Larry Swedroe - Saint Louis Post-Dispatch 05/06/07

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blacktupelo
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Larry Swedroe - Saint Louis Post-Dispatch 05/06/07

Post by blacktupelo » Sun May 06, 2007 2:37 pm

Larry's column today in the St. Louis Post-Dispatch is titled:
"Don't let your ego influence your investing":
Behavioral finance is a fascinating field. Behavioralists could be considered "investment psycho­logists," whose research can help us understand why investors act the way they do, which often is irrationally. One insight from this field is that individuals allow their egos to influence investment decisions. Let's explore some of the ways egos can cause irrational decisions.
Larry

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Post by stratton » Sun May 06, 2007 2:44 pm

Investors can avoid costly investment mistakes by not letting their egos into the investment decision-making process. One way to accomplish that objective is to accept market returns by investing in index (or other passively managed) funds. And this investment lesson bears repeating: The surest way to be above average is to not try.
The "alpha" is in the index funds that win 80% of the time through low expenses.

You can measure it by by subtracting your low index fund ER from the mananged fund's ER. That's the negative alpha drag the active manager has to overcome before even getting to the "positive" alpha everyone is supposedly paying said manager for.

Paul

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Post by mickeyd » Sun May 06, 2007 2:59 pm

Investors can avoid costly investment mistakes by not letting their egos into the investment decision-making process. One way to accomplish that objective is to accept market returns by investing in index (or other passively managed) funds. And this investment lesson bears repeating: The surest way to be above average is to not try.
Boy is that solid advice on a Sunday afternoon... :P
Part-Owner of Texas | | “The CMH-the Cost Matters Hypothesis -is all that is needed to explain why indexing must and will work… Yes, it is that simple.” John C. Bogle

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Re: Larry Swedroe - Saint Louis Post-Dispatch 05/06/07

Post by unclemick » Sun May 06, 2007 3:00 pm

blacktupelo wrote:Larry's column today in the St. Louis Post-Dispatch is titled:
"Don't let your ego influence your investing":
Ego will always influence my investing - as long as I am above ground. It's an incurable disease for this investor(hormones??? heh heh). Even my Lifestrategy mod which I held for ten years had 25% Asset Allocation fund. Truth told my er Bernsteinesque REIT Index(added 1998) and Small Cap Value Index were - nod, nod wink, wink - untouched by that alpha chasing disease. Riiiight!

Now as of jan 2006 - my 14th year(age 63) of retirement rides on Target 2015 - ??rational slice and dice??? - and I got's my ego over in the corner with my Norwegian widow div/div growth chasing stocks.

Finally finally finally (1966-2006) - not cured but have that pesky ego under control.

heh heh heh - fingers crossed :roll: :roll: :wink:

P.S. Great column BTY.

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Post by fundtalker123 » Sun May 06, 2007 3:42 pm

It enhances my ego perfectly well to know that I understand what Larry is saying, whereas most people don't or won't accept it.

Feynman, the famous physicist, was once asked a question about some observation being improbable. His response: "I had the most remarkable experience this evening. While coming in here I saw license plate ANZ 912. Calculate for me, please, the odds that of all the license plates in the state of Washington I should happen to see ANZ 912."

Along the same lines: see Mudfud's signature line.
Last edited by fundtalker123 on Sun May 06, 2007 10:51 pm, edited 1 time in total.

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Yes, but....

Post by JohnYaker » Sun May 06, 2007 3:43 pm

.
I agree with most of what Larry writes, but he appears a bit hypocritical when he asks you to not let your ego influence your investing. He has done exactly that, himself, with his own portfolio. Larry's extreme risk averse position (only 20% equities, last I heard) is contrary to an optimal allocation according to statistical history for someone with a 40 year planning horizon.

Those who claim "no need to take risk" are missing the point. Larry is giving up a 90+ chance of far exceeding his current portfolio by not investing more in stocks. Most studies on the utility of money have shown that the utility of an extra dollar decreases as wealth increases. If one has the basics covered, most people are willing to take a little more risk with the extras for the extremely likely opportunity for great wealth.

I expect that 20 or 30 years from now we will look back at Larry's portfolio and say that he missed the boat.

John
Last edited by JohnYaker on Sun May 06, 2007 5:49 pm, edited 1 time in total.

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Larry Swedroe's article in St.Louis Post-Dispatch

Post by Taylor Larimore » Sun May 06, 2007 4:11 pm

Hi:
This is a beautifuly written article explaining the truth about investing.

It's a shame that we don't see more article's like this instead of Wall Street's big lie:

"How to beat the stock market."

Best wishes.
Taylor

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Post by Prokofiev » Sun May 06, 2007 6:16 pm

" . . . but he appears a bit hypocritical when he asks you to not let your ego influence your investing. He has done exactly that, himself, with his own portfolio."

