LEARNING: Just because there is a correlation doesn’t mean that there’s causation.

“Just because there is a correlation doesn’t mean that there’s causation. The mere existence of a correlation doesn’t necessarily give it predictive value.”

Larry Swedroe

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 09: The Fed Model and the Money Illusion.

Chapter 09: The Fed Model and the Money Illusion

In this chapter, Larry illustrates why the Fed Model should not be used to determine whether the market is at fair value and that the E/P ratio is a much better predictor of future real returns.

The FED model

The stock and bond markets are filled with wrongheaded data mining. David Leinweber of First Quadrant famously illustrated this point with what he called “stupid data miner tricks.”

Leinweber sifted through a United Nations CD-ROM and discovered the single best predictor of the S&P 500 Index had been butter production in Bangladesh. His example perfectly illustrates that a correlation’s mere existence doesn’t necessarily give it predictive value. Some logical reason for the correlation is required for it to have credibility. Without a logical reason, the correlation is just a mere illusion.

According to Larry, the “money illusion” has the potential to create investment mistakes. It relates to one of the most popular indicators used by investors to determine whether the market is under or overvalued—what is known as “the Fed Model.”

The Federal Reserve was using the Fed model to determine if the market was fairly valued and how attractive stocks were priced relative to bonds. Using the “logic” that bonds and stocks are competing instruments, the model uses the yield on the 10-year Treasury bond to calculate “fair value,” comparing that rate to the earnings-price, or E/P, ratio (the inverse of the popular price-to-earnings, or P/E, ratio).

Larry points out two major problems with the Fed Model. The first relates to how the model is used by many investors. Edward Yardeni, at the time a market strategist for Morgan, Grenfell & Co. speculated that the Federal Reserve used the model to compare the valuation of stocks relative to bonds as competing instruments.

The model says nothing about absolute expected returns. Thus, stocks, using the Fed Model, might be priced under fair value relative to bonds, and they can have either high or low expected returns. The expected return of stocks is not determined by their relative value to bonds.

Instead, the expected real return is determined by the current dividend yield plus the expected real growth in dividends. To get the estimated nominal return, estimated inflation must be added. This is a critical point that seems to be lost on many investors. This leaves a trail of disappointed investors who believe low interest rates justify a high valuation for stocks without the high valuation impacting expected returns. The reality is that when P/Es are high, expected returns are low, and vice versa, regardless of the level of interest rates.

The second problem with the Fed Model, leading to a false conclusion, is that it fails to consider that inflation impacts corporate earnings differently than it does the return on fixed-income instruments.

Over the long term, the nominal growth rate of corporate earnings has been in line with the nominal growth rate of the economy. Similarly, the real growth rate of corporate earnings has been in line with the real growth of the economy. Thus, in the long term, the real growth rate of earnings is not impacted by inflation.

On the other hand, the yield to maturity on a 10-year bond is a nominal return—to get the real return, you must subtract inflation. The error of comparing a number that isn’t impacted by inflation to one that is, leads to the money illusion.

Understand how the money illusion is created

Understanding how the money illusion is created will prevent you from believing an environment of low interest rates allows for either high valuations or high future stock returns. Instead, if the current level of prices is high (a high P/E ratio), that should lead you to conclude that future returns to equities are likely to be lower than has historically been the case and vice versa. This doesn’t mean investors should avoid equities because they are highly valued or increase their allocations because they have low valuations.

Further reading

1. Kiplinger’s Personal Finance, February 1997.
2. Humphrey-Hawkins Report, Section 2: Economic and Financial Developments in 1997 Alan Greenspan, July 22, 1997.
3. William Bernstein, “The Efficient Frontier,” (Summer 2002).
4. Clifford S. Asness, “Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns,” (December 2002).

Did you miss out on the previous chapters? Check them out:

• Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
• Enrich Your Future 02: How Markets Set Prices
• Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
• Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
• Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
• Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
• Enrich Your Future 07: The Value of Security Analysis
• Enrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market Return

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth...]]>In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 09: The Fed Model and the Money Illusion.

LEARNING: Just because there is a correlation doesn’t mean that there’s causation.

“Just because there is a correlation doesn’t mean that there’s causation. The mere existence of a correlation doesn’t necessarily give it predictive value.”

Larry Swedroe

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 09: The Fed Model and the Money Illusion.

Chapter 09: The Fed Model and the Money Illusion

In this chapter, Larry illustrates why the Fed Model should not be used to determine whether the market is at fair value and that the E/P ratio is a much better predictor of future real returns.

The FED model

The stock and bond markets are filled with wrongheaded data mining. David Leinweber of First Quadrant famously illustrated this point with what he called “stupid data miner tricks.”

Leinweber sifted through a United Nations CD-ROM and discovered the single best predictor of the S&P 500 Index had been butter production in Bangladesh. His example perfectly illustrates that a correlation’s mere existence doesn’t necessarily give it predictive value. Some logical reason for the correlation is required for it to have credibility. Without a logical reason, the correlation is just a mere illusion.

According to Larry, the “money illusion” has the potential to create investment mistakes. It relates to one of the most popular indicators used by investors to determine whether the market is under or overvalued—what is known as “the Fed Model.”

The Federal Reserve was using the Fed model to determine if the market was fairly valued and how attractive stocks were priced relative to bonds. Using the “logic” that bonds and stocks are competing instruments, the model uses the yield on the 10-year Treasury bond to calculate “fair value,” comparing that rate to the earnings-price, or E/P, ratio (the inverse of the popular price-to-earnings, or P/E, ratio).

Larry points out two major problems with the Fed Model. The first relates to how the model is used by many investors. Edward Yardeni, at the time a market strategist for Morgan, Grenfell & Co. speculated that the Federal Reserve used the model to compare the valuation of stocks relative to bonds as competing instruments.

The model says nothing about absolute expected returns. Thus, stocks, using the Fed Model, might be priced under fair value relative to bonds, and they can have either high or low expected returns. The expected return of stocks is not determined by their relative value to bonds.

Instead, the expected real return is determined by the current dividend yield plus the expected real growth in dividends. To get the estimated nominal return, estimated inflation must be added. This is a critical point that seems to be lost on many investors. This leaves a trail of disappointed investors who believe low interest rates justify a high valuation for stocks without the high valuation impacting expected returns. The reality is that when P/Es are high, expected returns are low, and vice versa, regardless of the level of interest rates.

The second problem with the Fed Model, leading to a false conclusion, is that it fails to consider that inflation impacts corporate earnings differently than it does the return on fixed-income instruments.

Over the long term, the nominal growth rate of corporate earnings has been in line with the nominal growth rate of the economy. Similarly, the real growth rate of corporate earnings has been in line with the real growth of the economy. Thus, in the long term, the real growth rate of earnings is not impacted by inflation.

On the other hand, the yield to maturity on a 10-year bond is a nominal return—to get the real return, you must subtract inflation. The error of comparing a number that isn’t impacted by inflation to one that is, leads to the money illusion.

Understand how the money illusion is created

Understanding how the money illusion is created will prevent you from believing an environment of low interest rates allows for either high valuations or high future stock returns. Instead, if the current level of prices is high (a high P/E ratio), that should lead you to conclude that future returns to equities are likely to be lower than has historically been the case and vice versa. This doesn’t mean investors should avoid equities because they are highly valued or increase their allocations because they have low valuations.

Further reading

1. Kiplinger’s Personal Finance, February 1997.
2. Humphrey-Hawkins Report, Section 2: Economic and Financial Developments in 1997 Alan Greenspan, July 22, 1997.
3. William Bernstein, “The Efficient Frontier,” (Summer 2002).
4. Clifford S. Asness, “Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns,” (December 2002).

Did you miss out on the previous chapters? Check them out:

• Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
• Enrich Your Future 02: How Markets Set Prices
• Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
• Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
• Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
• Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
• Enrich Your Future 07: The Value of Security Analysis
• Enrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market Return

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

[spp-transcript]

Connect with Larry Swedroe

• LinkedIn
• Twitter
• Website
• Books

Andrew’s books

• How to Start Building Your Wealth Investing in the Stock Market
• My Worst Investment Ever
• 9 Valuation Mistakes and How to Avoid Them
• Transform Your Business with Dr.Deming’s 14 Points

Andrew’s online programs

• Valuation Master Class
• The Become a Better Investor Community
• How to Start Building Your Wealth Investing in the Stock Market
• Finance Made Ridiculously Simple
• FVMR Investing: Quantamental Investing Across the World
• Become a Great Presenter and Increase Your Influence
• Transform Your Business with Dr. Deming’s 14 Points
• Achieve Your Goals

Connect with Andrew Stotz:

• astotz.com
• LinkedIn
• Facebook
• Instagram
• Threads
• Twitter
• YouTube
• My Worst Investment Ever Podcast

LEARNING: High growth rates don’t always mean high stock returns.

“Emerging markets are very much like the rest of the world’s capital markets—they do an excellent job of reflecting economic growth prospects into stock prices.”

Larry Swedroe

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 08: Be Careful What You Ask For.

Chapter 08: Be Careful What You Ask For

In this chapter, Larry cautions people to be careful what they wish for in investing. He emphasizes the daunting challenge of active management, a path many choose in the belief that they can accurately forecast market trends.

However, as Larry points out, the reality is far from this ideal. The unpredictability of the market makes it almost impossible to predict with 100% accuracy, a fact that investors should be acutely aware of.

High growth rates don’t always mean high stock returns

It’s important to note that high growth rates don’t always translate into high stock returns, underscoring the unpredictability of market outcomes. According to Larry, for today’s investors, the equivalent of the “Midas touch” (the king who turned everything he touched into gold) might be the ability to forecast economic growth rates.

If investors could forecast with 100% certainty which countries would have the highest growth rates, they could invest in them and avoid those with low growth rates. This would lead to abnormal profits—or, perhaps not.

Nobody can predict with that accuracy. Even if one could make such a prediction, they may still not make the profits they think they will. This is because, as Larry explains, experts have found that there has been a slightly negative correlation between country growth rates and stock returns.

A 2006 study on emerging markets by Jim Davis of Dimensional Fund Advisors found that the high-growth countries from 1990 to 2005 returned 16.4%, and the low-growth countries returned the same 16.4%.

Such evidence has led Larry to conclude that it doesn’t matter if you can even forecast which countries will have high growth rates; the market will make the same forecast and adjust stock prices accordingly.

Therefore, to beat the market, you must be able to forecast better than the market already expects, and to do so, you need to gather information at a cost. In other words, you can’t just be smarter than the market; you have to be smarter than the market enough to overcome all your expenses of gathering information and trading costs.

