Larry Swedroe: Understanding Risk & Return

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Random Walker
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Larry Swedroe: Understanding Risk & Return

Post by Random Walker » Wed Nov 07, 2018 2:46 pm

https://www.etf.com/sections/index-inve ... nopaging=1

This is a great article that takes our understanding of risk beyond simply volatility. Larry explains that returns are not normally distributed and explains the meaning of skew and kurtosis. Negative skew and kurtosis, in addition to volatility, represent risks that warrant a return premium. He reviews three potential alternative investments that warrant risk premiums (in addition to a liquidity premium) because of these characteristics.
What I think the individual investor should think about is how the addition of different investments can affect the expected standard deviation, skew, and kurtosis of one’s entire portfolio. By combining multiple uncorrelated assets, each with their own particular SD, negative skew, and kurtosis, the individual can actually make the behavior of his portfolio look more like a normal distribution. Uncorrelated assets, each with their own unique asymmetric risks, can combine to make a more efficient portfolio: narrower SD, smaller maximal drawdown, skinnier tails, less volatility drag, closer to the northwest corner of an efficient frontier.
These are important issues. Variance drain is a real cost. More importantly, behaviorally, I think an investor is more likely to stick with his plan when the portfolio is more efficient. If this article sparks your interest, I recommend reading Larry’s newest edition of Reducing The Risk Of Black Swans.

Dave

Dottie57
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Re: Larry Swedroe: Understanding Risk & Return

Post by Dottie57 » Wed Nov 07, 2018 3:06 pm

I looked SRRIX and find it must be bought from an RIA ( registered investment advisor). Not thrilled about that. I also am not finding performance data.

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Lauretta
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Re: Larry Swedroe: Understanding Risk & Return

Post by Lauretta » Wed Nov 07, 2018 3:27 pm

Random Walker wrote:
Wed Nov 07, 2018 2:46 pm
If this article sparks your interest, I recommend reading Larry’s newest edition of Reducing The Risk Of Black Swans.

Dave
It's interesting that you mention Black Swans because as far as I understand the three alternative investments described in the article are vulnerable precisely to Black Swans (negative skweness and high kurtosis). As far as I have understood Taleb thinks we should shun such investments, and favour instead those which expose us to positive skweness (like biotech firms or VC; he even spoke favourably of bitcoin).
When everyone is thinking the same, no one is thinking at all

Random Walker
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Re: Larry Swedroe: Understanding Risk & Return

Post by Random Walker » Wed Nov 07, 2018 4:26 pm

Hi Lauretta,
I’m not that familiar with Taleb. My understanding is that he promotes a huge allocation to the safest investments and a small allocation to the highest risk/highest expected return : barbell approach. Makes sense that his high risk investments might have the lottery like positive skew.
I think though, that it is important to look at the portfolio as a whole and how components mix. Pretty sure Taleb and Larry in big agreement here. Although Taleb’s individual risky investments might have big positive skew, his big allocation to the safest low risk treasury bills within the portfolio improves the portfolio behavior tremendously. With regard to the investments with high kurtosis and negative skew, I think the important point is the lack of correlation with other portfolio components. The potential big left tail events warrant a risk premium in isolation, but when the risks are uncorrelated with everything else in the portfolio, don’t hurt so much when they occur.

Dave

edgeagg
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Re: Larry Swedroe: Understanding Risk & Return

Post by edgeagg » Wed Nov 07, 2018 4:37 pm

Random Walker wrote:
Wed Nov 07, 2018 2:46 pm
https://www.etf.com/sections/index-inve ... nopaging=1

By combining multiple uncorrelated assets, each with their own particular SD, negative skew, and kurtosis, the individual can actually make the behavior of his portfolio look more like a normal distribution. Uncorrelated assets, each with their own unique asymmetric risks, can combine to make a more efficient portfolio: narrower SD, smaller maximal drawdown, skinnier tails, less volatility drag, closer to the northwest corner of an efficient frontier.
Dave
Dave,
I don't see this at all: If you consider a very common class of fat-tail distributions (a'la Mandelbrot and a host of others), the stable distributions, then summing a set of independent stable random variables results in a stable random variable (with fat tails), since there is no free lunch, after all (See the section entitled "A Generalized Central Limit Theorem" in the wiki link). Also, in general, fat-tail distributions do not have a defined standard deviation since they have infinite variance.

FWIW Larry doesn't seem to make the claim that you do (or perhaps I missed it).

