Straight From The Source: Larry Swedroe

Larry Swedroe has established a reputation as one of the clearest thinkers and best writers in the field of passive investing. Swedroe is the author of many books, including Wise Investing Made Simple: Tales To Enrich Your Fortune, which hit the bookstands last Monday.

“Larry has written some of the most sensibly and clearly written books anywhere for sophisticated passive investors,” said Jim Wiandt, publisher of IndexUniverse.com and the Journal of Indexes. “Now he has one-upped himself by writing the book we’ve always wanted to give to our friends, relatives and clients when they ask us for tips. With a fireside chat manner, Larry goes through a wide array of complex financial ideas by explaining them clearly through stories. I found the book to be thoroughly entertaining. And investing novices will find it to be invaluable.”

Swedroe spoke recently with IndexUniverse.com editor Matt Hougan about the new book and, more broadly, about his overall investing philosophy.

IndexUniverse.com: Tell us a little bit about the new book, and why you wrote it.

Larry Swedroe (Swedroe): The book tries to take a topic that a lot of people are scared ofmoney and investingand bring it into the real world and make it simple and easy to understand by using stories … stories about sports, about family, about the things that aren’t scary. Because the basic concepts are easy to understand, and if you can get people to understand just a few key concepts, they’re going to be much better off in the long run. Most people remember stories more readily than a complicated chart.

IndexUniverse.com: Give me an example.

Swedroe: Well, I’ve found that the best way to teach people about investing is to tie it to the idea of betting on sports. Many people understand betting on sports, and not enough people understand investing. So one of the stories I use in the book is this …

Even someone who doesn’t know much about college football would recognize the answer to this question: If the University of Texas, a national contender for the championship every year, played a school called San Angelo State, which team is likely to win?

Easy, right? If they play 100 times, Texas would almost certainly win 100 of those games.

The problem is, if you’re trying to make money betting on Texas, you can’t do it. To make money, you might have to give the other team a 40-point spread.

As it turns out, the point spread is an unbiased estimator of the outcome. Even though a bunch of amateurs set the point spread by their betting actions, the favorites tend to win by more than the point spread half the time, and less than the point spread half the time. So it’s very difficult to make money betting on sports; the only people likely to make money are the bookies.

How does that tie to investing? Well, ask yourself the question: If you consider two companies, GE and Ford, you know that GE is the better company. But should you invest in GE just because it’s a better company? No, you have to pay a much higher price for GE than you do for Ford … the price-to-earnings ratio makes both of them equally good investments once you adjust for risk, the same way the point spread gives you an equal chance to win. In other words, GE is Texas and Ford is San Angelo State. Just as the point spread equalizes the risks of betting on either team, the difference in the P/E ratio makes both companies equal investments once we adjust for risk.

Most stockbrokers are nothing more than bookies. They just need you to playto buy and sell stocksand they pocket the commission. They win. You don’t win by playing their game. That’s why the bookies own the yachts, when it should be the investors that own the yachts.

I use stories like that one throughout my book to break down the myths about investing, to make it clear. Because stories are the easiest way to get people to learn.

If you tell somebody a fact, they’ll learn. If you tell them a truth, they’ll believe. If you tell them a story, it will live in their hearts forever.

IndexUniverse.com: Do you think younger investors with a longer time horizon should hold more small-caps, more international and more value exposure than the broad market? That seems to be the thinking among a lot of the DFA-inspired crowd.

Swedroe: Let’s begin by addressing this question: Why should anybody at all deviate from a market-cap-weighted strategy?

The answer begins by understanding that there isn’t one factor that determines equity returns. That’s what people used to believethe more exposure to beta you had, the higher your expected returns and risk. But along came Eugene Fama and Kenneth French. They demonstrated that a three-factor model explains returns much better than the one-factor model. Beta explains about two-thirds of returns while the three-factor model explains about 95% of returns. And unfortunately, prior beta does not determine future beta.

They came up with three factors to explain returns:

* Beta: exposure to stocks
* Value: exposure to stocks with lower valuations
* Size: exposure to small-caps

Because small-caps and value stocks are more risky than large-caps and growth stocks, there should be a risk premium for holding those stocks, and, therefore, higher potential returns.