Larry emphasizes that emerging markets are very much like the rest of the world’s capital markets—they do an excellent job of reflecting economic growth prospects into stock prices. The only advantage an investor would have is the ability to forecast surprises in growth rates, which, by definition, are unpredictable.

Did you miss out on the previous chapters? Check them out:

• Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
• Enrich Your Future 02: How Markets Set Prices
• Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
• Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
• Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
• Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
• Enrich Your Future 07: The Value of Security Analysis

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

[spp-transcript]

Connect with Larry Swedroe

• LinkedIn
• Twitter
• Website
• Books

Andrew’s books

• How to Start Building Your Wealth Investing in the Stock Market
• My Worst Investment Ever
• 9 Valuation Mistakes and How to Avoid Them
• Transform Your Business with Dr.Deming’s 14 Points

Andrew’s online programs

• Valuation Master Class
• The Become a Better Investor Community
• How to Start Building Your Wealth Investing in the Stock Market
• Finance Made Ridiculously Simple
• FVMR Investing: Quantamental Investing Across the World
• Become a Great Presenter and Increase Your Influence
• Transform Your Business with Dr. Deming’s 14 Points
• In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 08: Be Careful What You Ask For.

  LEARNING: High growth rates don’t always mean high stock returns.

   

  “Emerging markets are very much like the rest of the world’s capital markets—they do an excellent job of reflecting economic growth prospects into stock prices.”

  Larry Swedroe

   

  In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

  Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 08: Be Careful What You Ask For.

  Chapter 08: Be Careful What You Ask For

  In this chapter, Larry cautions people to be careful what they wish for in investing. He emphasizes the daunting challenge of active management, a path many choose in the belief that they can accurately forecast market trends.

  However, as Larry points out, the reality is far from this ideal. The unpredictability of the market makes it almost impossible to predict with 100% accuracy, a fact that investors should be acutely aware of.

  High growth rates don’t always mean high stock returns

  It’s important to note that high growth rates don’t always translate into high stock returns, underscoring the unpredictability of market outcomes. According to Larry, for today’s investors, the equivalent of the “Midas touch” (the king who turned everything he touched into gold) might be the ability to forecast economic growth rates.

  If investors could forecast with 100% certainty which countries would have the highest growth rates, they could invest in them and avoid those with low growth rates. This would lead to abnormal profits—or, perhaps not.

  Nobody can predict with that accuracy. Even if one could make such a prediction, they may still not make the profits they think they will. This is because, as Larry explains, experts have found that there has been a slightly negative correlation between country growth rates and stock returns.

  A 2006 study on emerging markets by Jim Davis of Dimensional Fund Advisors found that the high-growth countries from 1990 to 2005 returned 16.4%, and the low-growth countries returned the same 16.4%.

  Such evidence has led Larry to conclude that it doesn’t matter if you can even forecast which countries will have high growth rates; the market will make the same forecast and adjust stock prices accordingly.

  Therefore, to beat the market, you must be able to forecast better than the market already expects, and to do so, you need to gather information at a cost. In other words, you can’t just be smarter than the market; you have to be smarter than the market enough to overcome all your expenses of gathering information and trading costs.

  Larry emphasizes that emerging markets are very much like the rest of the world’s capital markets—they do an excellent job of reflecting economic growth prospects into stock prices. The only advantage an investor would have is the ability to forecast surprises in growth rates, which, by definition, are unpredictable.

  Did you miss out on the previous chapters? Check them out:

  • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
  • Enrich Your Future 02: How Markets Set Prices
  • Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
  • Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
  • Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
  • Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
  • Enrich Your Future 07: The Value of Security Analysis
  
  

  About Larry Swedroe

  Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

  Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

  Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

  Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

   

  [spp-transcript]

   

  Connect with Larry Swedroe

  • LinkedIn
  • Twitter
  • Website
  • Books
  
  

  Andrew’s books

  • How to Start Building Your Wealth Investing in the Stock Market
  • My Worst Investment Ever
  • 9 Valuation Mistakes and How to Avoid Them
  • Transform Your Business with Dr.Deming’s 14 Points
  
  

  Andrew’s online programs

  • Valuation Master Class
  • The Become a Better Investor Community
  • How to Start Building Your Wealth Investing in the Stock Market
  • Finance Made Ridiculously Simple
  • FVMR Investing: Quantamental Investing Across the World
  • Become a Great Presenter and Increase Your Influence
  • Transform Your Business with Dr. Deming’s 14 Points
  • Achieve Your Goals
  
  

  Connect with Andrew Stotz:

  • astotz.com
  • LinkedIn
  • Facebook
  • Instagram
  • Threads
  • Twitter
  • YouTube
  • My Worst Investment Ever Podcast
  
  ]]>d5f7b6d7-5658-4fdb-9e91-0fc3c395d422Tue, 06 Aug 2024 06:00:00 +070014:09falsefullEnrich Your Future 07: The Value of Security AnalysisIn this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 07: The Value of Security Analysis.

  LEARNING: Smart investors, like smart businesspeople, care about results, not efforts.

   

  “Smart investors, like smart businesspeople, care about results, not efforts. That is why “smart money” invests in “passively managed,” structured portfolios that invest systematically in a transparent and replicable manner.”

  Larry Swedroe

   

  In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years to help investors as the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

  Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 07: The Value of Security Analysis.

  Chapter 07: The Value of Security Analysis

  In this chapter, Larry explains how to test the efficiency of the market by looking at how good security analysts are at predicting the future. If they can outsmart the markets, then the markets are not efficient.

  Do investors who follow security analysts's recommendations outperform the market?

  In business, results are what matters— not effort. The same is true in investing because we cannot spend efforts, only results. The basic premise of active management is that, through their efforts, security analysts can identify and recommend undervalued stocks and avoid overvalued ones. As a result, investors who follow their recommendations will outperform the market. Is this premise myth or reality?

  To answer this question, Larry relies on the robust findings of academic research in the paper Analysts and Anomalies. The authors meticulously examined the recommendations of U.S. security analysts over the period 1994 through 2017. Their findings debunk the myth of analysts' infallibility and shed light on the surprising ways analysts' predictions conflict with well-documented anomalies. They also found that buy recommendations did not predict returns, though sell recommendations did predict lower returns. Another intriguing finding was that among the group of "market" anomalies (such as momentum and idiosyncratic risk), which are based only on stock returns, price, and volume data, analysts produce more favorable recommendations and forecast higher returns among the stocks that are stronger buys according to market anomalies. This is perhaps surprising, as analysts are supposed to be experts in firms' fundamentals. Yet, they performed best with anomalies not based on accounting data.

  The evidence in this academic paper suggests that analysts even contribute to mispricing, as their recommendations are systematically biased by favoring overvalued stocks according to anomaly-based composite mispricing scores. The authors concluded: "Analysts today are still overlooking a good deal of valuable, anomaly-related information."

  Results are what matters not effort

  In conclusion, Larry states that if corporate insiders (e.g., boards of directors), with access to far more information than any security analyst is likely to have, have such great difficulty in determining a "correct" valuation, then it is easy to understand why the results of active management are poor and inconsistent.

  While security analysts and active portfolio managers make great efforts to beat the market, historical evidence shows that those efforts have proven counterproductive most of the time. And savvy investors, like smart businesspeople, care about results, not efforts. That is why "smart money" invests in "passively managed," structured portfolios that invest systematically in a transparent and replicable manner.

  Further reading

  1. Joseph Engelberg, David McLean and Jeffrey Pontiff, “Analysts and Anomalies,” Journal of Accounting and Finance (February 2020).
  
  

  Did you miss out on the previous chapters? Check them out:

  • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
  • Enrich Your Future 02: How Markets Set Prices
  • Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
  • Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
  • Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
  • Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
  
  

  About Larry Swedroe

  Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

  Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

  Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

  Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

   

  [spp-transcript]

   

  Connect with Larry Swedroe

  • LinkedIn
  • Twitter
  • Website
  • Books
  
  

  Andrew’s books

  • How to Start Building Your Wealth Investing in the Stock Market
  • My Worst Investment Ever
  • 9 Valuation Mistakes and How to Avoid Them
  • Transform Your Business with Dr.Deming’s 14 Points
  
  

  Andrew’s online programs

  • Valuation Master Class
  • The Become a Better Investor Community
  • How to Start Building Your Wealth Investing in the Stock Market
  • In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 07: The Value of Security Analysis.

    LEARNING: Smart investors, like smart businesspeople, care about results, not efforts.

     

    “Smart investors, like smart businesspeople, care about results, not efforts. That is why “smart money” invests in “passively managed,” structured portfolios that invest systematically in a transparent and replicable manner.”

    Larry Swedroe

     

    In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years to help investors as the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

    Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 07: The Value of Security Analysis.

    Chapter 07: The Value of Security Analysis

    In this chapter, Larry explains how to test the efficiency of the market by looking at how good security analysts are at predicting the future. If they can outsmart the markets, then the markets are not efficient.

    Do investors who follow security analysts's recommendations outperform the market?

    In business, results are what matters— not effort. The same is true in investing because we cannot spend efforts, only results. The basic premise of active management is that, through their efforts, security analysts can identify and recommend undervalued stocks and avoid overvalued ones. As a result, investors who follow their recommendations will outperform the market. Is this premise myth or reality?

    To answer this question, Larry relies on the robust findings of academic research in the paper Analysts and Anomalies. The authors meticulously examined the recommendations of U.S. security analysts over the period 1994 through 2017. Their findings debunk the myth of analysts' infallibility and shed light on the surprising ways analysts' predictions conflict with well-documented anomalies. They also found that buy recommendations did not predict returns, though sell recommendations did predict lower returns. Another intriguing finding was that among the group of "market" anomalies (such as momentum and idiosyncratic risk), which are based only on stock returns, price, and volume data, analysts produce more favorable recommendations and forecast higher returns among the stocks that are stronger buys according to market anomalies. This is perhaps surprising, as analysts are supposed to be experts in firms' fundamentals. Yet, they performed best with anomalies not based on accounting data.

    The evidence in this academic paper suggests that analysts even contribute to mispricing, as their recommendations are systematically biased by favoring overvalued stocks according to anomaly-based composite mispricing scores. The authors concluded: "Analysts today are still overlooking a good deal of valuable, anomaly-related information."

    Results are what matters not effort

    In conclusion, Larry states that if corporate insiders (e.g., boards of directors), with access to far more information than any security analyst is likely to have, have such great difficulty in determining a "correct" valuation, then it is easy to understand why the results of active management are poor and inconsistent.

