Larry Swedroe: Investment Strategy In An Uncertain World

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Random Walker
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Larry Swedroe: Investment Strategy In An Uncertain World

Post by Random Walker » Fri Apr 12, 2019 2:35 pm

https://alphaarchitect.com/2019/04/11/i ... ain-world/

In this article written for Alpha Architect, Larry distinguishes risk from uncertainty. With risk the odds are calculable, with uncertainty they are not. In investing, whether we know it or not, we are likely dealing more with uncertainty than risk. If one believes markets are highly efficient, then he should also believe that all factors and asset classes should provide about equal risk adjusted returns. In this case, diversifying across sources of risk/return is the winning strategy. Larry reviews his 5 criteria for unique sources of risk/return worthy of consideration for portfolio inclusion. He then demonstrates the power of diversification with risk parity and 1/n portfolios. A typical 60/40 TSM portfolio has almost 90% of its risk wrapped up in a single factor, market beta.
This article is a dense condensation crib notes version of two of Larry’s recent books, Only Guide To Factor Based Investing and Reducing Risk Of Black Swans. Strongly recommend it.

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by willthrill81 » Fri Apr 12, 2019 2:42 pm

Random Walker wrote:
Fri Apr 12, 2019 2:35 pm
If one believes markets are highly efficient, then he should also believe that all factors and asset classes should provide about equal risk adjusted returns.
I agree that to the extent that markets are efficient, this is a logical conclusion. Some dispute this, however, stating that efficiency does not imply a particular asset pricing model.
Random Walker wrote:
Fri Apr 12, 2019 2:35 pm
In this case, diversifying across sources of risk/return is the winning strategy. Larry reviews his 5 criteria for unique sources of risk/return worthy of consideration for portfolio inclusion. He then demonstrates the power of diversification with risk parity and 1/n portfolios. A typical 60/40 TSM portfolio has almost 90% of its risk wrapped up in a single factor, market beta.
This article is a dense condensation crib notes version of two of Larry’s recent books, Only Guide To Factor Based Investing and Reducing Risk Of Black Swans. Strongly recommend it.
It sounds like a dense condensation of modern portfolio theory, which I know that Larry espouses greatly.
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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by Random Walker » Fri Apr 12, 2019 2:59 pm

Although it is implicit throughout the essay, I think it is important to emphasize the fact that the diversification benefits described derive from the lack of correlation between the sources of risk/return. Many of the described factors are effectively uncorrelated with one another. Also several of the factors and the alternatives have their own individual fat left tails. By combining different investments with uncorrelated left tails, the overall left tail risk of the portfolio is dramatically reduced.

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by RadAudit » Fri Apr 12, 2019 3:11 pm

If I read it correctly, Mr. Swedroe suggests a small cap value stock fund and an intermediate term investment grade bond fund portfolio. Should of read this and acted on it thirty years ago. IIRC, Mr. Swedroe also suggested that sometimes this type of factor investing takes sometime to even out. Looks as if I'll just have to ride it out the rest of the way with the risks inherent in a four fund portfolio.

But, thanks for the link.
Last edited by RadAudit on Fri Apr 12, 2019 3:17 pm, edited 1 time in total.
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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by Beliavsky » Fri Apr 12, 2019 3:15 pm

From the article:

"If you believe that markets are highly efficient, you should also believe that all diversified sources of systematic risk (unique sources of risk and return), such as major asset classes and factor exposures like size, value, momentum, quality, profitability and carry should have the same expected risk-adjusted return."

Huh? Because the stock market is efficient, investing in anomalies should be rewarded? The reverse is true. If the stock market is efficient, the pre-cost risk-adjusted return to factors such as size, value, momentum etc. should be zero, and the post-cost return should be negative. And empirically, factor investing in the U.S. has been an exercise in frustration for some time.

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by Random Walker » Fri Apr 12, 2019 4:48 pm

RadAudit wrote:
Fri Apr 12, 2019 3:11 pm
If I read it correctly, Mr. Swedroe suggests a small cap value stock fund and an intermediate term investment grade bond fund portfolio. Should of read this and acted on it thirty years ago. IIRC, Mr. Swedroe also suggested that sometimes this type of factor investing takes sometime to even out. Looks as if I'll just have to ride it out the rest of the way with the risks inherent in a four fund portfolio.