Random Walker
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Re: Larry Swedroe: Understanding Risk & Return

Post by Random Walker » Wed Nov 07, 2018 4:54 pm

No Larry didn’t make that claim in the article. Any error is my own. And I have read that Central Limit Theorm doesn’t necessarily apply; I’ll read the wiki and certainly learn something. But intuitively, and I’m pretty sure Larry would agree, mixing assets with different uncorrelated left tail risks should improve the portfolio behavior overall and minimize the effect of any one asset’s left tail.
You’ve probably read in the alternative threads that SRRIX, AVRPX, LENDX, QSPIX/QRPRX each have equity like expected returns and about half the expected volatility of equities. All four combined have the expected return of equities and about a quarter of the expected volatility of equities. So while I’m weak on the formal math, I’m pretty sure the general concept of mixing less than perfectly correlated assets applies, and I think it applies even more emphatically in a non normal distributions world.

Dave

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HomerJ
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Re: Larry Swedroe: Understanding Risk & Return

Post by HomerJ » Wed Nov 07, 2018 5:10 pm

Random Walker wrote:
Wed Nov 07, 2018 2:46 pm
By combining multiple uncorrelated assets, each with their own particular SD, negative skew, and kurtosis, the individual can actually make the behavior of his portfolio look more like a normal distribution. Uncorrelated assets, each with their own unique asymmetric risks, can combine to make a more efficient portfolio: narrower SD, smaller maximal drawdown, skinnier tails, less volatility drag, closer to the northwest corner of an efficient frontier.
Sounds good in theory.

Assuming they all have the same SD, negative skew, kurtosis, and asymmetric risks in the future as they did in the past.

Hope it works for you in practice.
The J stands for Jay

edgeagg
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Re: Larry Swedroe: Understanding Risk & Return

Post by edgeagg » Wed Nov 07, 2018 5:14 pm

Random Walker wrote:
Wed Nov 07, 2018 4:54 pm
No Larry didn’t make that claim in the article. Any error is my own. And I have read that Central Limit Theorm doesn’t necessarily apply; I’ll read the wiki and certainly learn something. But intuitively, and I’m pretty sure Larry would agree, mixing assets with different uncorrelated left tail risks should improve the portfolio behavior overall and minimize the effect of any one asset’s left tail.
Alas, no. Think about it this way. Suppose you mix independent random variables with different rates of decay of tail - right or left doesn't really matter. You're still going to be dominated by the random variable that has the fattest tail, since the others have thinner tails than this guy. Weighting doesn't matter too much since these fat tailed distributions are scale free. There is separate theorem that makes this formal, but the intuition is pretty clear.
Random Walker wrote:
Wed Nov 07, 2018 4:54 pm
You’ve probably read in the alternative threads that SRRIX, AVRPX, LENDX, QSPIX/QRPRX each have equity like expected returns and about half the expected volatility of equities. All four combined have the expected return of equities and about a quarter of the expected volatility of equities. So while I’m weak on the formal math, I’m pretty sure the general concept of mixing less than perfectly correlated assets applies, and I think it applies even more emphatically in a non normal distributions world.

Dave
It depends, the only way to figure this out is to get hold of the data and try to fit a fat tailed distribution to returns to see if these returns really have a thinner fat tail than (say) S&P 500. Essentially, the experiment would be to see if (say) SRRIX is "less extreme" than GSPC (S&P 500) or total index.

PM me if you are interested in this exercise.

afan
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Re: Larry Swedroe: Understanding Risk & Return

Post by afan » Wed Nov 07, 2018 6:00 pm

I am glad to see Larry admitting that moments higher than mean and variance are priced. I have been pointing this out for years.

It is frustrating however to see him implying that these risks are priced inefficiently and thus suggesting that one can generate higher risk adjusted returns by creating portfolios with negative skewness and high kurtosis.

Instead, what one would get is the market risk adjusted return with the expected return of the portfolio matching the higher risk. Minus the fees.

One can get the market risk adjusted return with a cap weighted index fund that is almost free.

Somehow, despite this, the evidence that higher moments are priced becomes an argument in favor of paying an advisor 1% per year to put you in a fund with astronomical expense ratios. SRRIX charges 2.29%. Add the advisor fee and you are up to 3.29%. All to get the same risk adjusted returns as the market (before fees of course).
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

Random Walker
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Re: Larry Swedroe: Understanding Risk & Return

Post by Random Walker » Wed Nov 07, 2018 6:39 pm

afan wrote:
Wed Nov 07, 2018 6:00 pm
I am glad to see Larry admitting that moments higher than mean and variance are priced. I have been pointing this out for years.