    While security analysts and active portfolio managers make great efforts to beat the market, historical evidence shows that those efforts have proven counterproductive most of the time. And savvy investors, like smart businesspeople, care about results, not efforts. That is why "smart money" invests in "passively managed," structured portfolios that invest systematically in a transparent and replicable manner.

    Further reading

    1. Joseph Engelberg, David McLean and Jeffrey Pontiff, “Analysts and Anomalies,” Journal of Accounting and Finance (February 2020).
    
    

    Did you miss out on the previous chapters? Check them out:

    • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
    • Enrich Your Future 02: How Markets Set Prices
    • Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
    • Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
    • Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
    • Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
    
    

    About Larry Swedroe

    Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

    Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

    Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

    Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

     

    [spp-transcript]

     

    Connect with Larry Swedroe

    • LinkedIn
    • Twitter
    • Website
    • Books
    
    

    Andrew’s books

    • How to Start Building Your Wealth Investing in the Stock Market
    • My Worst Investment Ever
    • 9 Valuation Mistakes and How to Avoid Them
    • Transform Your Business with Dr.Deming’s 14 Points
    
    

    Andrew’s online programs

    • Valuation Master Class
    • The Become a Better Investor Community
    • How to Start Building Your Wealth Investing in the Stock Market
    • Finance Made Ridiculously Simple
    • FVMR Investing: Quantamental Investing Across the World
    • Become a Great Presenter and Increase Your Influence
    • Transform Your Business with Dr. Deming’s 14 Points
    • Achieve Your Goals
    
    

    Connect with Andrew Stotz:

    • astotz.com
    • LinkedIn
    • Facebook
    • Instagram
    • Threads
    • Twitter
    • YouTube
    • My Worst Investment Ever Podcast
    
    ]]>4306afa6-eef0-476c-9c52-a1367c646c45Tue, 30 Jul 2024 06:00:00 +070029:59falsefullEnrich Your Future 06: Market Efficiency and the Case of Pete RoseIn this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 06: Market Efficiency and the Case of Pete Rose.

    LEARNING: Don’t try to pick stocks or time the market.

     

    “The evidence is very clear. The stocks retail investors buy underperform after they buy them, and the stocks they sell go on to outperform.”

    Larry Swedroe

     

    In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years to help investors as the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

    Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 06: Market Efficiency and the Case of Pete Rose.

    Chapter 06: Market Efficiency and the Case of Pete Rose

    Many people have difficulty understanding why smart investors working hard cannot gain an advantage over average investors who simply accept market returns. In this chapter, Larry uses an analogy in the world of sports betting to explain why the “collective wisdom of the market” is a difficult competitor.

    The case of Pete Rose

    Pete Rose was one of the greatest players in the history of baseball, finishing his career with more hits than any other player. It seems logical that Rose would have a significant advantage over other baseball bettors.

    Rose had 24 years of experience as a player and four years as a manager. In addition to having inside information on his own team, as a manager, he also studied the teams he competed against. Yet, despite these advantages, Rose lost $4,200 betting on his own team, $36,000 betting on other teams in the National League, and $7,000 betting on American League games.

    This reveals that if an expert like Rose, who had access to private information, could not “beat the market,” then it’s very unlikely that ordinary individuals without similar knowledge would be able to do so.

    Sports betting market efficiency

    Larry shares other examples of the efficiency of sports betting markets. One such example is a study covering six NBA seasons in which Professor Raymond Sauer found that the average difference between point spreads and actual point differences was astonishingly low—less than one-quarter of one point.

    In horse racing, the final odds, which reflect the judgment of all bettors, reliably predict the outcome—the favorite wins most often, the second favorite is next most likely to win, and so on. This predictability of the market further emphasizes the futility of trying to exploit mispricings and the need for a more reliable investment strategy.

    Larry goes on to quote James Surowiecki, author of “The Wisdom of Crowds,” who demonstrated that as long as people are acting independently (not in herds), they exhibit what might be called “collective wisdom.” With regard to sports betting, that means the market’s collective wisdom in setting point spreads (or odds) is tough competition to overcome, especially after the expenses of the effort. Larry advises sports bettors to have a small entertainment account to bet on their favorite team and not to invest their entire retirement account. The same holds true of investing.

    The market’s collective wisdom in setting prices is a difficult competition to overcome, especially after the expenses of the effort. Recognizing this, prudent investors don’t attempt to beat the market by trying to exploit mispricings. Instead, they invest in a globally diversified portfolio of funds (such as index funds) that invest systematically and do so in a transparent and replicable manner. In that way, they earn market returns and do so in a highly tax-efficient manner. And the evidence demonstrates that they outperform the vast majority of investors —institutional and individual.

    No retail investors to exploit

    The evidence is clear. On average, the stocks retail investors buy underperform after they buy them, and the stocks they sell outperform. The problem is there aren’t enough retail investors to exploit because they’re smart, talented, and have access to the best databases. But still, the market is too efficient, and the competition’s too tough.

    Larry insists that retail investors shouldn’t try to pick stocks or time the market unless they have different information. This advice is crucial for investors, guiding them away from risky strategies and towards more reliable investment methods.

    Further reading

    1. Douglas Coate, “Market Efficiency in the Baseball Betting Market: The Case of Pete Rose,” Rutgers University Newark Working Paper 2008-003, January 2008.
    2. Raymond D. Sauer, “The Economics of Wagering Markets,” Journal of Economic Literature, 36, p. 2021-64.
    3. James Surowiecki, The Wisdom of Crowds (Doubleday, 2004).
    
    

    Did you miss out on the previous chapters? Check them out:

    • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
    • Enrich Your Future 02: How Markets Set Prices
    • Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
    • Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
    • Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
    
    

    About Larry Swedroe

    Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

    Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

    Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

    Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

     

    [spp-transcript]

     

    Connect with Larry Swedroe

    • LinkedIn
    • Twitter
    • Website
    • Books
    
    

    Andrew’s books

    • How to Start Building Your Wealth Investing in the Stock Market
    • In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 06: Market Efficiency and the Case of Pete Rose.

      LEARNING: Don’t try to pick stocks or time the market.

       

      “The evidence is very clear. The stocks retail investors buy underperform after they buy them, and the stocks they sell go on to outperform.”

      Larry Swedroe

       

      In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years to help investors as the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

      Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 06: Market Efficiency and the Case of Pete Rose.

      Chapter 06: Market Efficiency and the Case of Pete Rose

      Many people have difficulty understanding why smart investors working hard cannot gain an advantage over average investors who simply accept market returns. In this chapter, Larry uses an analogy in the world of sports betting to explain why the “collective wisdom of the market” is a difficult competitor.

      The case of Pete Rose

      Pete Rose was one of the greatest players in the history of baseball, finishing his career with more hits than any other player. It seems logical that Rose would have a significant advantage over other baseball bettors.

      Rose had 24 years of experience as a player and four years as a manager. In addition to having inside information on his own team, as a manager, he also studied the teams he competed against. Yet, despite these advantages, Rose lost $4,200 betting on his own team, $36,000 betting on other teams in the National League, and $7,000 betting on American League games.

      This reveals that if an expert like Rose, who had access to private information, could not “beat the market,” then it’s very unlikely that ordinary individuals without similar knowledge would be able to do so.

      Sports betting market efficiency

      Larry shares other examples of the efficiency of sports betting markets. One such example is a study covering six NBA seasons in which Professor Raymond Sauer found that the average difference between point spreads and actual point differences was astonishingly low—less than one-quarter of one point.

      In horse racing, the final odds, which reflect the judgment of all bettors, reliably predict the outcome—the favorite wins most often, the second favorite is next most likely to win, and so on. This predictability of the market further emphasizes the futility of trying to exploit mispricings and the need for a more reliable investment strategy.

      Larry goes on to quote James Surowiecki, author of “The Wisdom of Crowds,” who demonstrated that as long as people are acting independently (not in herds), they exhibit what might be called “collective wisdom.” With regard to sports betting, that means the market’s collective wisdom in setting point spreads (or odds) is tough competition to overcome, especially after the expenses of the effort. Larry advises sports bettors to have a small entertainment account to bet on their favorite team and not to invest their entire retirement account. The same holds true of investing.

      The market’s collective wisdom in setting prices is a difficult competition to overcome, especially after the expenses of the effort. Recognizing this, prudent investors don’t attempt to beat the market by trying to exploit mispricings. Instead, they invest in a globally diversified portfolio of funds (such as index funds) that invest systematically and do so in a transparent and replicable manner. In that way, they earn market returns and do so in a highly tax-efficient manner. And the evidence demonstrates that they outperform the vast majority of investors —institutional and individual.

      No retail investors to exploit

      The evidence is clear. On average, the stocks retail investors buy underperform after they buy them, and the stocks they sell outperform. The problem is there aren’t enough retail investors to exploit because they’re smart, talented, and have access to the best databases. But still, the market is too efficient, and the competition’s too tough.

      Larry insists that retail investors shouldn’t try to pick stocks or time the market unless they have different information. This advice is crucial for investors, guiding them away from risky strategies and towards more reliable investment methods.

      Further reading

      1. Douglas Coate, “Market Efficiency in the Baseball Betting Market: The Case of Pete Rose,” Rutgers University Newark Working Paper 2008-003, January 2008.
      2. Raymond D. Sauer, “The Economics of Wagering Markets,” Journal of Economic Literature, 36, p. 2021-64.
      3. James Surowiecki, The Wisdom of Crowds (Doubleday, 2004).
      
      

      Did you miss out on the previous chapters? Check them out:

      • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
      • Enrich Your Future 02: How Markets Set Prices
      • Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
      • Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
      • Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
      
      

      About Larry Swedroe

      Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

      Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

      Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

      Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

       

      [spp-transcript]

       

      Connect with Larry Swedroe

      • LinkedIn
      • Twitter
      • Website
      • Books
      
      

      Andrew’s books

      • How to Start Building Your Wealth Investing in the Stock Market
      • My Worst Investment Ever
      • 9 Valuation Mistakes and How to Avoid Them
      • Transform Your Business with Dr.Deming’s 14 Points
      
      

      Andrew’s online programs

      • Valuation Master Class
      • The Become a Better Investor Community
      • How to Start Building Your Wealth Investing in the Stock Market
      • Finance Made Ridiculously Simple
      • FVMR Investing: Quantamental Investing Across the World
      • Become a Great Presenter and Increase Your Influence
      • Transform Your Business with Dr. Deming’s 14 Points
      • Achieve Your Goals
      
      

      Connect with Andrew Stotz:

      • astotz.com
      • LinkedIn
      • Facebook
      • Instagram
      • Threads
      • Twitter
      • YouTube
      • My Worst Investment Ever Podcast
      
      ]]>bccf06d8-e5c9-4e32-83be-cb97cfbce279Tue, 16 Jul 2024 06:00:00 +070033:13falsefullEnrich Your Future 05: Great Companies Do Not Make High-Return InvestmentsIn this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 05: Great Companies Do Not Make High-Return Investments.

