Interview with Larry Swedroe at the 2/23/13 RTP Bogleheads Meeting
Notes by Dan Griffin
Small edits by Steve Thorpe
Treating the unlikely as impossible: There is no way to estimate the likelihood of absolute catastrophes. You want to build a portfolio that protects you from these types of unforeseen events, but there are tradeoffs. Never treat the likely as certain.
Risk: Ability, Willingness, and Need to take
You might have the ability to take 100% equity risk, but that doesn’t mean you should.
Your working capital can be viewed as a bond that pays out over many future years.
You better have the need to take the risk, or you shouldn’t be taking it. Otherwise it is foolish.
First look at marginal utility of wealth. High marginal utility, you can take more risk. Once you have won the game (whether 1 million or whatever), you should take chips off the table. You have to think about the consequences. It doesn’t matter what you think is likely, you want to build protection against any possible occurrence.
Concentrate your equities and the buy the safest possible fixed income to get the highest sharpe ratio.
Risk is when you know (or estimate) the odds. Uncertainty is when you have no idea what the odds are. In “Fooled by Randomness” the author talks about envisioning what’s the worst that can happen. There’s no way to even estimate the odds of something like attacks and the like.
This is one of the reasons that the equity premium exists. Because in order to take risk where you can’t even estimate the odds, you need to be paid well for it. But for a lot of people, they meet their goals without taking those kinds of risk. But they likely need to reduce needs, work longer, etc. Probabilities of outcomes shouldn’t count for much. It is the consequences that should dominate your thinking.
If too many people start indexing, will it become a bad idea? In wise investing made simple, he has a chapter called “what if everyone indexes.” For example, we’re seeing a flood into high yield funds, that is pushing the price up and the yields down. The first sign of a bubble is when credit starts to be loosened. When the bond market is telling you one thing and the stock market tells you the other, listen to the bond market. The stock market is moved much more by emotion.
Junk bonds do well when the bond covenants are strong, but right now we are starting to see rather weak covenants.
The index trend is only moving at about 1% per year. Today 13-14% of individual money and 40% of inst. money is indexed. So it is still a fairly small percent. We have a long way to go before this becomes a problem. However, this may become a problem in the future. The acceleration into indexes is speeding up. Oddly enough, trading volumes have soared in the last decade even though indexing has grown.
What’s your opinion of enhanced index funds (DFA, RAFI, Wisdom Tree, etc.)?
DFA core funds is a brilliant strategy. If you think of a 4 components (large, large value, small, small value) with 25% in each. The problem with this is that you have to rebalance and trigger tax and have trading costs. It is more tax efficient to own 25/25/25/25 in one fund. You also have the same issue if a stock goes out of one category into another. The emerging market has to sell israel, and the developed market fund has to buy it. Much more efficient to hold in one fund.
One of the flaws in indexing is that they announce changes to indices and that active traders can trade ahead of the index funds and get an advantage. Vanguard is trying to correct this by going with MSCI.
What he doesn’t like about RAFI and Wisdom Tree is that they reconstitute once a year whereas the more efficient way to do it is to reconstitute every day.
A high dividend strategy is a very bad one. You may get lucky, but the long-term data shows underperformance.
Bill Bernstein has put thought into this. Bill thinks you are making a suckers bet by putting money in long-term bonds at this point. When the economy recovers, if the fed doesn’t remove the stimulus, we will get inflation. But the fed isn’t dumb, they are concerned about the risk. They are thinking of unwinding this sooner.
If you have a high equity allocation, you can have a longer duration bond portfolio because the volatility of the portfolio is going to be dominated by the equity side. Therefore you can earn the ‘term premium’ without affecting the portfolio risk. If you are going to go long, you shouldn’t own corporate bonds. There isn’t evidence that you get rewarded for that. Therefore, he wouldn’t own a total bond market fund ever. The duration of the TBM fund is only estimated -- assuming rates stay where they are. They can’t predict what will happen if rates go up. If no one moves because they don’t want to get a new mortgage, that extends the duration.
So the fix is to buy bonds without calls in them. TIPS, Govt. bonds, CDs. A barbell approach works perfectly well. Dampen the volatility of the portfolio. Low grade, junk, mortgage backs, etc. have no role in your portfolio. They do not add anything to a diversified portfolio. (Bank CDs are sometimes higher than treasuries and have low early redemption penalties.) You can go very simple on the bond side. David Swensen agrees with this.
If you have a high equity allocation, you can go longer. A good idea is 5-year maturity with duration a little lower. Pascal’s Wager.
A fixed rate mortgage also plays a role here. You can take more risk because the mortgage.
If you aren’t willing to write calls on your treasuries, when you own long bonds, you are being inconsistent.
Accept a lower expected return as cost of insurance. Likely 50-75 bps. If you own commodities and have a fixed rate mortgage (with both do well in inflation), you have less of a need for [insurance against unexpected inflation?].
Duration is irrelevant when it comes to tips, because it is a real return asset. You should only care about duration on a nominal return bond.
The higher the TIPS rate goes, the more you want to put them in. Then your need to take risk is lower because you are locking in a return on the tips. You’d be getting equity like returns. The other option is short-term high quality bonds. <3-year duration. You can also buy CDs like 2-3 years or 5 years with low redemption costs.
There are short-term TIPS funds. Or you can buy individual TIPS and save the fund expense.
Commodities and real estate are his favorites. You don't buy commodities for higher returns, you buy it for portfolio insurance. Correlation is only a tendency -- unless the correlation is 1. The correlation jumps around from year to year.
A good example of correlation:
Assets A and B. Every year for 10 years they reverse order where A earns 12 and B earns 8. Then it flips. When one is above average, the other is below average....so they are negatively correlated. But over a longer period …..?????
If you look at the period we have data for, there is a tendency for commodities to do well when stocks do poorly. But sometimes they go down together.
There are 2 reasons bond/interest rates go up. Inflation or GDP is increasing. In that type of environment, the commodity prices are going up. There are 2 reasons interest rates fall. The economy is weak or inflation is going down. So ideally when bonds do well, commodities do poorly. There is not a year on record where bonds and commodities moved in the same direction. Therefore if you are going to own long term bonds, you need some commodities.
Peer-to-peer lending. You want your fixed income to be super safe. Take your risk on the equity side.
International bonds are fine as long as they are hedged for currency risk. You do get more diversification but you have more costs.
In a year like 2008, peer-to-peer would get crushed. How do you rebalance? He would stay away from all of these things. They are not needed. You can get all of the risk you want/need on equities.
Larry’s biggest investing mistake:
In the very early 1980's, Larry bought shares of a small bank expecting consolidation. Then there was fraud in the bank, and the bank went under. Had he just bought a regional bank fund, he would have done well. But he concentrated on one and lost a lot of money (10% of his net worth!). Just another lesson in putting too many eggs in one basket.