but the market or the S&P, the volatility has been at roughly 18% to 20% a year for small cap stocks in general, and for large value stocks, it’s kind of high twenties, 28% or so. So, you got a higher return, but more volatility. Higher highs and lower lows. Small value stocks, which have had the greatest performance, that higher return is not a free lunch.
The volatility was even higher at about 35% a year, and emerging markets, I think we can recognize, are generally more volatile and risky. They have outperformed the S&P by quite a bit, but it’s compensation for taking extra risk. Now, the one thing we do know from the historical evidence is that these asset classes (as we call them) don’t have perfect correlation. They don’t tend to go up and down and by the same amounts at the same time, and so even though you’re adding by diversifying into these different asset classes, done properly, the evidence is that you’ve actually gotten higher returns with about the same amount of portfolio risk. So, that’s where the advantage comes in. If you diversify across these asset classes, on an individual basis, the stocks and the asset classes are higher, but the right way to look at it is in an entire portfolio context, and you’ve had about the same volatility but higher returns, depending on how much you, the word we use is ‘tilt’ it to small and value and emerging market. The more you tilt, the more you expose yourself to those factors, the higher the return.
Jim Lange: Now, Larry, I think of you as…I know you’re not really an academic, but I think of you as a true research, academic-based writer and commentator. Is the information that you’re giving us, is this backed up with academic studies, and is this something that our readers can rely on, or are you just one more guy spouting some opinions off the top of your head?
3. Active versus Passive Management
Larry Swedroe: Well, the good news, there is nothing that is said in my books, or in any of my blogs, my writings on etf.com or mutualfund.com, or advice I give to our clients, none of it is based upon my opinions. It’s all based upon, well, we like to refer to it as the ‘science’ of investing, or ‘evidence-based’ investing, evidence from peer reviewed academic journals. And everything written in my book, I even cite the studies for people so they can go read them if they like, they point to this simple fact, Jim, and I think this is where you were leading: if you’re an active investor, and, by that, I mean you’re trying to pick individual stocks, not just you’re going to say, “I’m going to invest in small stocks,” but “I know which of the fifty best small stocks to buy, and I know when small stocks are going to do poorly and I’ll get out of them and move into large stocks, and I can time the market,” you’re going to have trouble with Alpha. So, that’s the other option for active managers, either stock selection or market timing, neither of which either of us engage in in our recommendations.
There’s certainly a chance that you’re going to outperform the market, and when I first wrote my book in 1998, there was about 20% of all active managers, on a pre-tax basis, were outperforming their appropriate benchmarks. After taxes, the number was probably about 10%. Now, today, for the reasons I talk about in my book, there are four big themes. It’s become much harder, and even pre-tax, the odds of outperforming on an appropriate risk-adjusted basis have dropped down to 2%. Now, I don’t know about you, but I might put a dollar on a lottery ticket with those kinds of odds, but I’m not taking my retirement account to the Merrill Lynch or Goldman Sachs or Jim Cramer’s office with fifty-to-one odds, even pre-tax, and maybe a hundred-to-one on an after-tax basis. I want to invest in funds that are low-cost, well-diversified and passively managed, based on this academic research that we’ve talked about.
Jim Lange: Now, hold on, Larry. You’re knocking Jim Cramer. Did you know if you followed all of Jim Cramer’s advice, you would have a million dollars today…if you started with two million?
Larry Swedroe: Yeah, right, exactly!
Jim Lange: All right, now, I’m kidding! Jim Cramer’s office, please don’t sue me!
Larry Swedroe: But I have written several pieces on Jim Cramer, who, I think, is a very smart guy, but I wouldn’t follow any of his advice, and there are actually two studies, again, I only write about what you can find in peer reviewed journals and other academic papers, and there were two studies on Jim Cramer’s recommendations, and what they found is exactly what an academic would expect. After Cramer makes his recommendations, which appear on his show at night, they tracked his recommendations. The first move in the morning was, of course, individuals thinking that Cramer knows something would run in and buy, and then the professional investors, the mutual funds, hedge funds and others, would come in and short the stocks, driving the price right back down. Within three days, the price ended up exactly back where it started from, and the people who bought lost, and the professionals who shorted won. That’s what happened.