      LEARNING:  A higher PE doesn’t mean a higher expected return.

       

      “A higher PE doesn’t mean a higher expected return. It may mean that you’re paying a high price for high expected growth and safety because the company is really strong.”

      Larry Swedroe

       

      In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years or so that he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

      Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 05: Great Companies Do Not Make High-Return Investments

      Chapter 05: Great Companies Do Not Make High-Return Investments

      In this chapter, Larry explains why investing in great companies doesn’t guarantee high returns.

      When faced with the choice of buying the stocks of “great” companies or buying the stocks of “lousy” companies, Larry says most investors would instinctively choose the former.

      This is an anomaly because people think the whole idea of investing is to identify a great company and, therefore, will get great returns. But if you understand finance, that doesn’t make any sense because the first basic rule of investing is that something you know is only information; it’s not value-added information unless the market doesn’t know it. This is because that information is already embedded in the price through the trading actions of all marketplace investors.

      Small companies versus large companies

      According to Larry, if it were true that markets provide returns commensurate with the amount of risk taken, one should expect great results if they invest in a passively managed portfolio consisting of small companies, which are intuitively riskier than large companies.

      Small companies don’t have the economies of scale that large companies have, making them generally less efficient. They typically have weaker balance sheets and fewer sources of capital. When there is distress in the capital markets, smaller companies are generally the first to be cut off from access to capital, increasing the risk of bankruptcy. They don’t have the depth of management that larger companies do. They generally don’t have long track records from which investors can make judgments.

      The cost of trading small stocks is much greater, increasing the risk of investing in them. When one compares the performance of the asset class of small companies with that of large companies, one gets the same results produced by the great companies versus value companies comparison.

      Why great earnings don’t necessarily translate into great investment returns

      The simple explanation for why great earnings don’t necessarily translate into great investment returns is that investors discount the future expected earnings of value stocks at a higher rate than they discount the future expected earnings of growth stocks. This more than offsets the faster earnings growth rates of growth companies. The high discount rate results in low current valuations for value stocks and higher expected future returns relative to growth stocks.

      Risk versus expected return

      Larry talks of a simple principle that can help you avoid making poor investment decisions: Risk and expected return should be positively related. Value stocks have provided a premium over growth stocks for a logical reason: Value stocks are the stocks of riskier companies. That is why their stock prices are distressed. Investors refuse to buy them unless the prices are driven low enough so that they can expect to earn a rate of return that is high enough to compensate them for investing in risky companies. For similar reasons, small stocks have also provided a risk premium compared to large stocks.

      Larry reminds investors that if prices are high, they reflect low perceived risk, and thus, they should expect low future returns and vice versa. This does not make a highly-priced stock a poor investment. It simply makes it an investment perceived to have low risk and, thus, low future returns. Thinking otherwise would be like assuming government bonds are poor investments when the alternative is junk bonds.

      Larry advises investors not to engage in individual security selection. Instead, they should diversify and get the same risk-adjusted returns but with a much narrower dispersion of potential outcomes. Further, they should build a plan that incorporates the fact that when earnings yields are low, the investors expect low returns and adjust their asset allocation accordingly to make sure they have a good chance of achieving their investment goals when that’s the case. Larry also insists that if investors try to time the market, they should do it only at extremes and always remember that a higher PE doesn’t mean a higher expected return. The investor may be paying a high price for high expected growth and safety because the company is strong.

      Did you miss out on the previous chapters? Check them out:

      • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
      • Enrich Your Future 02: How Markets Set Prices
      • Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
      • Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
      
      

      About Larry Swedroe

      Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

      Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

      Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

      Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

       

      [spp-transcript]

       

      Connect with Larry Swedroe

      • LinkedIn
      • Twitter
      • Website
      • Books
      
      

      Andrew’s books

      • How to Start Building Your Wealth Investing in the Stock Market
      • My Worst Investment Ever
      • 9 Valuation Mistakes and How to Avoid Them
      • Transform Your Business with Dr.Deming’s 14 Points
      
      

      Andrew’s online programs

      • Valuation Master Class
      • In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 05: Great Companies Do Not Make High-Return Investments.

        LEARNING:  A higher PE doesn’t mean a higher expected return.

         

        “A higher PE doesn’t mean a higher expected return. It may mean that you’re paying a high price for high expected growth and safety because the company is really strong.”

        Larry Swedroe

         

        In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years or so that he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

        Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 05: Great Companies Do Not Make High-Return Investments

        Chapter 05: Great Companies Do Not Make High-Return Investments

        In this chapter, Larry explains why investing in great companies doesn’t guarantee high returns.

        When faced with the choice of buying the stocks of “great” companies or buying the stocks of “lousy” companies, Larry says most investors would instinctively choose the former.

        This is an anomaly because people think the whole idea of investing is to identify a great company and, therefore, will get great returns. But if you understand finance, that doesn’t make any sense because the first basic rule of investing is that something you know is only information; it’s not value-added information unless the market doesn’t know it. This is because that information is already embedded in the price through the trading actions of all marketplace investors.

        Small companies versus large companies

        According to Larry, if it were true that markets provide returns commensurate with the amount of risk taken, one should expect great results if they invest in a passively managed portfolio consisting of small companies, which are intuitively riskier than large companies.

        Small companies don’t have the economies of scale that large companies have, making them generally less efficient. They typically have weaker balance sheets and fewer sources of capital. When there is distress in the capital markets, smaller companies are generally the first to be cut off from access to capital, increasing the risk of bankruptcy. They don’t have the depth of management that larger companies do. They generally don’t have long track records from which investors can make judgments.

        The cost of trading small stocks is much greater, increasing the risk of investing in them. When one compares the performance of the asset class of small companies with that of large companies, one gets the same results produced by the great companies versus value companies comparison.

        Why great earnings don’t necessarily translate into great investment returns

        The simple explanation for why great earnings don’t necessarily translate into great investment returns is that investors discount the future expected earnings of value stocks at a higher rate than they discount the future expected earnings of growth stocks. This more than offsets the faster earnings growth rates of growth companies. The high discount rate results in low current valuations for value stocks and higher expected future returns relative to growth stocks.

        Risk versus expected return

        Larry talks of a simple principle that can help you avoid making poor investment decisions: Risk and expected return should be positively related. Value stocks have provided a premium over growth stocks for a logical reason: Value stocks are the stocks of riskier companies. That is why their stock prices are distressed. Investors refuse to buy them unless the prices are driven low enough so that they can expect to earn a rate of return that is high enough to compensate them for investing in risky companies. For similar reasons, small stocks have also provided a risk premium compared to large stocks.

        Larry reminds investors that if prices are high, they reflect low perceived risk, and thus, they should expect low future returns and vice versa. This does not make a highly-priced stock a poor investment. It simply makes it an investment perceived to have low risk and, thus, low future returns. Thinking otherwise would be like assuming government bonds are poor investments when the alternative is junk bonds.

        Larry advises investors not to engage in individual security selection. Instead, they should diversify and get the same risk-adjusted returns but with a much narrower dispersion of potential outcomes. Further, they should build a plan that incorporates the fact that when earnings yields are low, the investors expect low returns and adjust their asset allocation accordingly to make sure they have a good chance of achieving their investment goals when that’s the case. Larry also insists that if investors try to time the market, they should do it only at extremes and always remember that a higher PE doesn’t mean a higher expected return. The investor may be paying a high price for high expected growth and safety because the company is strong.

        Did you miss out on the previous chapters? Check them out:

        • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
        • Enrich Your Future 02: How Markets Set Prices
        • Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
        • Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
        
        

        About Larry Swedroe

        Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

        Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

        Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

        Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

         

        [spp-transcript]

         

        Connect with Larry Swedroe

        • LinkedIn
        • Twitter
        • Website
        • Books
        
        

        Andrew’s books

        • How to Start Building Your Wealth Investing in the Stock Market
        • My Worst Investment Ever
        • 9 Valuation Mistakes and How to Avoid Them
        • Transform Your Business with Dr.Deming’s 14 Points
        
        

        Andrew’s online programs

        • Valuation Master Class
        • The Become a Better Investor Community
        • How to Start Building Your Wealth Investing in the Stock Market
        • Finance Made Ridiculously Simple
        • FVMR Investing: Quantamental Investing Across the World
        • Become a Great Presenter and Increase Your Influence
        • Transform Your Business with Dr. Deming’s 14 Points
        • Achieve Your Goals
        
        

        Connect with Andrew Stotz:

        • astotz.com
        • LinkedIn
        • Facebook
        • Instagram
        • Threads
        • Twitter
        • YouTube
        • My Worst Investment Ever Podcast
        
        ]]>05fc898d-933a-4817-91c0-49ff25e1ed2aTue, 09 Jul 2024 06:00:00 +070027:22falsefullEnrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 04: Why Is Persistent Outperformance So Hard to Find?

        LEARNING:  Focus on building a robust asset allocation plan, regularly rebalancing it, and stick with it.

         

        “Investors should just build an asset allocation plan, rebalance, and stick with it. So, when there’s a bubble, take advantage of it and sell some stock high to buy those that haven’t performed.”

        Larry Swedroe

         

        In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years or so that he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

        Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 04: Why Is Persistent Outperformance So Hard to Find?

        Chapter 04: Why Is Persistent Outperformance So Hard to Find?

        In this chapter, Larry explains why persistent outperformance beyond the randomly expected is so hard to find.

        According to Larry, the equivalent of the Holy Grail is finding the formula that allows many investors to time the market successfully. For others, it is finding the fund manager who can exploit market mispricings by buying undervalued stocks and perhaps shorting overvalued ones. However, markets are very highly efficient. An efficient market means that the price is the best estimate investors have of the right price. They don’t know the right price until after the fact.

        The efficiency of the markets and the evidence of the effects of scale on trading costs explain why persistent outperformance beyond the randomly expected is so hard to find. Thus, the search by investors for persistent outperformance is likely to prove as successful as Sir Galahad’s search for the Holy Grail.