It is frustrating however to see him implying that these risks are priced inefficiently and thus suggesting that one can generate higher risk adjusted returns by creating portfolios with negative skewness and high kurtosis.
I don’t think Larry has ever said that risks beyond volatility are not priced. Moreover I don’t think he has made any claim that these investments are priced inefficiently and provide some sort of free lunch (higher risk adjusted returns). Instead he is simply talking about different kinds of risk. Somehow an efficient market should look at different types of risk (apples and oranges) and through a bizillion independent diverse opinions, price the varied risks appropriately for similar risk adjusted returns. Makes sense to me. How does one compare the severe left tail risk of reinsurance, the doing badly in bad times risk of value, the price risk of a growthy internet company? I have no clue, but pretty sure our nearly efficient markets do a very good job. There are no free lunches and I don’t think Larry would ever claim one at the individual investment level. But some portfolios can be constructed more efficiently than others. That improved portfolio efficiency comes at increasing marginal costs, and it’s up to each individual investor to make their best estimate of marginal improvements to the portfolio versus marginal costs.

Dave

Random Walker
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Re: Larry Swedroe: Understanding Risk & Return

Post by Random Walker » Wed Nov 07, 2018 6:49 pm

afan wrote:
Wed Nov 07, 2018 6:00 pm
I am glad to see Larry admitting that moments higher than mean and variance are priced. I have been pointing this out for years.

It is frustrating however to see him implying that these risks are priced inefficiently and thus suggesting that one can generate higher risk adjusted returns by creating portfolios with negative skewness and high kurtosis.


Also, if you’re talking about “equity like expected returns with half the expected volatility of equities”. There is no free lunch there. We are accepting a big left tail risk at the same time we are accepting lower expected average volatility. We trust the market to price those different types of risk appropriately for similar “risk adjusted returns” understanding that there are many many individual interpretations of the meaning of “risk”. Only the magic of markets could accomplish this.

Dave

afan
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Re: Larry Swedroe: Understanding Risk & Return

Post by afan » Wed Nov 07, 2018 7:59 pm

If the market prices risk adjusted returns appropriately, why pusue all these reinsurance, alt, in the past commodity funds? You get market risk adjusted returns at a grossly inflated price.

Why would that be desirable?
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

Random Walker
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Re: Larry Swedroe: Understanding Risk & Return

Post by Random Walker » Wed Nov 07, 2018 8:06 pm

afan wrote:
Wed Nov 07, 2018 7:59 pm
If the market prices risk adjusted returns appropriately, why pusue all these reinsurance, alt, in the past commodity funds? You get market risk adjusted returns at a grossly inflated price.

Why would that be desirable?
The expected returns are after costs. The investments should be uncorrelated with equities, making the portfolio more efficient. Equities may not perform as we hope or expect.

Dave

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Re: Larry Swedroe: Understanding Risk & Return

Post by golfCaddy » Wed Nov 07, 2018 8:18 pm

Random Walker wrote:
Wed Nov 07, 2018 4:26 pm
Hi Lauretta,
I’m not that familiar with Taleb. My understanding is that he promotes a huge allocation to the safest investments and a small allocation to the highest risk/highest expected return : barbell approach. Makes sense that his high risk investments might have the lottery like positive skew.
I think though, that it is important to look at the portfolio as a whole and how components mix. Pretty sure Taleb and Larry in big agreement here. Although Taleb’s individual risky investments might have big positive skew, his big allocation to the safest low risk treasury bills within the portfolio improves the portfolio behavior tremendously. With regard to the investments with high kurtosis and negative skew, I think the important point is the lack of correlation with other portfolio components. The potential big left tail events warrant a risk premium in isolation, but when the risks are uncorrelated with everything else in the portfolio, don’t hurt so much when they occur.

Dave
NO, NO, NO. Taleb and Larry are not remotely in agreement. Taleb believes you should buy way out of the money options. Larry believes you should sell way out of the money options to people like Taleb. They advocate taking opposite sides of the trade.

Random Walker
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Re: Larry Swedroe: Understanding Risk & Return

Post by Random Walker » Wed Nov 07, 2018 8:41 pm

I was speaking more generally. I think Larry and Taleb basically in agreement on the barbell approach: combine risky assets with safest assets and nothing in between.