Jim Lange: Well, you talk about the tougher competition today, and the greater amount of information that is available that gives professional investors an edge over private investors. Could you tell us a little bit more about why, before, 10% of the active money managers were beating the indexes and now, I mean, assuming that what you’re saying is right (and by the way, I heard 97%, so we’re within a percent), only 2% are beating the market? That sounds pretty tough. Why is it so tough? You know, let’s say I’m a…you know, I have an MBA from Harvard, and I have a team of MBAs and we have super-fast computers, and we all subscribe to the most expensive financial news, and we’re sitting there and we’re calling up different managers of different companies trying to do our research. Why wouldn’t more than 2% of them outperform an index?
Larry Swedroe: Well, the reason is fairly simple. You have to understand the nature of the game and the competition. So, I think it’s important for your listeners to understand. Let’s go back to 1945, and Warren Buffett is trying to pick stocks and identify winners. Who is his competition? At the time, 90% of all stocks were owned directly by people like you and me, individual investors. Now, if I ask you this question, or your listeners this question, Jim, let’s see what the answer is. So, Jim, who do you think are tougher competitors? Who knows more about the market and stocks? Is it individual investors or the professionals, like mutual funds, the hedge funds, pension plans, you know, endowments etc., who will hire top professionals to run money, who would you rather compete against: individuals who watch Jim Cramer on TV or the equivalent, or these professionals who have MBAs in finance, etc. who study this and do it full-time? Who’s the tougher competition?
Jim Lange: Well, of course, I’d rather bet on people who are studied and have knowledge and spend their lives doing it.
Larry Swedroe: Right, exactly. So, sixty-seventy years ago, Warren Buffett, 90% of the time he was trading, he was trading against people like you and me, and I don’t know about you, but when I look in the mirror, I don’t see Warren Buffett. I don’t want to try to compete against him. He’s likely to win. Even fifty years ago, there were less than one hundred mutual funds, and there were only a handful of hedge funds. Today, less than twenty percent of all stocks are owned by individuals. Ninety percent or more of the trading is done by institutions, hedge funds, mutual funds, etc., other equivalents of Warren Buffett. So, the game is being played with Warren Buffett ninety percent of the time, competing against somebody who is pretty skillful. Much harder for him. And even Buffett tells you, “There’s no way I can get the kind of returns I used to get,” and that’s one of the reasons.
When Goldman Sachs is trading today, ninety percent of the time, it’s Morgan Stanley on the other end of the trade. Exactly who is the victim? Where’s the sucker at the poker table there that’s being exploited? The problem is, the competition has gotten tougher. Not only are they institutions, but thirty-forty years ago, the average professional money manager at a mutual fund probably had a liberal arts degree and spent some time studying, you know, as an apprentice and worked his way up, maybe had a business degree. There weren’t even masters of finance. I got one of the first Masters of Finance degrees in the late sixties. Finance wasn’t even a profession until then. Today, almost everybody who’s running money at a hedge fund or a mutual fund is not only an MBA in finance or a PhD in finance, they’re literally rocket scientists. I know you’re a big believer, like we are, in Dimensional Fund Advisors. We invest heavily with Dimensional Fund Advisors, a mutual fund family with about $400 billion of assets. Their two chief investment officers are both PhD scientists with advanced degrees in math and science. The people who run hedge funds have similar degrees. Anyone who’s running money has a PhD or MBA in finance. The competition’s much tougher. It’s harder to outcompete these guys. So, here’s the analogy I think that’s very helpful for people: who would you say is the best tennis player in the world today, Jim?
Jim Lange: Well, that would be…
Larry Swedroe: Maybe Novak Djokovic.