Not sure where the EGO factors in this decision. By being risk-adverse and accepting probable lower returns he certainly has no bragging rights.

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Post by Adrian Nenu » Sun May 06, 2007 6:30 pm

Larry's financial goals do not require him to take risk in order to attempt to increase returns...therefore, he does not take much equity risk. While he may possibly have the ability and willingness to take on more equity risk , he has no need to do so. Larry at this point is more interested in wealth preservation than increasing returns (and risk).

Adrian
anenu@tampabay.rr.com

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Re: Yes, but....

Post by BrianTH » Mon May 07, 2007 6:08 am

JohnYaker wrote: Most studies on the utility of money have shown that the utility of an extra dollar decreases as wealth increases. If one has the basics covered, most people are willing to take a little more risk with the extras for the extremely likely opportunity for great wealth.

I expect that 20 or 30 years from now we will look back at Larry's portfolio and say that he missed the boat.
You've got the logic the wrong way around. The decreasing marginal utility of wealth is why people become MORE risk-averse the more wealth they have. And I am quite confident Larry is in a position such that he could reasonably expect very little increased utility from increasing his wealth, so it makes little sense for him to take on any significant amount of risk.

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Re: Yes, but....

Post by ramsfan » Mon May 07, 2007 6:21 am

JohnYaker wrote:.
I agree with most of what Larry writes, but he appears a bit hypocritical when he asks you to not let your ego influence your investing. He has done exactly that, himself, with his own portfolio. Larry's extreme risk averse position (only 20% equities, last I heard) is contrary to an optimal allocation according to statistical history for someone with a 40 year planning horizon.

Those who claim "no need to take risk" are missing the point. Larry is giving up a 90+ chance of far exceeding his current portfolio by not investing more in stocks. Most studies on the utility of money have shown that the utility of an extra dollar decreases as wealth increases. If one has the basics covered, most people are willing to take a little more risk with the extras for the extremely likely opportunity for great wealth.

I expect that 20 or 30 years from now we will look back at Larry's portfolio and say that he missed the boat.

John
Good post, and actually Larry's commentary on these boards around this topic "need to take risk", is some of the most valuable advice I have heard here. I help a friend with his finances, and he agrees. For example, if someone "needs" a $2Million portfolio to never work again, then even if they are 22 years old, and most rule of thumb allocation call for 80-90% equity, should this person do it just because of their age? I vote no, that need actually should be the larger factor. Very tough thing to do behavior wise, since people in this country (me included) are generally wired to make the most of every opportunity.

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Re: Yes, but....

Post by unclemick » Mon May 07, 2007 6:41 am

ramsfan wrote: Very tough thing to do behavior wise, since people in this country (me included) are generally wired to make the most of every opportunity.
You bet your sweet bippy(with apologies to the old 'Laugh In'). With Target 2015(age 63) my ego says I can live on current yield in hard times while the equity portion - ? combats inflation or ? chases performance.

Do I 'know' I'm rationalizing?

heh heh heh - Yeah you rite! :lol: :lol: 8) And expect to beat those pesky life span averages also - as an optimist.

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Myopic Loss Aversion

Post by JohnYaker » Mon May 07, 2007 10:34 am

BrianTH wrote: You've got the logic the wrong way around. The decreasing marginal utility of wealth is why people become MORE risk-averse the more wealth they have.
Brian, I'll have to respectfully disagree. Extreme risk aversion in long-term investing is likely more due to myopic loss aversion. Matthew Rabin wrote an article (2000) titled Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion in which he concludes:

".... people are significantly more averse to losses relative to the status quo than they are attracted by gains, .... People tend to assess risky choices in isolation, and as a result behave differently than if they assessed these risks jointly. We might reject one 50/50 lose $100/gain $200 gamble on each of 100 days, but accept all of these gambles if they are offered at the same time. Benartzi and Thaler (1995) argue that a related type of myopia is an explanation for the “equity premium puzzle”—the mystery about the curiously large premium on returns that investors seem to demand as compensation for the riskiness associated with investing in stocks. Such risk aversion can be explained with plausible loss-averse preferences—if investors are assumed to assess gains and losses over a short-run (yearly) horizon rather than the longer-term horizon for which they are actually investing. This is but one illustration of how recognizing that the expected-utility model is fundamentally flawed and massively miscalibrated can lead us to consider behaviorally realistic alternatives that permit us to improve economic analysis.

The article
http://repositories.cdlib.org/cgi/viewc ... =iber/econ

Related: Benartzi and Thaler (1995):
http://ideas.repec.org/a/tpr/qjecon/v11 ... 73-92.html

I have great respect for Larry and all he has done for investors, and only take issue with the logic of foregoing a 95%+ probability of a winning bet on stocks over the long term to insure against the extremely unlikely possibility that stocks might post their first-ever 40 year loss, much less one big enough to matter to someone in his situation.