But, thanks for the link.
Hi RadAudit,
I think the conclusions from the article are different from what you stated. Firstly, he simply compared SV+bonds to S&P500+bonds to show how diversifying across sources of risk/return starts to improve portfolio efficiency. In the big picture he would most likely recommend diversifying across other factors, asset classes, alternatives.
Secondly, any factor can underperform for long periods of time. In that case, perhaps somewhat ironically, diversification may well be more important the shorter one’s time frame is. Many people say something to the effect “I can’t wait that long for a factor premium to show up”. This is backwards thinking. Diversification is important for any time frame, but perhaps more important in the short run. Imagine market beta performing poorly during the first 5 years of retirement. During that critical short period which can strongly influence the remainder of retirement, being diversified across uncorrelated sources of risk/return can be crucially important.

Dave

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by Random Walker » Fri Apr 12, 2019 5:00 pm

Beliavsky wrote:
Fri Apr 12, 2019 3:15 pm
From the article:

"If you believe that markets are highly efficient, you should also believe that all diversified sources of systematic risk (unique sources of risk and return), such as major asset classes and factor exposures like size, value, momentum, quality, profitability and carry should have the same expected risk-adjusted return."

Huh? Because the stock market is efficient, investing in anomalies should be rewarded? The reverse is true. If the stock market is efficient, the pre-cost risk-adjusted return to factors such as size, value, momentum etc. should be zero, and the post-cost return should be negative. And empirically, factor investing in the U.S. has been an exercise in frustration for some time.
Larry mentions in the article that he has more faith in risk based factors than behavioral ones. I think the statement that all risky assets should provide about same risk adjusted return makes sense. If it didn’t, people would buy and sell until the risk adjusted returns on different assets were equalized. Nothing is black and white though. There are different kinds of risk: volatility, doing badly in bad times, bubble risk, liquidity risk, and I don’t know what else. The market has to take each individual’s perception of a multitude of risks and consolidate them into a single number, the price of an asset. It does a pretty good job of that. If a factor represents increased risk of any type, an efficient market should depress the price and increase the expected return commensurately. I would add that because of market asymmetries and limits to arbitrage, there is strong reason to expect behavioral anomalies to persist as well. I’m particularly a fan of value since it has both strong risk based and behavior based rationale behind it.

Dave

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by RadAudit » Fri Apr 12, 2019 5:18 pm

Random Walker wrote:
Fri Apr 12, 2019 4:48 pm
I think the conclusions from the article are different from what you stated.
Thanks for the correction. I'll go back and look at it again.
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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by Seasonal » Fri Apr 12, 2019 5:25 pm

Summarizing, in a world of uncertainty, where there are no crystal balls allowing you to foresee the future, if you believe markets are efficient, you should believe that sources of systematic risk and return have similar expected risk-adjusted returns.
Seems reasonable. Basically, all investable assets have the same risk-adjusted return. If one asset had a higher risk-adjusted return, investors would buy more of it, increasing the price and decreasing returns until we reach an equilibrium where everything has the same risk-adjusted return.
And that should lead you to conclude that you should diversify across as many unique sources of risk and return as you can identify that meet all the established criteria.
Does not necessarily follow.

If markets are efficient, then the market is right or at least it incorporates all available information (including as to valuations, expected returns, risks, correlations, portfolio construction, etc., etc.). The market has "chosen" the market portfolio, diversified by market cap.
Actually, I have indeed found a great asset allocation calculator. It uses MPT and all the other modern models like Fama-French. It uses a huge database of expert analyst's estimates of correlations and expected returns and standard deviations and all the other information available on the entire planet. It actually runs on an analog computer (not digital). It uses the latest state-of-the-art neural network and artificial intelligence algorithms. It always produces extremely reasonable asset allocation percentages for any and all possible assets and asset classes. Anyone can easily use the calculator for free.

It's called the market.
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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by columbia » Fri Apr 12, 2019 5:46 pm

It seems that factor premiums (including size and value) wouldn’t exist, if markets were truly efficient.

So which one is it?

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by vineviz » Fri Apr 12, 2019 5:56 pm

columbia wrote:
Fri Apr 12, 2019 5:46 pm
It seems that factor premiums (including size and value) wouldn’t exist, if markets were truly efficient.