Jim Lange: Is it Djokovic?
Larry Swedroe: Yeah.
Jim Lange: Maybe Nadal.
Larry Swedroe: Yeah, so let’s say Novak Djokovic, and he’s playing in the first round of a tournament, let’s say it’s something like the U.S. Open. How many times does he lose a first round match because he’s against somebody who’s not even ranked probably in the top hundred in the world?
Jim Lange: Certainly less than five percent, maybe one or two percent.
Larry Swedroe: Less than one percent. I don’t even think he’s lost a first round match in years, but the competition there is much easier. Think of that as Warren Buffett competing against you and me seventy years ago. As Djokovic wins each round and he advances through, the competition is getting harder, and in his first round match, he probably wins 6-0 or 6-1, something like that. They rarely last more than an hour or so. By the time he gets to the finals, he’s playing Federer or Andy Murray or Rafa Nadal, and it’s a four- or five-hour marathon, five sets, tie breakers, it’s very hard to tell who’s really better, right? The competition is much more difficult. So, when Buffett and professional investors, even just twenty years ago, when they had a twenty percent pre-tax chance of outperforming, it was because there was competition that was easier. That’s the early rounds of the competition, like Buffett, say, seventy years ago when ninety percent of the money was individuals competing. But today, it’s these professional investors, these hedge funds and mutual funds, etc., they’re competing in the U.S. Open in the finals. It’s Djokovic against Federer, and maybe he wins, but boy, the ability to outperform, it’s very hard to tell, and that’s why you’re seeing it’s so much harder. There’s a much smaller pool of victims that you can exploit, and the remaining competition is becoming more and more skilled, making it harder for you to outperform.
Jim Lange: If you’re sitting at a poker table and you can’t spot the sucker, it’s probably you. We are here with Larry Swedroe, who is the author of a new book called The Incredible Shrinking Alpha, which I highly recommend, particularly for people who are, let’s say, trying to figure out whether they should pursue an active versus a passive strategy. Larry, in your book, one of my favorite analogies, because you have a very good way of making a complex issue easily understood, is you talk about finding a twenty dollar bill on the ground. Can you tell us why that has anything to do with being an active versus a passive manager?
Larry Swedroe: Yeah. So, there’s a standard joke in the academic community that goes like this: there’s two economists walking down the street, and one of them stops and says, “Look, there’s a twenty dollar bill on the floor,” and the other says, “Ah, that can’t be. The market’s too efficient. There can’t be a twenty dollar bill there. If there was, someone would’ve picked it up already.” So, that’s the joke. The real analogy to this, the way economists would think about it, is yeah, it’s certainly possible that you can find twenty dollar bills sitting on the floor, if you will, meaning that there’s a stock that you could identify that is mispriced. But the odds of your finding it are very low, and you could spend years trying to find one, and after all of the expenses of the effort, you’re likely to end up losing because there aren’t many of them around. Just think about how many people would spend their lives at the beach trying to find, with those metal detectors, those equivalents of twenty dollar bills, right? And they don’t find them. That’s really the right way to think about this problem. There may be twenty dollar bills, but it’s not a good idea to spend your life trying to find them, because there aren’t many of them around.
Jim Lange: Well, okay. So, let’s say that somebody says, “Okay. Hey, gee, only two percent of the active money managers outperform the indexes. Well, in that case, why don’t I just get an appropriate percentage of stocks and bonds, buy Vanguard indexes (which is probably the least expensive and certainly a quality index fund) and go home?” Is that a reasonable strategy, or should we talk about the premiums that you had mentioned earlier, in terms of equity premium and small cap premium and value premium, and then a few that we haven’t talked about? What should an investor be thinking about when they are putting together a portfolio, let’s even assuming that they buy the argument that it’s very difficult to beat the market? So then, what should they be doing and thinking about in terms of premiums?