Dave

edgeagg
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Re: Larry Swedroe: Understanding Risk & Return

Post by edgeagg » Thu Nov 08, 2018 12:07 pm

golfCaddy wrote:
Wed Nov 07, 2018 8:18 pm

NO, NO, NO. Taleb and Larry are not remotely in agreement. Taleb believes you should buy way out of the money options. Larry believes you should sell way out of the money options to people like Taleb. They advocate taking opposite sides of the trade.
OK, I'll ask a stupid question here: What difference does it make? Either way, you're buying insurance against a tail probability, aren't you? Is the idea of Taleb that the "professionals" writing the option have done careful analysis of the tails in order to price the option correctly?

Also, btw does anyone have data on the returns of the alternative investments (SRRIX/..) proposed in Larry's blog? The data on daily returns from Yahoo seems to be bogus.

Random Walker
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Re: Larry Swedroe: Understanding Risk & Return

Post by Random Walker » Thu Nov 08, 2018 1:42 pm

I have some returns data on the alternatives. All are annualized returns

SRRIX: 1 year -12.67%, since inception 12/9/13 2.98%
LENDX 1 year 5.98%, since inception 6/1/16 8.61%
AVRPX 1 year 0.01%, since inception 4/2/15 4.65%
QSPIX 1 year -7.62%, 5 years since inception 10/31/13 4.85%

Dave

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Lauretta
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Re: Larry Swedroe: Understanding Risk & Return

Post by Lauretta » Thu Nov 08, 2018 2:27 pm

golfCaddy wrote:
Wed Nov 07, 2018 8:18 pm
Random Walker wrote:
Wed Nov 07, 2018 4:26 pm
Hi Lauretta,
I’m not that familiar with Taleb. My understanding is that he promotes a huge allocation to the safest investments and a small allocation to the highest risk/highest expected return : barbell approach. Makes sense that his high risk investments might have the lottery like positive skew.
I think though, that it is important to look at the portfolio as a whole and how components mix. Pretty sure Taleb and Larry in big agreement here. Although Taleb’s individual risky investments might have big positive skew, his big allocation to the safest low risk treasury bills within the portfolio improves the portfolio behavior tremendously. With regard to the investments with high kurtosis and negative skew, I think the important point is the lack of correlation with other portfolio components. The potential big left tail events warrant a risk premium in isolation, but when the risks are uncorrelated with everything else in the portfolio, don’t hurt so much when they occur.

Dave
NO, NO, NO. Taleb and Larry are not remotely in agreement. Taleb believes you should buy way out of the money options. Larry believes you should sell way out of the money options to people like Taleb. They advocate taking opposite sides of the trade.
precisely, and as far as I understand Taleb thinks that his strategy loses a little money regularly, and then makes a big win from time to time outweighing the regular losses. The strategies with negative skewness described but Swedroe do exactly the opposite: they earn most of the time positive returns, but are vulnerable to big losses. But unless I am missing something in the long run both strategies cannot both right: either the regular gains outweight the big occasional loss (in which case Swedroe is right) or viceversa. Or is there something I am missing
When everyone is thinking the same, no one is thinking at all

Random Walker
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Re: Larry Swedroe: Understanding Risk & Return

Post by Random Walker » Fri Nov 09, 2018 8:47 am

I think especially now, people need to appreciate this article on risk and return. Whatever the negative skew and positive kurtosis of the actual equity return distribution looks like, we need to appreciate that equities are generously valued. The mean expected return on equities is muted and perhaps most importantly, the whole distribution of potential returns is shifted towards the left. Good outcomes less good and bad outcomes worse. A typical 60/40 portfolio has about 90% of its risk wrapped up in the equities. And if that is a TSM portfolio, that’s 90% of portfolio risk wrapped up in a single factor, market beta. This is why Larry asks us to “look at diversification a different way”.

Dave

edgeagg
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Re: Larry Swedroe: Understanding Risk & Return

Post by edgeagg » Fri Nov 09, 2018 8:57 am

Random Walker wrote:
Thu Nov 08, 2018 1:42 pm
I have some returns data on the alternatives. All are annualized returns

SRRIX: 1 year -12.67%, since inception 12/9/13 2.98%
LENDX 1 year 5.98%, since inception 6/1/16 8.61%
AVRPX 1 year 0.01%, since inception 4/2/15 4.65%
QSPIX 1 year -7.62%, 5 years since inception 10/31/13 4.85%

Dave
@Dave: Should have been more clear. I was interested in daily/weekly return variation. If you look at historical data from Yahoo, the dataset shows zero volumes and the opening and closing prices are identical for many days for SRRIX. I'm not sure if this is just bad data or whether there is something more fundamental with these funds that I am missing.

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