        Larry adds that the only place we find the persistence of performance (beyond that which we would randomly expect) is at the very bottom—poorly performing funds tend to repeat. And the persistence of poor performance is not due to poor stock selection. Instead, it is due to high expenses.

        The efficient market hypothesis

        Larry says the efficient market hypothesis (EMH) explains why all investors should expect a lack of persistence. It states that it is only by random good luck that a fund can persistently outperform after the expenses of its efforts. But there is also a practical reason for the lack of persistence: Successful active management sows the seeds of its own destruction.

        Just as the EMH explains why investors cannot use publicly available information to beat the market (because all investors have access to that information, and it is therefore already embedded in prices), the same is true of active managers. Investors should not expect to outperform the market by using publicly available information to select active managers. Any excess return will go to the active manager (in the form of higher expenses).

        Instead of fruitlessly chasing outperformance, Larry advocates for a more strategic approach. He advises investors to focus on building a robust asset allocation plan, regularly rebalancing it, and, most importantly, sticking with it. This approach helps investors take advantage of market bubbles and ensures they are well-positioned to buy stocks that haven’t performed well, thereby promoting a more balanced and sustainable investment strategy.

        Further reading

        1. Amit Goyal and Sunil Wahal, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” Journal of Finance (July 2008).
        2. Jonathan B. Berk, “Five Myths of Active Portfolio Management.”
        3. Roger Edelen, Richard Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund performance: The Role of Trading Costs,” March 17, 2007.
        
        

        Did you miss out on the previous chapters? Check them out:

        • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
        • Enrich Your Future 02: How Markets Set Prices
        • Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
        
        

        About Larry Swedroe

        Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

        Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

        Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

        Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

         

        [spp-transcript]

         

        Connect with Larry Swedroe

        • LinkedIn
        • Twitter
        • Website
        • Books
        
        

        Andrew’s books

        • How to Start Building Your Wealth Investing in the Stock Market
        • My Worst Investment Ever
        • 9 Valuation Mistakes and How to Avoid Them
        • Transform Your Business with Dr.Deming’s 14 Points
        
        

        Andrew’s online programs

        • Valuation Master Class
        • The Become a Better Investor Community
        • How to Start Building Your Wealth Investing in the Stock Market
        • Finance Made Ridiculously Simple
        • FVMR Investing: Quantamental Investing Across the World
        • Become a Great Presenter and Increase Your Influence
        • In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 04: Why Is Persistent Outperformance So Hard to Find?

          LEARNING:  Focus on building a robust asset allocation plan, regularly rebalancing it, and stick with it.

           

          “Investors should just build an asset allocation plan, rebalance, and stick with it. So, when there’s a bubble, take advantage of it and sell some stock high to buy those that haven’t performed.”

          Larry Swedroe

           

          In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years or so that he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

          Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 04: Why Is Persistent Outperformance So Hard to Find?

          Chapter 04: Why Is Persistent Outperformance So Hard to Find?

          In this chapter, Larry explains why persistent outperformance beyond the randomly expected is so hard to find.

          According to Larry, the equivalent of the Holy Grail is finding the formula that allows many investors to time the market successfully. For others, it is finding the fund manager who can exploit market mispricings by buying undervalued stocks and perhaps shorting overvalued ones. However, markets are very highly efficient. An efficient market means that the price is the best estimate investors have of the right price. They don’t know the right price until after the fact.

          The efficiency of the markets and the evidence of the effects of scale on trading costs explain why persistent outperformance beyond the randomly expected is so hard to find. Thus, the search by investors for persistent outperformance is likely to prove as successful as Sir Galahad’s search for the Holy Grail.

          Larry adds that the only place we find the persistence of performance (beyond that which we would randomly expect) is at the very bottom—poorly performing funds tend to repeat. And the persistence of poor performance is not due to poor stock selection. Instead, it is due to high expenses.

          The efficient market hypothesis

          Larry says the efficient market hypothesis (EMH) explains why all investors should expect a lack of persistence. It states that it is only by random good luck that a fund can persistently outperform after the expenses of its efforts. But there is also a practical reason for the lack of persistence: Successful active management sows the seeds of its own destruction.

          Just as the EMH explains why investors cannot use publicly available information to beat the market (because all investors have access to that information, and it is therefore already embedded in prices), the same is true of active managers. Investors should not expect to outperform the market by using publicly available information to select active managers. Any excess return will go to the active manager (in the form of higher expenses).

          Instead of fruitlessly chasing outperformance, Larry advocates for a more strategic approach. He advises investors to focus on building a robust asset allocation plan, regularly rebalancing it, and, most importantly, sticking with it. This approach helps investors take advantage of market bubbles and ensures they are well-positioned to buy stocks that haven’t performed well, thereby promoting a more balanced and sustainable investment strategy.

          Further reading

          1. Amit Goyal and Sunil Wahal, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” Journal of Finance (July 2008).
          2. Jonathan B. Berk, “Five Myths of Active Portfolio Management.”
          3. Roger Edelen, Richard Evans, and Gregory B. Kadlec, “Scale Effects in Mutual Fund performance: The Role of Trading Costs,” March 17, 2007.
          
          

          Did you miss out on the previous chapters? Check them out:

          • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
          • Enrich Your Future 02: How Markets Set Prices
          • Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
          
          

          About Larry Swedroe

          Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

          Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

          Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

          Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

           

          [spp-transcript]

           

          Connect with Larry Swedroe

          • LinkedIn
          • Twitter
          • Website
          • Books
          
          

          Andrew’s books

          • How to Start Building Your Wealth Investing in the Stock Market
          • My Worst Investment Ever
          • 9 Valuation Mistakes and How to Avoid Them
          • Transform Your Business with Dr.Deming’s 14 Points
          
          

          Andrew’s online programs

          • Valuation Master Class
          • The Become a Better Investor Community
          • How to Start Building Your Wealth Investing in the Stock Market
          • Finance Made Ridiculously Simple
          • FVMR Investing: Quantamental Investing Across the World
          • Become a Great Presenter and Increase Your Influence
          • Transform Your Business with Dr. Deming’s 14 Points
          • Achieve Your Goals
          
          

          Connect with Andrew Stotz:

          • astotz.com
          • LinkedIn
          • Facebook
          • Instagram
          • Threads
          • Twitter
          • YouTube
          • My Worst Investment Ever Podcast
          
          ]]>e2914528-5f33-459f-a029-b40ba47b7a55Tue, 02 Jul 2024 06:00:00 +070022:53falsefullEnrich Your Future 03: Persistence of Performance: Athletes Versus Investment ManagersIn this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 03: Persistence of Performance: Athletes Versus Investment Managers.

          LEARNING:  The nature of the competition in the investment arena is so different that conventional wisdom does not apply. What works in one paradigm does not necessarily work in another.

           

          “Active managers fail with great persistence not because they’re dumb, it’s just that they have a burden of costs, which makes it very difficult for them to outperform and overcome those costs.”

          Larry Swedroe

           

          In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years or so that he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

          Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 03: Persistence of Performance: Athletes Versus Investment Managers.

          Chapter 03: Persistence of Performance: Athletes Versus Investment Managers

          In this chapter, Larry expounds on why we do not see the persistence of the outperformance of investment managers. He also tries to help investors understand how securities markets set prices.

          Skills versus luck

          One of the most strongly held beliefs is that successful people succeed not through luck but through the skill of persistence over time. So, people assume that successful active managers must also result from this skill, not just luck. Larry explains that while this may be true for athletes where competition is one-on-one, it is not the case when it comes to investing.

          According to Dr. Mark Rubinstein, competition for an investment manager is not other individual investment managers but rather the market’s collective wisdom. Further, Rex Sinquefield states that just because there are some investors smarter than others, that advantage will not show up. The market is too vast and too informationally efficient. Many people fail to comprehend that in many forms of competition, such as chess, poker, or investing, the relative skill level plays the more critical role in determining outcomes, not the absolute level. The “paradox of skill” means that even as skill level rises, luck can become more crucial in determining outcomes if the level of competition also increases.

          The cost of outperformance

          When it comes to outperforming the market, Larry cautions that investment managers are not engaged in a zero-sum game. In pursuing market-beating returns, they face significantly higher expenses than passive investors. These costs, which include research expenses, other fund operating expenses, bid-offer spreads, commissions, market impact costs, and taxes, can pose significant financial risks. Investors must be aware of these potential pitfalls and factor them into their investment strategies.

          According to Larry, small-cap stocks tend to outperform large stocks in the long term. This performance isn’t a size effect but a merger effect. Active managers fail with remarkable persistence in emerging markets because there are costs to exploit market inefficiencies, and the more inefficient the market is, the more the implementation costs.

          Why conventional wisdom doesn’t apply in investing

          In conclusion, Larry states that conventional wisdom states that past performance is a good predictor of future performance. It is conventional wisdom because it holds true in most endeavors, be it a sporting event or any other form of competition. The problem for investors who believe in conventional wisdom is that the nature of the competition in the investment arena is so different that conventional wisdom does not apply. What works in one paradigm does not necessarily work in another. Peter Bernstein said, “In the real world, investors seem to have great difficulty outperforming one another in any convincing or consistent fashion. Today’s hero is often tomorrow’s blockhead.”

          Further reading

          1. Dr. Mark Rubinstein, “Rational Markets: Yes or No? The Affirmative Case,” Financial Analysts Journal (May-June 2001).
          2. Ron Ross, The Unbeatable Market (Optimum Press, 2002).
          3. Raymond Fazzi, “Going Their Own Way,” Financial Advisor (March 2001).
          4. Tim Riley, “Can Mutual Fund Stars Still Pick Stocks?: A Replication and Extension of Kosowski, Timmermann, Wermers, and White (2006).” January 2019.
          5. Robert Kosowski, Allan Timmermann, Russ Wermers and Hal White, “Can Mutual Fund ‘Stars’ Really Pick Stocks? New Evidence from a Bootstrap Analysis, Journal of Finance (December 2006)
          6. Ralph Wanger, A Zebra in Lion Country (Simon & Schuster, 1997).
          7. Peter Bernstein, Against the Gods (Wiley, 1996).
          
          

          Did you miss out on the previous chapters? Check them out:

          • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
          • Enrich Your Future 02: How Markets Set Prices
          
          

          About Larry Swedroe

          Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

          Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

          Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

          Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

           

          [spp-transcript]

           

          Connect with Larry Swedroe

          • LinkedIn
          • Twitter
          • Website
          • Books
          
          

          Andrew’s books

          • How to Start Building Your Wealth Investing in the Stock Market
          • My Worst Investment Ever
          • 9 Valuation Mistakes and How to Avoid Them
          • Transform Your Business with Dr.Deming’s 14 Points
          
          

          Andrew’s online programs

          • In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 03: Persistence of Performance: Athletes Versus Investment Managers.