John

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Post by BrianTH » Mon May 07, 2007 11:45 am

John,

I certainly agree that to truly understand general behavioral patterns in the face of risk, you need something like prospect theory and the other insights of behavioral economics developed by Kahneman, Thaler, and so on. One should be cautious, however, about assuming every individual exhibits the same behavioral patterns. And there is also a "just-so story" problem with specific behaviorialist explanations of something like the observed ERP: unless you can provide a more general model of investor valuation under the behavioral theory in question (and one which makes falsifiable predictions), you are left with nothing more than a (perhaps) plausible but untested hypothesis.

And personally, I think the most promising explanation of the ERP actually starts with the observation that stock returns are not normally distributed, but rather exhibit fat tails. Once you do that, the math (either under conventional expected utility theory or modern behavioral variants) starts looking more plausible.

An additional complicating factor is the structural break (AKA info-gap) problem, which is basically the idea that there may be no reliable way in which to project future stock return probability distributions from past stock returns because stock returns are in part the function of various legal, macroeconomic, and even cultural factors which are themselves subject to structural breaks. Modeling decisions when risks take that form (what I would call "highly ambiguous" risks, following Daniel Ellsberg) becomes extremely complicated and this structural break/"info-gap" problem may well contribute to the observed ERP (I believe there is a recent paper to that effect, which I have not read).

And this structural breaks/info-gap problem fits together with the "fat tails" problem, insofar as it becomes essentially impossible to assign a probability distribution across the possible fat tails scenarios and the durations of those scenarios. And indeed, we have a prominent example of this happening recently (in Japan, which has experienced a very long asset crisis from which it has yet to recover some 15+ years later).

So, I wouldn't be too hasty to conclude that Larry does not know what he is doing by keeping his stock percentage relatively low. At a minimum, I know he is aware of and concerned about the fat tails problem, and I also think other things he has said reflect a concern with the structural breaks problem.

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A fool for a client

Post by JohnYaker » Mon May 07, 2007 1:05 pm

.
Thank you, Brian, for the thoughtful reply. We are clearly dealing with a lot of future unknowns.

I'm sure you've heard the old lawyer's expression that "a man who represents himself will have a fool for a client" and I sometimes think the same is true for financial advice. Many good lawyers hire another lawyer when their personal interests are at stake. Perhaps they know how personal biases cloud one's decision-making.

John

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Post by JeanY » Mon May 07, 2007 1:10 pm

I'm a recent convert to indexing and it is thanks to the books by Swedroe, Bogle, Bernstein, Taylor et. al. that I now understand the meaning of this line from the article:
Many within Wall Street want investors to confuse market returns with average returns. Index funds earn market returns.
And market returns are nothing to be sneezed at!!!! Especially, as most Diehards know, that the person who gets market returns is in reality enjoying "above average" returns when compared to all investors as a group.

I'm sure all Diehards understand that message, but why is it so difficult to REALLY understand it? Why did it take me so long to understand it? Came across Vanguard Index 500 fund in the early 80's and could not understand back then why anyone in their right mind would want to put money in a fund rated "average" or even "below average" by Forbes and other magazines. In a competitive world, whether it's sports or job performance, "average" often implies "unsatisfactory" so we are taught to thumb our noses at anything "average".

Thank you, all you great Diehards with your valuable advice in books, postings on this and the Morningstar forum. I have to believe that I, as well as many others, have been helped immensely by you -- more than you will ever know,


.... jean

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Post by BrianTH » Mon May 07, 2007 1:24 pm

John,

I actually think it would be a good idea for financial advisors to have their investments in a blind trust. Although I'm less concerned about their welfare than their clients', I agree it is likely going to be hard to prevent spillover, emotional or otherwise.

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Re: A fool for a client

Post by WiseNLucky » Mon May 07, 2007 1:35 pm

JohnYaker wrote:I'm sure you've heard the old lawyer's expression that "a man who represents himself will have a fool for a client" and I sometimes think the same is true for financial advice.
Wouldn't this imply that all of us should have a financial advisor, and not just financial advisors? We know where that will end up.

I think the difference is that most of us can follow a simple plan and do well compared to how we would fare if we gave our finances over entirely to a financial advisor. The same is not true of medicine or law. It shouldn't be true of the financial advisor either, but that profession has proven itself not to practice in the best interest of its clients. By so doing, they have created an environment where indexing is a viable strategy.