Larry Swedroe: Right. Well, first thing, I want to emphasize the point you’re making, your choice of words is exactly right, neither of us would ever say that it’s impossible to beat the market. It’s just that the odds of doing so are so poor that you shouldn’t try. So, we state it’s certainly possible. If you try to beat the market, it’s possible you will outperform.
Jim Lange: Well, apparently, two percent of the money managers are. Is that right?
Larry Swedroe: Yeah, and two percent pre-tax, right? The problem is, neither you nor I nor anyone else has figured out a way to identify those few ahead of time. That’s really the problem. So, that’s why it’s a loser’s game there. If we could identify those two percent, even though it was two percent, it would be a different story. But no one has figured that out yet. So, that’s the first thing.
Jim Lange: Including Charley Ellis, who’s been on the show, who’s the author of a book called The Loser’s Game, which is looking for those two percent.
Larry Swedroe: Exactly, and Charles Ellis, if your listeners aren’t familiar with his books, I would urge them to read them. He inspired a lot of my writing. So, that’s the first thing. Second thing, many people confuse indexing, and I think this may be what you were leading to, with the simple use, or exclusive use, of an S&P 500 index fund. So, you could own Vanguard funds and buy small caps and value stocks and emerging market stocks, etc. That’s not exclusive. The question is, can you do it yourself? Well, my own estimate of the people who could actually do it themselves, even though the winning strategy is actually pretty simple, you and I know that the right strategy is simply to build a globally-diversified portfolio and then have the discipline to stay the course. It isn’t easy. First, you have to know to figure out what the right asset allocation for you is. Two, you have to choose the best vehicles. Vanguard funds are good. You and I both use Dimensional Fund Advisors funds, for example. We think they’re superior vehicles and they have, historically, outperformed similar Vanguard funds. So, you can do a bit better. And then, you’ve got all the issues of tax management. You’ve got all of the issues of having the discipline being able to stay the course, rebalance, tax manage, and also, as you well know, Jim, as you’re an expert in this area, you have to be able to integrate a well-thought out investment plan into an overall estate tax and risk management plan, meaning insurance of all kinds. Otherwise, the whole plan could blow up for reasons that have nothing to do with investing, right?
Jim Lange: Yeah, it is. In fact, even Jack Bogle (who’s been on the show) said that there is a value to having a financial advisor, which actually shocked me because I think of him…by the way, an American hero. Don’t get me wrong.
Larry Swedroe: Yeah, you and I agree.
Jim Lange: But I don’t think of him as the kind of guy who is a big fan of paying any kind of fee to anybody.
Larry Swedroe: Right, yeah. So, in my book Think, Act and Invest Like Warren Buffett, I give people a series of questions to answer to see if they can do it themselves. Do they have the discipline, the knowledge, etc. to do it? My own estimate, and Bill Bernstein, another author (and I’d recommend his books to all of your listeners), he agrees with my estimate, it’s probably less than five percent of people truly have the ability to do it themselves. They also have to have the interest, the discipline, even if they have the knowledge.
Jim Lange: And by the way, that doesn’t take into consideration, and this might sound a little bit self-serving, but in our company, we have a unique arrangement where our company, and our CPAs, we ‘run the numbers,’ we tell people what the ideal Roth IRA conversion strategy, the ideal Social Security strategy, how much money they can spend, then the money manager actually uses DFA, or Dimensional Fund Advisor, funds, doing what the appropriate asset allocation would be, and also doing what he calls the ‘bucket analysis,’ meaning you wouldn’t have one portfolio, you would have multiple ones based on different time needs.
Larry Swedroe: Umm-hmm.