            LEARNING:  The nature of the competition in the investment arena is so different that conventional wisdom does not apply. What works in one paradigm does not necessarily work in another.

             

            “Active managers fail with great persistence not because they’re dumb, it’s just that they have a burden of costs, which makes it very difficult for them to outperform and overcome those costs.”

            Larry Swedroe

             

            In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years or so that he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

            Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 03: Persistence of Performance: Athletes Versus Investment Managers.

            Chapter 03: Persistence of Performance: Athletes Versus Investment Managers

            In this chapter, Larry expounds on why we do not see the persistence of the outperformance of investment managers. He also tries to help investors understand how securities markets set prices.

            Skills versus luck

            One of the most strongly held beliefs is that successful people succeed not through luck but through the skill of persistence over time. So, people assume that successful active managers must also result from this skill, not just luck. Larry explains that while this may be true for athletes where competition is one-on-one, it is not the case when it comes to investing.

            According to Dr. Mark Rubinstein, competition for an investment manager is not other individual investment managers but rather the market’s collective wisdom. Further, Rex Sinquefield states that just because there are some investors smarter than others, that advantage will not show up. The market is too vast and too informationally efficient. Many people fail to comprehend that in many forms of competition, such as chess, poker, or investing, the relative skill level plays the more critical role in determining outcomes, not the absolute level. The “paradox of skill” means that even as skill level rises, luck can become more crucial in determining outcomes if the level of competition also increases.

            The cost of outperformance

            When it comes to outperforming the market, Larry cautions that investment managers are not engaged in a zero-sum game. In pursuing market-beating returns, they face significantly higher expenses than passive investors. These costs, which include research expenses, other fund operating expenses, bid-offer spreads, commissions, market impact costs, and taxes, can pose significant financial risks. Investors must be aware of these potential pitfalls and factor them into their investment strategies.

            According to Larry, small-cap stocks tend to outperform large stocks in the long term. This performance isn’t a size effect but a merger effect. Active managers fail with remarkable persistence in emerging markets because there are costs to exploit market inefficiencies, and the more inefficient the market is, the more the implementation costs.

            Why conventional wisdom doesn’t apply in investing

            In conclusion, Larry states that conventional wisdom states that past performance is a good predictor of future performance. It is conventional wisdom because it holds true in most endeavors, be it a sporting event or any other form of competition. The problem for investors who believe in conventional wisdom is that the nature of the competition in the investment arena is so different that conventional wisdom does not apply. What works in one paradigm does not necessarily work in another. Peter Bernstein said, “In the real world, investors seem to have great difficulty outperforming one another in any convincing or consistent fashion. Today’s hero is often tomorrow’s blockhead.”

            Further reading

            1. Dr. Mark Rubinstein, “Rational Markets: Yes or No? The Affirmative Case,” Financial Analysts Journal (May-June 2001).
            2. Ron Ross, The Unbeatable Market (Optimum Press, 2002).
            3. Raymond Fazzi, “Going Their Own Way,” Financial Advisor (March 2001).
            4. Tim Riley, “Can Mutual Fund Stars Still Pick Stocks?: A Replication and Extension of Kosowski, Timmermann, Wermers, and White (2006).” January 2019.
            5. Robert Kosowski, Allan Timmermann, Russ Wermers and Hal White, “Can Mutual Fund ‘Stars’ Really Pick Stocks? New Evidence from a Bootstrap Analysis, Journal of Finance (December 2006)
            6. Ralph Wanger, A Zebra in Lion Country (Simon & Schuster, 1997).
            7. Peter Bernstein, Against the Gods (Wiley, 1996).
            
            

            Did you miss out on the previous chapters? Check them out:

            • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
            • Enrich Your Future 02: How Markets Set Prices
            
            

            About Larry Swedroe

            Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

            Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

            Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

            Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

             

            [spp-transcript]

             

            Connect with Larry Swedroe

            • LinkedIn
            • Twitter
            • Website
            • Books
            
            

            Andrew’s books

            • How to Start Building Your Wealth Investing in the Stock Market
            • My Worst Investment Ever
            • 9 Valuation Mistakes and How to Avoid Them
            • Transform Your Business with Dr.Deming’s 14 Points
            
            

            Andrew’s online programs

            • Valuation Master Class
            • The Become a Better Investor Community
            • How to Start Building Your Wealth Investing in the Stock Market
            • Finance Made Ridiculously Simple
            • FVMR Investing: Quantamental Investing Across the World
            • Become a Great Presenter and Increase Your Influence
            • Transform Your Business with Dr. Deming’s 14 Points
            • Achieve Your Goals
            
            

            Connect with Andrew Stotz:

            • astotz.com
            • LinkedIn
            • Facebook
            • Instagram
            • Twitter
            • YouTube
            • My Worst Investment Ever Podcast
            
            ]]>ed90887a-c1fd-41cb-8a64-859899e1bce4Tue, 25 Jun 2024 06:00:00 +070029:25falsefullEnrich Your Future 02: How Markets Set PricesIn this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 02: How Markets Set Prices.

            LEARNING: Invest in passively managed funds and adopt a simple buy, hold, and rebalance strategy. While gamblers make bets, investors let the markets work for them, not against them.

             

            “The only way to beat an efficient market is to either know something the market doesn’t—such as the fact that a team’s best player is injured and will not be able to play—or to be able to interpret information about the teams better than the market (other gamblers collectively) does.”

            Larry Swedroe

             

            In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years or so that he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

            Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 02: How Markets Set Prices.

            Chapter 02: How Markets Set Prices

            In this chapter, Larry explains how markets set prices—probably the most important thing investors need to learn before they invest a penny. Without this knowledge, investors won’t know whether the stock they buy is undervalued or overvalued. Larry insists that investors should have a good understanding of how the market gets to a specific price.

            Point spread betting

            To explain the complicated concept of how markets set prices, Larry uses an analogy related to college basketball backed up by academic research. Duke is a perennial contender for the national championship. Every year, it’s ranked in the top 25. At the start of every season, most college teams that are good try to schedule a few of what are called “cupcake” games to give their players a chance to get in the routine, learn the plays, get to know each other, etc., before they meet tougher competition.

            Duke often scheduled a game against Army. Army traveled down every year to Duke, where they would get a big payday, and Duke would have an easy win. No one in their right mind would bet on Army to win that game because they have played probably 30-40 times already, and Duke has won every game. And they could play another 30 or 40 times and win every game. However, people decide to entice others to bet on Army.

            To make it an equal bet, they create a point spread. The bookies set the initial point spread where they think they can get an equal amount of money bet on both sides. The bookies do their analysis and set the initial spread, but they don’t set the actual spread, which is determined by the betters in their actions. So if a lot of money starts coming in betting on Duke, the bookies will raise the spread until money starts coming in on Army until they get an equal amount of money. Then, the winner has to put up $110 to win $100. If they win, you get their $110 back and the bookies’s $100. But if you lose, you lose $110, not $100. So the bookies collect that $10 on the total of $200. So, what happens is that the point spread is moving based on the collective wisdom of the markets.

            It’s very easy to determine whether Duke is going to win or not. But it’s tough to beat that point spread. Very rarely does the point spread predict the actual outcome. However, it is an unbiased estimator of the outcome. An “unbiased estimator” is a statistic that is, on average, neither too high nor too low. Evidence from a study covering six NBA seasons shows that the average error was less than one-quarter of one point. So, there’s no way to exploit that information.

            In terms of investing, Larry gives an example of when you want to buy a stock (making a bet on the company), you have to buy it from someone. A stockbroker will not sell that stock to you because he might lose money. Instead, they find someone who wants to sell the stock and match the buyer with the seller. He is taking bets, not making bets. In the process, he earns the vigorish (a commission). Like stockbrokers, bookies want to take bets, not make them. Thus, they set the initial point spread at the “price” they believe will balance the forces of supply and demand (the point at which an equal amount of money will be bet on Duke and Army).

            How to beat an efficient market

            A market in which it is difficult to persistently exploit mispricing after the expenses of the effort is called an “efficient” market. According to Larry, the only way to beat an efficient market is to either know something the market doesn’t—such as the fact that a team’s best player is injured and will not be able to play—or to be able to interpret information about the teams better than the market (other gamblers collectively) does.

            The existence of an efficient public market in which the knowledge of all bettors (investors) is used to set prices protects the less informed bettors (investors) from being exploited. On the other hand, the existence of an efficient market prevents the sophisticated and more knowledgeable bettors (investors) from exploiting their less knowledgeable counterparts.

            Since about 90 percent of all trading is done by large institutional traders, these sophisticated investors are setting prices, not amateur individual investors. The competition is undoubtedly tougher, with professionals (instead of amateurs) dominating the market. Every time an individual buys a stock, he should consider that he is competing with these giant institutional investors. The individual investor should also acknowledge that institutions have more resources, and thus, they will likely succeed.

            However, study after study demonstrates that the majority of individual and institutional investors who attempt to beat the market by either picking stocks or timing the market fail miserably, and they do so with great persistence.

            A study by University of California professors Brad Barber and Terrance Odean found that the stocks individual investors buy underperform the market after they buy them, and the stocks they sell outperform after they sell them. They also found that male investors underperform the market by about 3% per annum, and women (because they trade less and thus incur less costs) trail the market by about 2% per annum. In addition, they found that those investors who traded the most trailed the market on a risk-adjusted basis by over 10 percent per annum. And to prove that more heads are not better than one, they found that investment clubs trailed the market by almost 4% per annum.

            Betting against an efficient market

            Betting against an efficient market is a loser’s game. It doesn’t matter whether the “game” is betting on a sporting event or trying to identify which stocks will outperform the market. While it is possible to win by betting on sporting events, because the markets are highly efficient, the only likely winners are the bookies. In addition, the more you play the game, the more likely you will lose, and the bookies will win. The same is true of investing. And the reason is that the securities markets are also highly efficient.

            If you try to time the market, pick stocks, or hire managers to engage in that activity for you, you are playing a loser’s game. Just as you can win by betting on sporting events, you can win (outperform) by picking stocks, timing the market, or using active managers to play the game on your behalf. However, the odds are poor. And just as with gambling, the more and the longer you play the game, the more likely you will lose (as the costs of playing compound). This makes accepting market returns (passive investing) the winner’s game.