Some things, like pumping gas, are easier and cheaper to do yourself for the amount of money to be charged by having someone do it for you.
WiseNLucky

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Post by BrianTH » Mon May 07, 2007 1:48 pm

WiseNLucky,

Not that I expect it to happen, but one of the additional benefits of the blind trust idea is that I strongly suspect financial advisors would start seeing the benefits of more carefully regulating the ethics and practices of the fellow members of their own industry (once their money was in their fellows' hands).

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Post by Prokofiev » Mon May 07, 2007 6:33 pm

" Larry's extreme risk averse position (only 20% equities, last I heard) is contrary to an optimal allocation according to statistical history for someone with a 40 year planning horizon"

I will admit that I too was surprised to learn of Larrys 20/80 portfolio. But without more and specific info on net worth and lifestyle I can at least rationalize the logic behind such a portfolio. Indeed I myself have lowered my stock allocation based on Larry's advice and reasoning.

For someone who is struggling to meet retirement "critical mass", I would recommend a higher equity position. To someone who is very wealthy - say a minimum of $5MM or more, I would again recommend more equities in that some of this money will really be destined for others or charity and with a much longer timeframe. For instance, I can't imagine Warren Buffet with only 20% equities . . .

But for someone quite well off - say $2MM to $4MM in or near retirement -I can completely understand the conservative logic of having it made with TIPS (2-2.5% real) and fearing an unlikely but possible reversal in stocks putting me back to worrying about running out of money. Again the point of finally "having it made" depends on individual lifestyle and may be only $1MM or less for some or as high as $4 or $5MM for others. But the belief that I have a 95% chance of doing better with a different AA and more risk cannot compete with the warm and fuzzy feeling of being virtually "bullet-proof" in the here and now.

In fact I could see my equity AA going UP as I get older, reaching a minimum at age 50-60 or retirement and then going up again if my net worth continues to increase as my remaining lifespan goes down.

Just my thoughts . . . -P

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Re: A fool for a client

Post by JohnYaker » Mon May 07, 2007 7:04 pm

WiseNLucky wrote:"Wouldn't this imply that all of us should have a financial advisor, and not just financial advisors?"
This is exactly why I recommend that even the most knowledgable Boglehead take advantage of Vanguard's free financial planning advice. It forces one to question, once again, where we vary from Vanguard's very sound, but plain vanilla, investing advice.

John
PS: Prokofiev, your scenario exemplifies the myopia I described very well.

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Re: A fool for a client

Post by unclemick » Tue May 08, 2007 7:10 am

JohnYaker wrote:
WiseNLucky wrote:"Wouldn't this imply that all of us should have a financial advisor, and not just financial advisors?"
This is exactly why I recommend that even the most knowledgable Boglehead take advantage of Vanguard's free financial planning advice. I
Target Retirement Series - saves (me) time on useless palaver and un-necessary jawing.

Better spent at the donut shop with my fellow retired old pharts talking fishing, sports and stock picking - as well as other forms of social noise.

heh heh heh 8)

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Post by larryswedroe » Wed May 09, 2007 12:45 pm

John
I believe you miss the point.
I know exactly what the odds are and what I am LIKELY giving up.
But the marginal utility of that likely incremental wealth is fairly close to zero for me and even for my kids.
So why would/should I take that risk.
In addition, fat tails do show up from time to time and I don't worry about them any longer, allowing me to enjoy life more---which is far more important than any incrmental returns I might earn

Understanding how much is enough is truly one of the keys to life IMO. On that same subject, research has shown that once you get beyond the basic needs being met (food, shelter, etc) there are two keys to happiness (I assume besides good health) and they have NOTHING to do with how wealthy you are.
They are your connectedness to society (depth and number of your relationships) and continuing to learn (stimulate your brain).

Those are important lessons I try to pass on to the high net worth people I consult with.

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Larry,

Post by JohnYaker » Wed May 09, 2007 1:35 pm

Larry,
... once you get beyond the basic needs being met (food, shelter, etc) there are two keys to happiness (I assume besides good health) ...They are your connectedness to society (depth and number of your relationships) and continuing to learn (stimulate your brain).
At least we agree on the true keys to a happy life. :)

I fully understood your position as you previously explained. Further, I respect everyone's right to invest their own money as they please, according to their own needs and risk-tolerance.

However, it is important to recognise that many very smart people of extreme wealth (who probably also share our 'keys' to happiness'), DO invest heavily in equities. I believe is a matter of risk tolerance.

John
Last edited by JohnYaker on Wed May 09, 2007 1:42 pm, edited 1 time in total.

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Post by larryswedroe » Wed May 09, 2007 1:42 pm

John
Like I said, I know how much I have already left on table, but it makes no difference to me. I slept much better through 911 for example and the ensuing losses.
Life too important not to enjoy it.