Jim Lange: But what I’d like to get back to, because you mentioned it briefly, is when you were talking about the equity premium and the small cap premium and the value premium, there’s actually other premiums in the market also that you identify in your book, and by the way, we don’t have all that much time, so I want to just mention, in case anybody’s just tuned in, we are here with Larry Swedroe, who is the author of what I think…well, actually, about fifteen books, but his latest one, I think, is just terrific, and it’s a great resource for people who are thinking about whether to invest with an active money manager or a passive or index-type approach, and the name of the book is The Incredible Shrinking Alpha by Larry Swedroe, which is available at Amazon.com. But anyway, Larry, if you could talk a little bit more about either the existing premiums that we’d already mentioned, or even some of the ones that we didn’t.
Larry Swedroe: Right. So, the academic literature has been advancing over time. The first premium, if you will, that was discovered was the market premium, or ‘Beta’ in academic terms. Then, the value and size premiums were reported on, and after that, there’s been a couple of others. One of them is called momentum. That means there’s a tendency for not only stocks, but bonds and commodities and currencies that have done well in the recent past to continue to do well in the near future before they mean revert. So, a stock that has outperformed in the last year is likely to continue to outperform for about another, on average, five to six months. The same thing is true with currencies, etc. So, that’s one premium, and that’s been persistent around the world and across asset classes, as I mentioned. So, that’s one thing.
Another is, from more recent research, what’s called the ‘profitability premium.’ Companies that have been more profitable have higher growth margins and tended to outperform companies that are less profitable. By the way, that’s one of the things Warren Buffett has been telling people to buy, not only buy stocks that are low priced, but that have tended to be more profitable companies. So, in other words, the scientists have finally discovered, if you will, the secret sauce that Warren Buffett knew before everybody else, and now, they’ve actually found (and I write about it in my book) if you constructed an index of stocks that have these characteristics that Buffett has told you to buy over the last, basically, fifty years, Buffett’s Alpha disappears. So, I give him all the credit. He discovered it before the academics. Even though he’s outperformed the S&P 500, say, by five percent or whatever the number is now, per year. If you properly risk adjust for accounts of these factors, Buffett’s Alpha literally disappears. So, we now can have clients, you have clients through DFA who are investing, basically, the way Warren Buffett has been telling people to invest for the last fifty years, and doing so globally, by the way.
Jim Lange: All right. By the way, that’s really a telling, telling thought, that is that Warren Buffett (and again, all the credit in the world to him because he came up with these premiums ahead of time) actually was not as great a stock picker as we might think because he was very astute in recognizing and utilizing, let’s say, the small cap premium, the value premium (which I think a lot of people know about), the equity premium, of course, is buying stocks instead of bonds, and now, we’re introducing two others that perhaps Warren Buffett has been using without necessarily making it clear he was using it, that you’re calling the profitability premium and the momentum premium, and if I understand you right, what you’re saying is, if you know that these premiums exist and you go backwards and you’re, let’s say, buying based on the knowledge of these premiums, that Warren Buffett didn’t outperform or pick stocks that were so outrageously better than, let’s say, a set of index funds that would have taken these premiums into account. Is that fair?
Larry Swedroe: Yeah, just to be clear, Warren Buffett discovered that you should buy these stocks before the academics, but what we now know is if you bought an index of all of the stocks that had these characteristics, you did as well as Buffett. So, what that means is that Buffett’s skill was really composed of two things. He added value in two ways. First, he was able to discover these characteristics before anybody else, and he also had the discipline to stay the course. But if you bought an index of all of these stocks, you would’ve done just as well. Of course, you also would have had to have the same discipline. So, here’s an example of that: Buffett was not a player in small cap stocks, but he was a player in value stocks. So, if you bought companies (keeping it simple) with low price-to-earnings ratios, he bought more profitable companies, but he also focused on companies that were high in quality, now academics use this term ‘quality,’ which is a broader definition. For your readers who are interested, there’s a paper called “Buffett’s Alpha,” which is really an excellent piece describing this. But Buffett looked at companies that also had strong balance sheets. So, they didn’t have a lot of debt. They had persistent and low volatility of earnings, for example, and they had low operating and financial leverage. So, if you just rank stocks and, say, bought the top thirty percent of companies and bought all of them, where Buffett bought only ten that he thought would have been the best, your entire list of the thirty percent would have done as well as Buffett’s ten that he actually bought. So, his skill was identifying the characteristics before the academics did, not in individual stock option, and staying the course. Let me just add this point, Jim. What academics often do to uncover these things is they look at the performance of the great money managers and try to, let’s use the word ‘reverse’ engineer, look for the types of characteristics of stocks that they’re buying, and then see if they could identify those characteristics, and then systematize it.