So which one is it?
It’s both, or at least it can be. Risk premia exist even in efficient markets.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by vineviz » Fri Apr 12, 2019 5:58 pm

willthrill81 wrote:
Fri Apr 12, 2019 2:42 pm
Random Walker wrote:
Fri Apr 12, 2019 2:35 pm
If one believes markets are highly efficient, then he should also believe that all factors and asset classes should provide about equal risk adjusted returns.
I agree that to the extent that markets are efficient, this is a logical conclusion. Some dispute this, however, stating that efficiency does not imply a particular asset pricing model.
Yeah, that’s me. I didn’t read the article, but I hope Larry doesn’t actually say this. That’d be disappointing.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by Random Walker » Fri Apr 12, 2019 6:35 pm

columbia wrote:
Fri Apr 12, 2019 5:46 pm
It seems that factor premiums (including size and value) wouldn’t exist, if markets were truly efficient.

So which one is it?
The risk premiums should exist BECAUSE markets are efficient. Markets price risk, they don’t equilibrate returns.

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by willthrill81 » Fri Apr 12, 2019 7:35 pm

vineviz wrote:
Fri Apr 12, 2019 5:58 pm
willthrill81 wrote:
Fri Apr 12, 2019 2:42 pm
Random Walker wrote:
Fri Apr 12, 2019 2:35 pm
If one believes markets are highly efficient, then he should also believe that all factors and asset classes should provide about equal risk adjusted returns.
I agree that to the extent that markets are efficient, this is a logical conclusion. Some dispute this, however, stating that efficiency does not imply a particular asset pricing model.
Yeah, that’s me. I didn’t read the article, but I hope Larry doesn’t actually say this. That’d be disappointing.
This is what we said.
If you believe that markets are highly efficient, you should also believe that all diversified sources of systematic risk (unique sources of risk and return), such as major asset classes and factor exposures like size, value, momentum, quality, profitability and carry should have the same expected risk-adjusted return.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by vineviz » Fri Apr 12, 2019 9:05 pm

willthrill81 wrote:
Fri Apr 12, 2019 7:35 pm
This is what he said.
If you believe that markets are highly efficient, you should also believe that all diversified sources of systematic risk (unique sources of risk and return), such as major asset classes and factor exposures like size, value, momentum, quality, profitability and carry should have the same expected risk-adjusted return.
Hmm. That’s a bit of a word salad, to the degree that’s it’s hard for me to parse out what he’s trying to say.

But I see two problems immediately. One is the issue I raised in a different thread, which is that the EMH itself is risk-agnostic: you need to combine an assumption of EMH with an assumed pricing model to get a prediction about returns, risk-adjusted or otherwise.

A second is related, and that is that if you’re explicitly assuming multiple sources of risk (not just variance, which is the only source of risk in the Markowitz CAPM), then traditional and common measures of risk-adjusted return (like Sharpe ratio) are no longer relevant. You’d have to describe what you mean by risk-adjusted return , and its really hard to do that in an n-dimensional world where n>2.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by Random Walker » Fri Apr 12, 2019 9:15 pm

vineviz wrote:
Fri Apr 12, 2019 9:05 pm
if you’re explicitly assuming multiple sources of risk (not just variance, which is the only source of risk in the Markowitz CAPM), then traditional and common measures of risk-adjusted return (like Sharpe ratio) are no longer relevant. You’d have to describe what you mean by risk-adjusted return , and its really hard to do that in an n-dimensional world where n>2.
Why not just assume all the different types of risk are efficiently incorporated into the prices determined in the market? What makes the equity markets so fascinating is that everyone’s knowledge, opinions, hopes, fears, perceptions of risk all get incorporated into a single number, price.

Dave

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by smectym » Fri Apr 12, 2019 11:29 pm

Interesting that none of the above posts incorporate awareness of “Fed” or “central bank (‘CB’) risk,” although the market distortions perpetuated by unprecedented intervention by global central banks over the last decade, and counting, arguably (uncouth to say “obviously”) constitute a major risk to all investors over the next decade, and counting. I don’t attempt to keep abreast of Swedroe’s seemingly voluminous output, though I glean quite a bit from the frequent updates re his work on this forum; where does Larry situate Fed Risk in his Risk vs. Uncertainty paradigm?

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by marcopolo » Fri Apr 12, 2019 11:41 pm

smectym wrote:
Fri Apr 12, 2019 11:29 pm
Interesting that none of the above posts incorporate awareness of “Fed” or “central bank (‘CB’) risk,” although the market distortions perpetuated by unprecedented intervention by global central banks over the last decade, and counting, arguably (uncouth to say “obviously”) constitute a major risk to all investors over the next decade, and counting. I don’t attempt to keep abreast of Swedroe’s seemingly voluminous output, though I glean quite a bit from the frequent updates re his work on this forum; where does Larry situate Fed Risk in his Risk vs. Uncertainty paradigm?