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Re: Larry,

Post by BrianTH » Wed May 09, 2007 1:49 pm

JohnYaker wrote: However, it is important to recognise that many very smart people of extreme wealth (who probably also share our 'keys' to happiness'), DO invest heavily in equities. I believe is a matter of risk tolerance.
This is actually a real puzzle as I understand it (why do people still invest in equities when the marginal utility of extra dollars is literally zero, because they are so wealthy that they could not possible spend that money, nor could their children, or their children, and so on). For a limited few it makes sense, to the extent they are basically investing for the benefit of their favorite charities (eg, like Buffett). But I gather a lot of the billionaire types do not actually give all that much percentage-wise to charity.

The best explanation I have heard is that it is basically just a game to them, and money is the way they keep score. So, for example, maybe they are looking at where they rank on the Forbes list, and just competing to get higher.

And if that is right, then I wonder to what it extent it actually does make them happy. It may not, at least not any more than playing Monopoly as a vocation would make us happy.

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Brian

Post by JohnYaker » Wed May 09, 2007 1:55 pm

Brian,

You're right. It's really risk-tolerance and GOALS.

John

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Re: Brian

Post by BrianTH » Wed May 09, 2007 2:33 pm

JohnYaker wrote:It's really risk-tolerance and GOALS.
Indeed. And frankly, what goals the truly superrich should have for their money, if they don't want to give it to charity, is a somewhat odd question. Basically, we have pointed out that they could make a bunch more money and it wouldn't matter to their consumption, and they could lose a bunch of money and it wouldn't matter to their consumption. So, the amount of money they have at the end of the day doesn't really seem to matter at all in any conventional sense.

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Brian,

Post by JohnYaker » Wed May 09, 2007 2:47 pm

Brian,

If you look at the list of the world's largest donors to your favorite charity, you likely find that many of them obtained their wealth through risky investments. They could not never have made their contribution to society by investing in low-risk bonds or cash. Bill and Melinda Gates, Warren Buffet, Boon Pickens snf The Carnegie Foundation are just a few examples. They are doing good. I appaud their donations.

John

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Re: Larry,

Post by grumel » Wed May 09, 2007 3:05 pm

BrianTH wrote:
JohnYaker wrote:
The best explanation I have heard is that it is basically just a game to them, and money is the way they keep score. So, for example, maybe they are looking at where they rank on the Forbes list, and just competing to get higher.

And if that is right, then I wonder to what it extent it actually does make them happy. It may not, at least not any more than playing Monopoly as a vocation would make us happy.
I doubt its a game whos richer. From a society point of view, its great if people that got a lot of self made money keep being active enterpreneuers, as they seem to be far over average good at it, at least on the average, cant exclude rare cases of luck.

For billionairs investing/running companies is their job. And they are really good at it, or more precise on the absolute top. And you dont get on the very top without likeing if not loveing your job. Studies about luck show that people are actually very happy while they do a job they like. I bet they are much hapier then average people playing monoply with it. So id say they just keep doing their job, cause they like it, and i bet they care much less about the forbes list then we do.

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Re: Brian,

Post by BrianTH » Wed May 09, 2007 3:28 pm

JohnYaker wrote:If you look at the list of the world's largest donors to your favorite charity, you likely find that many of them obtained their wealth through risky investments. They could not never have made their contribution to society by investing in low-risk bonds or cash. Bill and Melinda Gates, Warren Buffet, Boon Pickens snf The Carnegie Foundation are just a few examples. They are doing good. I appaud their donations.
Indeed, and I specifically noted that it makes sense for the superrich to stick with equities if they are investing for charity.
But that apparently is not what many of them are doing. See here for a discussion of all this:

NYT Article on Super Rich

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Re: Larry,

Post by BrianTH » Wed May 09, 2007 3:34 pm

grumel wrote: For billionairs investing/running companies is their job. And they are really good at it, or more precise on the absolute top. And you dont get on the very top without likeing if not loveing your job. Studies about luck show that people are actually very happy while they do a job they like. I bet they are much hapier then average people playing monoply with it. So id say they just keep doing their job, cause they like it, and i bet they care much less about the forbes list then we do.
I think we need to distinguish a few different things. If you are running a company and it makes you rich, that is one sort of thing (we could call this the Gates scenario). Similarly, if you invest in other companies but take an active role in managing them, that is another sort of thing but closely related (we could call this the Buffett scenario). But a third sort of thing is just passively investing in equities (meaning you are not taking a role in running the company), and there I think it is a bit harder to see these efforts as a job in the conventional sense.