Jim Lange: All right, and just one last thought before the break. I believe that there is a fine financial researcher and analyst who’s written a book that has something to do with Invest Like Warren Buffett. Do you know who that would be and where they could get that book?
Dan Weinberg: This one right here, you mean?
Larry Swedroe: Yeah. It’s called Think, Act and Invest Like Warren Buffett, and I wrote it a few years ago and you, of course, can get it on Amazon, and I talk about some really key attributes that can help you get the kinds of returns Buffett has earned.
Jim Lange: Okay, so we have two fine books by Larry Swedroe. Actually, there’s fifteen of them, but two that we’ll mention. One, The Incredible Shrinking Alpha, which is the new one, and then Think, Act and Invest Like Warren Buffett.
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Jim Lange: We are here with Larry Swedroe, who is the author of fifteen books, but the most recent, and the one that I think is just incredible, interestingly enough, is called The Incredible Shrinking Alpha, and he is talking about how tough it is to beat the market, and I think does a pretty convincing case of saying that really only about two percent of the active money managers are beating the market, and that’s including these really smart guys with MBAs, etc. etc. And for the individual investor to beat the market is even tougher. Is that fair, Larry?
Larry Swedroe: Yeah. That two percent, by the way, is confirmed in two studies and, I’ll repeat what I mentioned earlier. That two percent is before taxes, not after taxes. So, if you’ve got your money in an IRA account, you’ve got a two percent chance. Many people are holding their equities. They don’t have enough room in their IRA accounts where they should be holding their bond portfolios, and if they’re holding equities in a taxable account, then if you’re an active manager, the odds of winning go way down because for active managers, taxes are often the greatest expense. So, the odds are probably less than one percent. So, that’s one in a hundred odds. I don’t know about you, Jim, but I don’t like those kind of odds playing with my retirement account.
Jim Lange: Again, Charley Ellis calls that ‘the loser’s game.’ So, let me ask you this. Maybe I’ll ask two questions before we end the show, but the first one, and I want to be fair because, of course, I’m trying to get some business for my own company with the appropriate clients, because I’m at the age and stage where I don’t need pains in the you-know-what. And I actually mean that. We have a $500,000 minimum, and to become a client, you probably have to go through about two meetings with me, probably two meetings with the money manager and have a $500,000 minimum. But we do have a 99% retainage rate. So, we’re careful about who we take, but then, once we take them, it usually works out pretty well. But I want to be fair because I know that there are a lot of listeners here who are, let’s say, do-it-yourselfers, and people who are naturally inclined to prefer Vanguard funds, although don’t feel limited to Vanguard funds. But for the pure do-it-yourselfer, the person who says, “Hey, I don’t want to pay any money manager a nickel. I want to keep my costs down.” What kind of advice would you have for the do-it-yourselfer listener?
5. Advice for the Do-It-Yourselfer
Larry Swedroe: Well, I would, first of all, tell them to read a few of my books on how to build a prudent strategy. I’ve written a book called The Only Guide You’ll Ever Need for the Right Financial Plan. That would be helpful for them. So, you want to make sure one, you have a plan, you write it down, it identifies what I call your unique ability, willingness and need to take risk. Getting that asset allocation right, as you know, is so critical and it changes over time. As you age and life events happen, you might inherit money and you have more ability to take risk, but certainly less need to take it. You may have a divorce or a loss of a job. That’s going to lessen your ability to take risk than you probably should have, and less equity allocation, all these issues. So, you have to be able to identify that.