Smectym
I am not sure I would regard it as market distortion, or unprecedented intervention. The actions of the Fed and other Central Banks are just another input into the price discovery that happens in the market. Today it is very accommodating, and people call it "unprecedented", maybe that is true regarding how accommodating they are currently, but their intervention in markets is certainly not unprecedented. Some would say their tightening made the Great Depression worse. Fed policy in the 70s probably contributed to the hyper inflation, and Volcker's "intervention" in the 80s brought us out of that tail spin. Cycles, just like the markets themselves.
Once in a while you get shown the light, in the strangest of places if you look at it right.

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by vineviz » Sat Apr 13, 2019 6:07 am

Random Walker wrote:
Fri Apr 12, 2019 9:15 pm
vineviz wrote:
Fri Apr 12, 2019 9:05 pm
if you’re explicitly assuming multiple sources of risk (not just variance, which is the only source of risk in the Markowitz CAPM), then traditional and common measures of risk-adjusted return (like Sharpe ratio) are no longer relevant. You’d have to describe what you mean by risk-adjusted return , and its really hard to do that in an n-dimensional world where n>2.
Why not just assume all the different types of risk are efficiently incorporated into the prices determined in the market? What makes the equity markets so fascinating is that everyone’s knowledge, opinions, hopes, fears, perceptions of risk all get incorporated into a single number, price.
Getting to a single price is one thing, but when we talk about risk-adjusted expected returns we are going quite a ways past that.

For example, EMH doesn’t require investors to have homogeneous preferences but that is one of the assumptions necessary to make the Sharpe ratio work as a measure of risk-adjusted returns. That’s a tough assumption to defend where there are multiple risk factors.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by larryswedroe » Sat Apr 13, 2019 9:10 am

to help out, by risk adjusted returns it doesn't mean say Sharpe ratio which assumes normal distributions and only looks at volatility, it means ALL FORMS of risks, such as skewness and kurtosis (which is priced) and illquidity (which is also priced). The SR is at least a reasonable measure to consider.

And if you think markets are efficient you must believe this as if A was underpriced on risk adjusted basis and B overpriced, capital would flow from B to A until had equilibrium.

Now we also know markets not perfectly efficient due to limits to arbitrage.

Finally, addressing another comment, size and value are NOT anomalies except for the single factor CAPM, they are other unique sources of risk and return. MOM on other hand is an anomaly as there are no good risk based explanations, only behavioral ones. But that is why we know markets not perfectly efficient, and limits to arbitrage prevent it from becoming perfectly so, as well as human behavior persisting even in face of evidence showing it's bad behavior.

The belief in above is why the risk parity strategies such as Ray Dalio at Bridgewater were developed and used by many, including the large endowments like Harvard and Yale.

Hope that is helpful
Larry

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by expatFIRE » Sat Apr 13, 2019 7:13 pm

From the article:
wrote: Portfolios can be constructed to add exposures to other unique sources of risk, such as the ones mentioned earlier (carry, momentum, variance risk premium, reinsurance and others).
What funds or alternatives would these sources of risk include? Is it discussed in one of Larry’s recent books?

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Re: Larry Swedroe: Investment Strategy In An Uncertain World

Post by Random Walker » Sun Apr 14, 2019 9:05 am

expatFIRE wrote:
Sat Apr 13, 2019 7:13 pm
From the article:
wrote: Portfolios can be constructed to add exposures to other unique sources of risk, such as the ones mentioned earlier (carry, momentum, variance risk premium, reinsurance and others).
What funds or alternatives would these sources of risk include? Is it discussed in one of Larry’s recent books?
Yes, discussed extensively in Reducing The Risk Of Black Swans and Your Complete Guide To Factor Based Investing. One can go as far down the portfolio efficiency path as they desire. One can think of it as a stepwise process.
1. Move toward global market weights on equity side
2. Tilt as far as want to size and value
3. Decrease equity allocation and increase bond allocation to target desired rate of return
4. Consider adding alternatives

Recommended equity funds generally from DFA, Bridgeway, Vanguard
Style funds from AQR: QRPRX and QSPRX
Reinsurance, alternative lending, variance risk premium Stone Ridge Funds: SRRIX, LENDX, AVRPX.

Dave

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