            Larry advises investors to invest in passively managed funds and adopt a simple buy, hold, and rebalance strategy. This way, you are guaranteed to earn market rates of returns at a low cost and relatively tax-efficient manner. You are also virtually guaranteed to outperform the majority of professional and individual investors. Thus, it is the strategy most likely to achieve the best results. The bottom line is that while gamblers make bets (speculate on individual stocks and actively managed funds), investors let the markets work for them, not against them.

            Further reading

            1. William J. Bernstein, The Four Pillars of Investing (McGraw-Hill, 2002).
            2. Raymond D. Sauer, “The Economics of Wagering Markets,” Journal of...]]>In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 02: How Markets Set Prices.

               LEARNING: Invest in passively managed funds and adopt a simple buy, hold, and rebalance strategy. While gamblers make bets, investors let the markets work for them, not against them.

                

               “The only way to beat an efficient market is to either know something the market doesn’t—such as the fact that a team’s best player is injured and will not be able to play—or to be able to interpret information about the teams better than the market (other gamblers collectively) does.”

               Larry Swedroe

                

               In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years or so that he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

               Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 02: How Markets Set Prices.

               Chapter 02: How Markets Set Prices

               In this chapter, Larry explains how markets set prices—probably the most important thing investors need to learn before they invest a penny. Without this knowledge, investors won’t know whether the stock they buy is undervalued or overvalued. Larry insists that investors should have a good understanding of how the market gets to a specific price.

               Point spread betting

               To explain the complicated concept of how markets set prices, Larry uses an analogy related to college basketball backed up by academic research. Duke is a perennial contender for the national championship. Every year, it’s ranked in the top 25. At the start of every season, most college teams that are good try to schedule a few of what are called “cupcake” games to give their players a chance to get in the routine, learn the plays, get to know each other, etc., before they meet tougher competition.

               Duke often scheduled a game against Army. Army traveled down every year to Duke, where they would get a big payday, and Duke would have an easy win. No one in their right mind would bet on Army to win that game because they have played probably 30-40 times already, and Duke has won every game. And they could play another 30 or 40 times and win every game. However, people decide to entice others to bet on Army.

               To make it an equal bet, they create a point spread. The bookies set the initial point spread where they think they can get an equal amount of money bet on both sides. The bookies do their analysis and set the initial spread, but they don’t set the actual spread, which is determined by the betters in their actions. So if a lot of money starts coming in betting on Duke, the bookies will raise the spread until money starts coming in on Army until they get an equal amount of money. Then, the winner has to put up $110 to win $100. If they win, you get their $110 back and the bookies’s $100. But if you lose, you lose $110, not $100. So the bookies collect that $10 on the total of $200. So, what happens is that the point spread is moving based on the collective wisdom of the markets.

               It’s very easy to determine whether Duke is going to win or not. But it’s tough to beat that point spread. Very rarely does the point spread predict the actual outcome. However, it is an unbiased estimator of the outcome. An “unbiased estimator” is a statistic that is, on average, neither too high nor too low. Evidence from a study covering six NBA seasons shows that the average error was less than one-quarter of one point. So, there’s no way to exploit that information.

               In terms of investing, Larry gives an example of when you want to buy a stock (making a bet on the company), you have to buy it from someone. A stockbroker will not sell that stock to you because he might lose money. Instead, they find someone who wants to sell the stock and match the buyer with the seller. He is taking bets, not making bets. In the process, he earns the vigorish (a commission). Like stockbrokers, bookies want to take bets, not make them. Thus, they set the initial point spread at the “price” they believe will balance the forces of supply and demand (the point at which an equal amount of money will be bet on Duke and Army).

               How to beat an efficient market

               A market in which it is difficult to persistently exploit mispricing after the expenses of the effort is called an “efficient” market. According to Larry, the only way to beat an efficient market is to either know something the market doesn’t—such as the fact that a team’s best player is injured and will not be able to play—or to be able to interpret information about the teams better than the market (other gamblers collectively) does.

               The existence of an efficient public market in which the knowledge of all bettors (investors) is used to set prices protects the less informed bettors (investors) from being exploited. On the other hand, the existence of an efficient market prevents the sophisticated and more knowledgeable bettors (investors) from exploiting their less knowledgeable counterparts.

               Since about 90 percent of all trading is done by large institutional traders, these sophisticated investors are setting prices, not amateur individual investors. The competition is undoubtedly tougher, with professionals (instead of amateurs) dominating the market. Every time an individual buys a stock, he should consider that he is competing with these giant institutional investors. The individual investor should also acknowledge that institutions have more resources, and thus, they will likely succeed.

               However, study after study demonstrates that the majority of individual and institutional investors who attempt to beat the market by either picking stocks or timing the market fail miserably, and they do so with great persistence.

               A study by University of California professors Brad Barber and Terrance Odean found that the stocks individual investors buy underperform the market after they buy them, and the stocks they sell outperform after they sell them. They also found that male investors underperform the market by about 3% per annum, and women (because they trade less and thus incur less costs) trail the market by about 2% per annum. In addition, they found that those investors who traded the most trailed the market on a risk-adjusted basis by over 10 percent per annum. And to prove that more heads are not better than one, they found that investment clubs trailed the market by almost 4% per annum.

               Betting against an efficient market

               Betting against an efficient market is a loser’s game. It doesn’t matter whether the “game” is betting on a sporting event or trying to identify which stocks will outperform the market. While it is possible to win by betting on sporting events, because the markets are highly efficient, the only likely winners are the bookies. In addition, the more you play the game, the more likely you will lose, and the bookies will win. The same is true of investing. And the reason is that the securities markets are also highly efficient.

               If you try to time the market, pick stocks, or hire managers to engage in that activity for you, you are playing a loser’s game. Just as you can win by betting on sporting events, you can win (outperform) by picking stocks, timing the market, or using active managers to play the game on your behalf. However, the odds are poor. And just as with gambling, the more and the longer you play the game, the more likely you will lose (as the costs of playing compound). This makes accepting market returns (passive investing) the winner’s game.

               Larry advises investors to invest in passively managed funds and adopt a simple buy, hold, and rebalance strategy. This way, you are guaranteed to earn market rates of returns at a low cost and relatively tax-efficient manner. You are also virtually guaranteed to outperform the majority of professional and individual investors. Thus, it is the strategy most likely to achieve the best results. The bottom line is that while gamblers make bets (speculate on individual stocks and actively managed funds), investors let the markets work for them, not against them.

               Further reading

               1. William J. Bernstein, The Four Pillars of Investing (McGraw-Hill, 2002).
               2. Raymond D. Sauer, “The Economics of Wagering Markets,” Journal of Economic Literature, 36.
               3. Daniel C. Hickman, “Efficiency in the Madness? Examining the Betting Market for the NCAA Men’s Basketball Tournament,” Journal of Economics and Finance (July 2020).
               4. Guy Elaad, James Reade, and Carl Singleton, “Information, Prices and Efficiency in an Online Betting Market,” Finance Research Letters (July 2020).
               5. James Suroweicki, “The Wisdom of Crowds,” (Doubleday 2004).
               6. Brad Barber and Terrance Odean, “Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment,” Quarterly Journal of Economics (February 2001).
               7. Brad Barber and Terrance Odean, “Trading Is Hazardous to Your Wealth.”
               8. Brad Barber and Terrance Odean, “Too Many Cooks Spoil the Profits: Investment Club Performance,” Financial Analysts Journal (January/February 2000).
               9. Andrew Tobias, The Only Investment Book You Will Ever Need (Harcourt, 1978).
               10. Fama, Eugene F., and Kenneth R. French. 2010. “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” Journal of Finance, vol. 65, no. 5 (October):1915.
               11. Meyer-Brauns, Philipp, “Mutual Fund Performance through a Five-Factor Lens.” Dimensional Fund Advisors white paper. 2016.
               12. Andrew Berkin and Larry E. Swedroe, “The Incredible Shrinking Alpha,” Harriman House (2020).
               13. William Berlind, “Bookies in Exile,” New York Times, August 17, 2003.
               
               

               Did you miss out on the previous chapter? Check them out:

               • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
               
               

               About Larry Swedroe

               Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

               Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

               Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

               Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

                

               [spp-transcript]

                

               Connect with Larry Swedroe

               • LinkedIn
               • Twitter
               • Website
               • Books
               
               

               Andrew’s books

               • How to Start Building Your Wealth Investing in the Stock Market
               • My Worst Investment Ever
               • 9 Valuation Mistakes and How to Avoid Them
               • Transform Your Business with Dr.Deming’s 14 Points
               
               

               Andrew’s online programs

               • Valuation Master Class
               • The Become a Better Investor Community
               • How to Start Building Your Wealth Investing in the Stock Market
               • Finance Made Ridiculously Simple
               • FVMR Investing: Quantamental Investing Across the World
               • Become a Great Presenter and Increase Your Influence
               • Transform Your Business with Dr. Deming’s 14 Points
               • Achieve Your Goals
               
               

               Connect with Andrew Stotz:

               • astotz.com
               • LinkedIn
               • Facebook
               • Instagram
               • Twitter
               • YouTube
               • My Worst Investment Ever Podcast
               
               ]]>f3ab3201-9735-48bf-8661-849a8c899a56Tue, 18 Jun 2024 06:00:00 +070036:53falsefullEnrich Your Future 01: The Determinants of the Risk and Return of Stocks and BondsIn this episode of Investing Principles, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 1: The Determinants of the Risk and Return of Stocks and Bonds.

               LEARNING: Look for key metrics, traits, or characteristics that help them identify stocks that will outperform the market.

                

               “Intelligent people maintain open minds when it comes to new ideas. And they change strategies when there is compelling evidence demonstrating the ‘conventional wisdom’ is wrong.”

               Larry Swedroe

                

               In this episode of Investing Principles, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories Larry has developed over the 30+ years he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

               Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 1: The Determinants of the Risk and Return of Stocks and Bonds.

               Chapter 1: The Determinants of the Risk and Return of Stocks and Bonds

               In this chapter, Larry looks at research that revolutionized how people think about investing and how to build a winning portfolio. The goal is to help investors learn how to look for key metrics, traits, or characteristics that help them identify stocks that will outperform the market, at least in terms of delivering higher returns, not necessarily higher risk-adjusted returns.

               The three-factor model

               The first research Larry talks about is by Eugene Fama and Kenneth French. Their paper “The Cross-Section of Expected Stock Returns” in The Journal of Finance focused on research that produced what has become known as the three-factor model. A factor is a common trait or characteristic of a stock or bond. The three factors explained by Fama and French are:

               1. Market beta (the return of the market minus the return on one-month Treasury bills)
               2. Size (the return on small stocks minus the return on large stocks)
               3. Value (the return on value stocks minus the return on growth stocks).
               