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Post by larryswedroe » Wed May 09, 2007 8:06 pm

John
I should have added this
While I do have a very low equity allocation the equities are all in the riskiest asset classes. Thus the expected return of my portfolio is the same as that of a more typical TSM portfolio with a MUCH higher equity allocation.
Example, SV stocks have outperformed S&P by 4% a year.
Let's assume market rises say 8% a year and bonds return say 5% (to keep it simple).
My equities would expect to return 12%.
So let's use 20% x 12% and 80% x 5%. Portfolio expected return is 6.4%.
Now take a 60/40 portfolio. It would have expected return of not much higher at 6.8%. But it would have much wider dispersion of potential returns.
So cannot just look at equity to bond allocation but need to look at holdings within

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Post by Bob K. » Thu May 10, 2007 1:50 pm

larryswedroe wrote: Example, SV stocks have outperformed S&P by 4% a year.
Let's assume market rises say 8% a year and bonds return say 5% (to keep it simple).
My equities would expect to return 12%.
So let's use 20% x 12% and 80% x 5%. Portfolio expected return is 6.4%.
Now take a 60/40 portfolio. It would have expected return of not much higher at 6.8%. But it would have much wider dispersion of potential returns.
So cannot just look at equity to bond allocation but need to look at holdings within
Larry,
I have reread the above and thought about it. I'm not sure how your portfolio gives you a narrower dispersion of potential returns.

Could you expand a bit more?

Bob
"The average investor has only 11,000 more genes than a worm"-New York Times

johndcraig

Post by johndcraig » Thu May 10, 2007 2:11 pm

The disconnect

John Yaker says,
Larry's extreme risk averse position (only 20% equities, last I heard) is contrary to an optimal allocation according to statistical history for someone with a 40 year planning horizon…. Larry is giving up a 90+ chance of far exceeding his current portfolio by not investing more in stocks.
Part of Larry’s response is,
I know exactly what the odds are and what I am LIKELY giving up…. fat tails do show up from time to time and I don't worry about them any longer.
It seems to me that the two of you are starting from a different set of assumptions.

John

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Post by larryswedroe » Thu May 10, 2007 5:20 pm

bob K

This is simple and very interesting stuff for portfolio construction IMO

If you have only 20% equity then assume market drops even to zero, you can only lose 20% of total portfolio---and likely bonds will rise in value significantly so might even make net profit. But if had 60% equity allocation then you would suffer large loss.

On other hand, if market had big rise, the 60% equity allocation would far outperform in all likelihood. Reason is I only have about 20% exposure to beta vs 60%. And beta is the big driver.

Think of the 60% portfolio as a bell curve of potential dispersion--one with fat tails. My portfolio has same height but thin tails, fitting inside of the other. Show those two potential dispersions to most investors and they almost certainly will choose the one with the thinner tails.

I have looked at the historical data on this and it is quite impressive IMO.
Example. An all equity portfolio from 70-06

100% S&P up 11.2 with SD of 16.8. Best year 38% worst -27
But 34% SV and 66 1 Year T bills had same 11.2 and SD of less than half at 7.8. Best year just 25% but worst loss only 5%.
And the first portfolio had 8 negative years and the second had only 4.

Which portfolio would you rather have had?

This is IMO one of the major benefits of tilting that no one seems to discuss. At least I have never read anything on it. Though I wrote a paper on this for our clients.

Hope you find it helpful

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Post by larryswedroe » Thu May 10, 2007 5:26 pm

bob k

BTW- consider also that SD of equities is about 19 while SD of HmL is about 12.

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Post by stratton » Thu May 10, 2007 6:21 pm

This is IMO one of the major benefits of tilting that no one seems to discuss. At least I have never read anything on it. Though I wrote a paper on this for our clients.
Larry, any way to make that paper available to the Diehards community?

Paul

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Post by larryswedroe » Thu May 10, 2007 7:25 pm

Paul

Here is an old version I wrote last year. Doesnt have the data I showed above unfortunately but makes the point

Effective Diversification in a Three-Factor World
Prior to the publication of the study by Professors Eugene F. Fama and Kenneth R. French the conventional wisdom was that we lived in a one-factor world—the risk and return of a portfolio is determined by its beta. Beta is a measure of equity-type risk (or market risk) of a stock, mutual fund, or portfolio, relative to the risk of the overall (U.S.) stock market. An asset with a beta above one has more equity-type risk than the overall market, while an asset with a beta below one has less equity-type risk than the overall market.
Fama and French hypothesized that we actually lived in a three-factor world—the risk and return of a portfolio is explained by not only beta, but also by its exposure to two other risk factors. Those risk factors are the risk of size (small companies) and price (value stocks). Fama and French found that while small and value stocks have higher beta (they have more equity-type risk), they also have additional risk unrelated to beta. Thus small and value stocks are riskier than large and growth stocks and thus they have higher expected returns. Studies have confirmed that the three-factor model explains well over 90 percent of the returns of diversified portfolios.
For the period the 1927–2005, the average annual returns to these three risks factors was:
·Market Factor (The return of the all equity universe minus the return on one-month Treasury bills): 8.08 percent.
·Size Factor (The return of small stocks minus the return of large stocks): 3.17 percent.
·Price Factor (The return of high book-to-market [value] stocks minus the return of low book-to-market [growth] stocks: 5.03 percent.