Once you do that, then what you want to do is make the decision on how much U.S. stocks and international stocks. I recommend a starting point of fifty percent U.S. and fifty percent international because that’s how the market is, pretty much. But there’s nothing wrong with sixty percent U.S. and forty percent international, or whatever you think is appropriate, as long as you stick with whatever allocation you choose and are diversified. And then you have to choose how much large and small and value, etc. and how much emerging markets, all those things. You can certainly use Vanguard’s funds, but there are also other alternatives. There are ETFs that might even be cheaper and may be more appropriate. You have to know how to make those decisions, but even if you chose a simple two fund with stocks portfolio, Vanguard’s U.S. total stock market fund and a Vanguard total international fund, and then bought maybe a safe intermediate treasury or investment grade bond fund for your bonds, if you do that, and also have the discipline to stay the course, I’m confident that you’ll outperform eighty to ninety percent of the professional money managers, even though you’re not choosing the optimal type of strategy, which can be improved on. So, that’s the key. Keep it simple, make sure you understand the strategy, stay the course. That’s really Buffett’s key to success. He never panicked when others were panicking. In fact, he would be buying, which is exactly, Jim, what you recommend to your clients, not because you’re trying to time the market because you tell them to buy when they need to rebalance, which means after equities have done poorly, they have to buy to get back to their target.
Jim Lange: It’s interesting that you say that fifty/fifty’s okay in terms of international and U.S., or even sixty/forty, but whatever you choose, and I would imagine you would say the same thing with stocks and bonds in general, whatever you choose, to stick with it, and I remember Jonathan Clements saying the exact same thing, saying that it’s not as important which allocation you go in with, as the fact that you stick with the allocation that you decide on.
Larry Swedroe: Yeah. In fact, one of my favorite expressions is there’s no one right portfolio. The right portfolio for you is the one that will most likely enable you to stay the course. So, even though I think having about, say, fifteen percent of your equities in emerging markets is about the right mix, that’s about where they are as a global market capitalization. If you will panic and sell, because the last few years, emerging markets have done poorly and you’re reading about China and Brazil doing poorly, then you should have zero, and you’d be better off because you will panic and sell, of course, at the wrong time, and, you know, you’re worse off. So, whatever is most likely to enable you to stay the course is what you should stick with.
6. How to Choose the Right Advisor
Jim Lange: All right, and we only have about one minute left, and I hate to shortchange the advice for an investor that may have been burned in the past, but doesn’t want to manage their own money. What are some of the options or ways that a not do-it-yourselfer could move forward?
Larry Swedroe: Well, in my book Think, Act and Invest Like Warren Buffett, there’s a short chapter on how to choose an advisor, but I’ll give people a few simple rules. One, it must be someone who is prepared to put in writing that they are a fiduciary, which means they’re giving advice solely in your interests.
Jim Lange: I agree.
Larry Swedroe: Number two, they have to be able to show you that they’re investing in exactly the same vehicles that they’re recommending to you. Of course, they may have a different asset allocation because they’re a different person. If they’re not prepared to show you that, run! Number three, they should be prepared to show you that their recommendations are based upon not their opinions, but on academic research, and share that with you. And the fourth thing, I think, is exactly what you talk to your clients about. You don’t want to work with a money manager. You want to work with a wealth advisor, someone who integrates estate planning, insurance and all these other things because even the best investment plan, a perfect one, can blow up for reasons that have nothing to do with investing. You die early and you don’t have enough life insurance. You don’t have an umbrella policy and your teenage son, you know, gets in a car accident, maims, or worse, kills somebody. You have an attorney who writes up good estate documents, but the trusts never get funded. I’m sure you’ve seen plenty of those things.
Jim Lange: We sure have. Again, thank you, Larry Swedroe, author of The Incredible Shrinking Alpha, a great book that I highly recommend.
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