IndexUniverse.com: So a younger investor should tilt toward small and value to achieve higher returns?

Swedroe: There are good reasons why one might want to take on more risk in a portfolio. One reason is that, as you get bigger risk premiums, you have higher expected returns. A young person may have a longer investment horizon than an older person, and therefore more ability to wait out a bear market. Thus, the younger person might be willing to have a higher equity allocation. They won’t always have better returns, but the longer their time horizon, the more likely it is they will benefit from a higher equity allocation and the value premium as well.

The same is true for small and value stocksthey don’t always outperform, but the longer your horizon, the more likely you’ll get the benefit of the small/value premium.

There is a second factor in people’s ability to take risk: the correlation of your earned income to the economic cycle risks that drives stock returns. Someone whose earned income is highly correlated with economic risksa construction worker, a small-business owner, etc., might want to underweight small/value to the market and also have a smaller equity allocation. On the other hand, people with very low correlationsdoctors, lawyers, tenured professorshave more ability to take risk. And that means they can increase both their equity allocations and their size/value exposure.

Age is part of the equation, but it’s just as important or more important to look at the correlation of your income.

IndexUniverse.com: Will small and value always outperform? Or have those premiums been priced out of the market?

Swedroe: The answer is the same as if you asked me if stocks will always outperform bonds. We know that they will not. If they did, there would be no risk. But we must always expect that they will over any time period. The reason is simple. They are riskier. And thus investors price them for higher expected returns.

Well, value and small stocks are riskier and they too must be priced for higher expected returns. At least if markets are acting rationally. But investors must also keep the following in mind: If you own more than the market share of small-caps and value stocks, your portfolio will perform differently than the market. You are taking on what is called the risk of tracking error.

In the 1990s, when large and growth stocks performed well, a lot of people abandoned the small/value exposures. But unfortunately, a strategy is either right or wrong before the fact. We don’t say it was a bad strategy to buy life insurance because we have not yet died. The strategy must be right before we know the outcome. Similarly, the strategy to buy small-cap stocks and value stocks must be right or wrong before you know the outcome. It won’t always work, but it has worked over long time horizons for a very long time. Unfortunately, people make mistakes and typically abandon their strategies at the worst possible time.

Having the discipline to stay with whatever strategy you choose is far more important than the specifics of your asset allocation. If you choose a strategy that you will, in all likelihood, abandon when things get tough, you’ll likely do far worse than if you chose a different strategy and stuck to it.

IndexUniverse.com: Are growth stocks really less risky than value stocks?

Swedroe: Here’s the difference: We have great companies and we have high expected returning stocks. People think those are the same thing, but they are not. In my new book, I have a story called, “Great Companies Do Not Make High Return Investment,” which walks through this in a very simple fashion.

Again, imagine you have two companies, GE and Ford. If we ask people which is the better company, people would say GE. If we ask people which is safer to invest in, they’ll also say GE. After all, if GE goes to borrow money from banks or raise equity in the stock market, they get a lower cost of capital: They have a higher P/E on their stock and a lower interest rate on loans. The lower cost of capital reflects the view by the providers of capital that GE is a safer investment.

But here is where people get confused. GE is a great company and “safer,” and Ford is riskier. But GE may have that greatness priced in. GE’s stock might be traded at a price-to-earnings ratio of 25, while the market average trades at 16 and Ford trades at 7. If the market gets what it expects, people will get the returns off what is bid into the prices: GE gets a lower expected return, because it is “safer,” and Ford gets a higher expected return, because it is riskier.

The problem is if unexpected risks show up. In GE’s case, you’re more exposed to price risk if that happens: The P/E could come way down. In Ford’s case, much of the risks of bad news have already been built into the price, so you are more protected. That’s how people should think of the risk of growth stocks: The price-to-earnings ratio could fall more dramatically than for value stocks. We saw that in March 2000, when the tech stocks were priced as if everything would go right. When that turned out to be wrong, prices collapsed.

The way to think about it is: The odds of something going wrong at GE must be low, otherwise the price would not be high. But if something does go wrong, it could fall sharply. It’s a risk, but one with a low probability.

IndexUniverse.com: Is there a place for commodities, currency, real estate and other alternative investments in most people’s asset allocations?