Independent Risk Factors
It is important to understand that size and price are independent (unique) risk factors in that they provide investors with exposure to different risks than does exposure to market risks. We can see evidence of their independence when we examine the historical correlations of the size and price factors to the market factor. If the correlations are high, the risk factors will be relatively good substitutes for each other. If that is the case then while investors can increase the expected return (and, of course, risk) of the portfolio by increasing their exposure to these risk factors, there is no real diversification benefit. On the other hand, if the correlations are low, not only will investors increase expected returns, but they will also gain a diversification benefit.
For the period 1927–2005, the correlation of the market risk factor to the size risk factor was just 0.408, and its correlation to the price risk factor was 0.091. And the correlation of the size risk factor to the price risk factor was almost zero (.026). In other words, we can effectively diversify equity risks by diversifying across the three independent risk factors. And each of the three risk factors has the potential for increasing investment returns. The following are two recent examples demonstrating that size and price are independent risk factors.
·In 2001, small stocks returned 18 percent and small value stocks returned 40.6 percent while the S&P 500 produced a negative return of 11.9 percent.
·In 1998, while the S&P rose 28.6 percent while small stocks fell 2.3 percent and small value stocks fell 10 percent.

Diversifying Risk
In the one-factor world there were only two ways to increase returns—either increase the allocation to stocks or buy higher beta stocks. In either case you were taking more of the exact same type of risk you were already taking. The work by Fama and French showed investors that there are other ways to increase the expected return of a portfolio. Instead of adding more of the same type of risk, you could add different types of risk. By adding different types of risk you achieve more effective diversification (not all of your eggs are in one risk basket). The following simplified example (it ignores the diversification return) will illustrate the point.
Let’s assume that in the future we expected equities to provide an annualized return of 7 percent. And we have current bond yields of about 5 percent. Now let’s consider an investor with a portfolio that is currently 50 percent bonds and 50 percent stocks. This allocation results in an expected portfolio return of 6 percent. While developing a financial plan our investor determines that in order to achieve his objective he must achieve a return of return of 6.5 percent, greater than the 6 percent expected return of his portfolio. One way to increase the expected return to 6.5 percent is to increase his allocation to stocks from 50 percent to 75 percent.
(75% x 7%) + (25% x 5%) = 6.5%
Let’s now consider an alternative strategy; one that diversifies risk to other risk factors. For the period 1927–2005, small value stocks achieved an annualized return that was 5.4 percent above the market’s annualized return (15.5 percent versus 10.1 percent). Let’s assume that same relationship will continue in the future. (Note that since size and price are risk factors we do not know that this relationship will continue.) Thus if we are forecasting returns to the market of 7 percent, we would also forecast that small value stocks would return 12.4 percent. Using this information we can look at the expected returns for a few different portfolio allocations.
Let’s first consider a portfolio that takes one-half of the equities and allocates to small value stocks. The expected return would now be:
(25% x 7%) + (25% x 12.4%) + (50% x 5%) = 7.35%
By increasing the allocation to riskier stocks we increased the expected return. We did, however, also increase the risk of the portfolio. The result might be more risk than the investor has the ability, willingness, or need to take. So let’s consider another alternative. This time while we will shift some of the equity allocation to small value stocks (increasing risk), we will also lower the overall equity allocation to just 32 percent (lowering risk). The new allocations are 16 percent total market index, 16 percent small value stocks, and 68 percent bonds. The expected return would now be:
(16% x 7%) + (16% x 12.4%) + (68% x 5%) = 6.5%
We now have a portfolio with a 32 percent allocation to stocks that has virtually the same expected return as the portfolio that had a 75 percent allocation to stocks. Consider, however, that in this case, instead of increasing the expected return by taking more of the same type of risk (market risk), we increased returns by adding different types of risk—the risks of small and value stocks. Thus we diversified our equity risks across these two independent factors. We believe that this a more effective form of diversification. Again, it doesn’t place all of our eggs in one risk-factor basket—while the expected returns of the two portfolios are the same, their risks are, in fact, different.

Risk Aversion
There is another consideration that is especially important to risk averse investors (and most investors are risk averse). Since bonds are safer investments than stocks, if we were to experience a severe bear market, the maximum loss the portfolio could experience is far lower with a 32 percent equity allocation than it is with a 75 percent equity allocation. Thus while the expected returns of the two portfolios are the same, the downside risk is much less with the portfolio with the lower equity allocation. Of course, the upside potential is correspondingly lower as well. For an investor for whom the pain of a loss is greater than the benefit of an equal-sized gain, reducing downside risk as the price of reducing upside potential is a good trade-off.