               

               The model can explain more than 90% of the variation of returns of diversified US equity portfolios. The research shows that ensemble funds are superior to individual funds. It’s better to have a multi-factor portfolio. So you could own, say, five different funds that have exposure to each individual factor, or you own one fund that gives you exposure to all those factors. The ensemble strategies always tend to do better.

               The two-factor model

               Larry also highlights a second model by professors Fama and French, the two-factor model that explains the variation of returns of fixed-income portfolios. The two risk factors are term and default (credit risk). According to the model, the longer the term to maturity, the greater the risk; the lower the credit rating, the greater the risk. Markets compensate investors for taking risks with higher expected returns. As with equities, individual security selection and market timing do not play a significant role in explaining returns of fixed-income portfolios and thus should not be expected to add value.

               Buffett’s Alpha

               Another significant academic research publication is the study “Buffett’s Alpha.” The authors, Andrea Frazzini, David Kabiller, and Lasse Pedersen, examined the performance of the stocks owned by legendary investor Warren Buffett’s Berkshire Hathaway. They found that, besides benefiting from using cheap leverage provided by Berkshire’s insurance operations, Buffett buys safe, cheap, high-quality, and large stocks. Their most interesting finding was that stocks with these characteristics tend to perform well in general, not just the stocks with these characteristics that Buffett buys. Larry observes that Buffett’s strategy, or exposure to factors, explains his success, not his stock-picking skills. Also, he never engages in panicked selling.

               Larry says that investors don’t need to be stock pickers like Warren Buffett. They can simply buy stocks with the same characteristics as Warren Buffett’s stocks without doing all the research. Today, companies like AQR, Avantis, Bridgeway, Dimensional, and others use that research so that every investor can access those characteristics and decide which characteristics they want to invest in. The iShares MSCI USA Quality Factor ETF (QUAL) buys quality stocks. It has an expense ratio of just 0.15% and is highly tax-efficient as an ETF.

               Luck versus skill

               Academic research has demonstrated that efforts to outperform the market by either security selection or timing are improbable in proving productive after taking into account the costs, including taxes, of the efforts. For example, studies such as the “Luck versus Skill in the Cross-Section of Mutual Fund Returns” have found that fewer active managers (about 2%) can outperform their three-factor-model benchmark than would be expected by chance. That is even before considering the impact of taxes, which for taxable investors is typically the most significant expense of active management (greater than the fund’s expense ratio and/or trading costs).

               Larry, therefore, recommends:

               • Developing a portfolio that reflects your unique ability, willingness, and need to take risks. The equity portion should be globally diversified across multiple asset classes. The fixed-income portion should be diversified in terms of credit and term risk, as appropriate.
               • Avoiding the use of actively managed funds. Instead, invest in funds that provide systematic exposure to the factors you seek exposure to, such as low-risk and tax-efficient index funds.
               • In the case of fixed-income assets (for those individuals who have sufficient assets to do so), build a portfolio of individual Treasury securities and/or FDIC-insured CDs, and for taxable accounts, AAA- and AA-rated municipal bonds that are also either general obligation or essential service revenue bonds. Doing so dramatically reduces the credit risk and, therefore, the need for diversification (which is the benefit of a mutual fund).
               • Having the discipline to stay the course, ignoring the noise of the markets and the emotions caused by the noise—emotions that cause investors to abandon even the most well-developed plans.
               
               

               Notes

               1. Michael Lewis, Moneyball (Norton 2003), p. 67.
               2. Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns,” The Journal of Finance (June 1992).
               3. Andrea Frazzini, David Kabiller and Lasse Pedersen, “Buffett’s Alpha,” Financial Analysts Journal (September 2018).
               4. Eugene Fama and Kenneth French, “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” The Journal of Finance (September 2010).
               
               

               About Larry Swedroe

               Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

               Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

               Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

               Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

                

               [spp-transcript]

                

               Connect with Larry Swedroe

               • LinkedIn
               • Twitter
               • In this episode of Investing Principles, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 1: The Determinants of the Risk and Return of Stocks and Bonds.

                 LEARNING: Look for key metrics, traits, or characteristics that help them identify stocks that will outperform the market.

                  

                 “Intelligent people maintain open minds when it comes to new ideas. And they change strategies when there is compelling evidence demonstrating the ‘conventional wisdom’ is wrong.”

                 Larry Swedroe

                  

                 In this episode of Investing Principles, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories Larry has developed over the 30+ years he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

                 Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 1: The Determinants of the Risk and Return of Stocks and Bonds.

                 Chapter 1: The Determinants of the Risk and Return of Stocks and Bonds

                 In this chapter, Larry looks at research that revolutionized how people think about investing and how to build a winning portfolio. The goal is to help investors learn how to look for key metrics, traits, or characteristics that help them identify stocks that will outperform the market, at least in terms of delivering higher returns, not necessarily higher risk-adjusted returns.

                 The three-factor model

                 The first research Larry talks about is by Eugene Fama and Kenneth French. Their paper “The Cross-Section of Expected Stock Returns” in The Journal of Finance focused on research that produced what has become known as the three-factor model. A factor is a common trait or characteristic of a stock or bond. The three factors explained by Fama and French are:

                 1. Market beta (the return of the market minus the return on one-month Treasury bills)
                 2. Size (the return on small stocks minus the return on large stocks)
                 3. Value (the return on value stocks minus the return on growth stocks).
                 
                 

                 The model can explain more than 90% of the variation of returns of diversified US equity portfolios. The research shows that ensemble funds are superior to individual funds. It’s better to have a multi-factor portfolio. So you could own, say, five different funds that have exposure to each individual factor, or you own one fund that gives you exposure to all those factors. The ensemble strategies always tend to do better.

                 The two-factor model

                 Larry also highlights a second model by professors Fama and French, the two-factor model that explains the variation of returns of fixed-income portfolios. The two risk factors are term and default (credit risk). According to the model, the longer the term to maturity, the greater the risk; the lower the credit rating, the greater the risk. Markets compensate investors for taking risks with higher expected returns. As with equities, individual security selection and market timing do not play a significant role in explaining returns of fixed-income portfolios and thus should not be expected to add value.

                 Buffett’s Alpha

                 Another significant academic research publication is the study “Buffett’s Alpha.” The authors, Andrea Frazzini, David Kabiller, and Lasse Pedersen, examined the performance of the stocks owned by legendary investor Warren Buffett’s Berkshire Hathaway. They found that, besides benefiting from using cheap leverage provided by Berkshire’s insurance operations, Buffett buys safe, cheap, high-quality, and large stocks. Their most interesting finding was that stocks with these characteristics tend to perform well in general, not just the stocks with these characteristics that Buffett buys. Larry observes that Buffett’s strategy, or exposure to factors, explains his success, not his stock-picking skills. Also, he never engages in panicked selling.

                 Larry says that investors don’t need to be stock pickers like Warren Buffett. They can simply buy stocks with the same characteristics as Warren Buffett’s stocks without doing all the research. Today, companies like AQR, Avantis, Bridgeway, Dimensional, and others use that research so that every investor can access those characteristics and decide which characteristics they want to invest in. The iShares MSCI USA Quality Factor ETF (QUAL) buys quality stocks. It has an expense ratio of just 0.15% and is highly tax-efficient as an ETF.

                 Luck versus skill

                 Academic research has demonstrated that efforts to outperform the market by either security selection or timing are improbable in proving productive after taking into account the costs, including taxes, of the efforts. For example, studies such as the “Luck versus Skill in the Cross-Section of Mutual Fund Returns” have found that fewer active managers (about 2%) can outperform their three-factor-model benchmark than would be expected by chance. That is even before considering the impact of taxes, which for taxable investors is typically the most significant expense of active management (greater than the fund’s expense ratio and/or trading costs).

                 Larry, therefore, recommends:

                 • Developing a portfolio that reflects your unique ability, willingness, and need to take risks. The equity portion should be globally diversified across multiple asset classes. The fixed-income portion should be diversified in terms of credit and term risk, as appropriate.
                 • Avoiding the use of actively managed funds. Instead, invest in funds that provide systematic exposure to the factors you seek exposure to, such as low-risk and tax-efficient index funds.
                 • In the case of fixed-income assets (for those individuals who have sufficient assets to do so), build a portfolio of individual Treasury securities and/or FDIC-insured CDs, and for taxable accounts, AAA- and AA-rated municipal bonds that are also either general obligation or essential service revenue bonds. Doing so dramatically reduces the credit risk and, therefore, the need for diversification (which is the benefit of a mutual fund).
                 • Having the discipline to stay the course, ignoring the noise of the markets and the emotions caused by the noise—emotions that cause investors to abandon even the most well-developed plans.
                 
                 

                 Notes

                 1. Michael Lewis, Moneyball (Norton 2003), p. 67.
                 2. Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns,” The Journal of Finance (June 1992).
                 3. Andrea Frazzini, David Kabiller and Lasse Pedersen, “Buffett’s Alpha,” Financial Analysts Journal (September 2018).
                 4. Eugene Fama and Kenneth French, “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” The Journal of Finance (September 2010).
                 
                 

                 About Larry Swedroe

                 Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

                 Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

                 Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

                 Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

                  

                 [spp-transcript]

                  

                 Connect with Larry Swedroe

                 • LinkedIn
                 • Twitter
                 • Website
                 • Books
                 
                 

                 Andrew’s books

                 • How to Start Building Your Wealth Investing in the Stock Market
                 • My Worst Investment Ever
                 • 9 Valuation Mistakes and How to Avoid Them
                 • Transform Your Business with Dr.Deming’s 14 Points
                 
                 

                 Andrew’s online programs

                 • Valuation Master Class
                 • The Become a Better Investor Community
                 • How to Start Building Your Wealth Investing in the Stock Market
                 • Finance Made Ridiculously Simple
                 • FVMR Investing: Quantamental Investing Across the World
                 • Become a Great Presenter and Increase Your Influence
                 • Transform Your Business with Dr. Deming’s 14 Points
                 • Achieve Your Goals
                 
                 

                 Connect with Andrew Stotz:

                 • astotz.com
                 • LinkedIn
                 • Facebook
                 • Instagram
                 • Twitter
                 • YouTube
                 • My Worst Investment Ever Podcast
                 
                 ]]>b1457c85-ce34-42cf-9c52-5c489fa60253Tue, 04 Jun 2024 06:00:00 +070044:11falsefull