I believe the answer to that is yes and no. I’ve actually written a book tentatively called, The Only Guide to Alternative Investments You’ll Ever Need. In it, I divide alternative assets into four categories: the good, the bad, the flawed and the ugly.

There are about 20 of these alternative investments altogether. Of the ones you mentioned, real estate and commodities have a place in almost everyone’s portfolio.

REITs in the form of domestic REITs give you broad exposure across a number of asset classes: hotels, apartment houses, etc. There are now even international REITs, which add another benefit of further diversification. After all, there’s an old saying that all real estate is local.

Commodities are a good diversifier, but I would never recommend investing in commodities themselves or in the equities of commodity producers. But I would recommend investing in fully collateralized commodity futures, investable through exchange-traded funds (ETFs), exchange-traded notes (ETNs) and mutual funds. That gives you a passive exposure to an asset class that actually has real expected returns, because you are able to invest the collateral in Treasuries or other instruments. More importantly, commodities are just about the only asset class that has negative correlations to both stocks and bonds. In the nine years that bonds have had negative returns since 1970, commodities are up all 9 years … and they are up on average 30%. And in the eight years when stocks have produced negative returns, commodities averaged a return of about 23 percent. Commodities are volatile, and they tend to perform poorly for a very long time, with then short bursts of very high returns, so you need discipline. Think of them as portfolio insurance. Commodities add a lot of value to a portfolio because they tend to provide their best returns when the rest of the portfolio is having the worst returns.

IndexUniverse.com: What else is in the good category?

Swedroe: I have four other assets in the good category. First, international equities, which I consider alternatives because most investors underweight them. Note that the greatest diversification benefits come from international small-cap and emerging markets stocks. People tend to stick to international large caps, which are a good diversifier, but the correlations are much higher.

The next assets class which I think should be in everybody’s portfolio is TIPS (Treasury Inflation Protected Securities). The literature from academia says that TIPS should even dominate fixed-income portfolio, and I agree, particularly in tax-advantaged accounts.

Two others that I recommend are:

* Stable-value funds, provided they are from very strong credits (AAA providers)
* For some investors, fixed immediate annuities are worth considering, if you need longevity insurance.

IndexUniverse.com: Briefly, what is in the flawed, the bad and the ugly categories?

Swedroe: In flawed, there are a lot of things people invest in that I wouldn’t recommend: junk bonds, venture capital, covered call writing strategies, socially responsible investments, precious metals equities, preferred stock, convertible bonds and emerging market bonds, and private equity. They are flawed in the sense that they might have some positive characteristics (e.g., low correlation), but their negative characteristics more than offset the positives. In other words, there are more effective ways to achieve the same objective.

The bad? Hedge funds, leveraged buyouts and variable annuities. These are all products that are sold, not bought. Once you adjust for the biases in the data and the risks involved, for instance, the data show that hedge fund returns barely compete with T-bills. Variable annuities are way too expensive. The ugly? Equity index annuities. These may be the worst investment known to man. I’ve looked at many of them, and I’ve never found one that looks attractive. Another ugly is leveraged funds. And finally, I would add the broad category of structured investment products put out by Wall Street.

The best advice I can give regarding products created by Wall Street is this: The more complex a product, the faster you should run away from it. It is far more likely that the complexity benefits the seller/issuer than the buyer.

IndexUniverse.com: If you had just five minutes to talk to a 25-year-old who knows nothing about investing, what would you tell them?

Swedroe: The sad truth is that outside of your family and your health, there’s nothing more important than moneynot the money itself, but what it can do for you. Yet our education system has failed to educate the public about investingunless you happen to get an MBA in finance. So my suggestion would be to get educated. First, read James Surecki’s book, The Wisdom of Crowds. Then I would tell him to read Your Money and Your Brain by Jason Zwieg. And then I would tell him to read my books. And if our investor did that, he would know how to avoid all the mistakes most people make. One of my favorite lines is this: If you think education is expensive, try ignorance.

The best news is: As I explain in my new book, the winning strategy is very simple. But it’s not easy: We’re human beings subject to our emotions, and we make mistakes. And that’s where a good advisor can help people. A good advisor develops not only an investment plan, but then integrates that plan into an estate, tax and risk management (insurance) plan.