Considerations
There are several factors that should be given careful consideration when deciding on the appropriate portfolio mix. The first is that an investor should consider how their intellectual capital (earning power) correlates with the greater economic cycle risks that small and value stocks have as compared to large and growth stocks. Thus a tenured professor or doctor, with a low correlation to those risks, can prudently take greater small and value risks. On the other, it may not be prudent for a construction or automobile worker, with a high correlation to those risks, to increase exposure to those risk factors.
The second consideration is a psychological one. It is risk called tracking error regret. For equities tracking error is the amount by which the performance of a portfolio varies from that of the total market, or other broad market benchmark such as the S&P 500 Index. By diversifying across risk factors you take on tracking error risk. While very few investors care when tracking error is positive (their portfolio beats the benchmark), it seems that most investors care when the tracking error is negative. To have a chance for positive tracking error, you must accept the almost certainty that negative tracking error will appear from time to time (or there would be no risk). And, unfortunately, the emotions that negative tracking error can lead to causes many investors to throw their well-thought-out plans into the trash heap. And losing discipline is a recipe for failure. Thus only those investors that are willing and able to accept tracking error risk should consider diversifying across the other risk factors.

Summary
Fama and French showed us that there were two additional risk factors that we should consider when constructing portfolios. We can either use those risk factors to increase the expected return (and risk) of a portfolio, or we can maintain the expected return of the portfolio by diversifying across these independent risk factors while lowering the equity allocation. For many investors we believe that diversifying across these independent risk factors is a more effective way to diversify portfolio risk.

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Post by stratton » Thu May 10, 2007 7:29 pm

Thanks Larry! :)

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Post by Russell F. » Thu May 10, 2007 7:54 pm

Mr. Swedroe,

It would be disingenuous of me if I did not say that I have not only benefited tremendously from your books, but your numerous postings as well.

Thank you.



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Last edited by Russell F. on Fri May 11, 2007 3:17 pm, edited 1 time in total.

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Post by stratton » Fri May 11, 2007 8:46 am

Larry's posting here has gotten me to buy two of his books. "The only Guide..."

Paul

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Post by larryswedroe » Fri May 11, 2007 8:48 am

Russell
Quite welcome--I THINK---

Think you meant so say that it would be disingenous if you DID NOT state that you have benefitted (:-))

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Post by Bob K. » Fri May 11, 2007 9:19 am

larryswedroe wrote:bob K

This is simple and very interesting stuff for portfolio construction IMO

Hope you find it helpful
This was tremendously helpful, and simple enough for me to understand. Thanks.

Thinking now about a modified portfolio (Note to Trev-can you model this?):

80%-TIPS
19%-Equity
1%-Yearly night in a Vegas casino-though right now I could only last maybe an hour or two....

Seriously-this idea certainly deserves an article from you (in your spare time :lol:)

Bob
"The average investor has only 11,000 more genes than a worm"-New York Times

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Post by Russell F. » Fri May 11, 2007 3:17 pm

larryswedroe wrote:Russell
Quite welcome--I THINK---

Think you meant so say that it would be disingenous if you DID NOT state that you have benefitted (:-))
All apologies for the typo. You are quite correct, Larry, my post should have DID NOT state. :shock:

Good thing typos can fixed on this forum. Now if I can master proofreading my posts, I'll be all set...

Thanks again for the time and effort you put in to this forum.


Russell F.

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Post by larryswedroe » Fri May 11, 2007 3:19 pm

bob
With that low an equity allocation I would suggest strong tilt to small value, and EM and ISV

Also note that historically about 20% equity is about same risk as all long bonds!!
At least in terms of SD

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Post by ataloss » Sun May 13, 2007 4:30 am

I read Larry's "Investment Strategy" book of 1998 and saw the error of my ways (I was a tsm investor.) Diversification helped me tremendously in the debacle of 2000.

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Re: Larry Swedroe - Saint Louis Post-Dispatch 05/06/07

Post by xram » Tue Apr 30, 2013 8:23 pm

Great Thread. Bump.
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Re: Larry Swedroe - Saint Louis Post-Dispatch 05/06/07

Post by gkaplan » Tue Apr 30, 2013 8:33 pm

You're bumping a six-year old thread.
Gordon

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Re: Larry Swedroe - Saint Louis Post-Dispatch 05/06/07

Post by xram » Tue Apr 30, 2013 10:08 pm

gkaplan wrote:You're bumping a six-year old thread.
So what?
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