During this time of investment market turmoil, investors look to professionals for help in weathering the storm. Larry Swedroe, director of research for Buckingham and the BAM Alliance as well as author of 13 investing books, offers insights and information to help cope with market turbulence and investing.
In this excerpted interview, we asked Swedroe about his “Larry portfolio,” his thoughts on Warren Buffett’s investing arsenal and his advice for millennials.
Explain “two-stage thinking” from your book, “Think, Act, and Invest Like Warren Buffett.” How might this practice help investors, especially in this rocky market?
Stage one thinking occurs when something bad happens, you catastrophize and assume things will continue to get worse. This might play out when you have a bad day, feel a bit depressed and begin to think your entire life stinks. In the investment markets, stage one thinking happens when the averages hit a rough patch, asset prices fall and you think you’re going to lose all of your money.
Clearly, it’s useful to go beyond stage one thinking.
Stage two thinking can help you move beyond catastrophizing. With stage two thinking, you can reassess your extreme reaction and take action — take a walk, plan a fun activity or get some sunlight. These simple stage two thinking strategies will circumvent the possibility of falling into a more serious depressive downward spiral.
[Read: Reshape the Way You Measure Your Portfolio’s Success.]
When applied to investing, stage two thinking is especially helpful during times like the present, when the markets start off the year with a tumble. Instead of fearing that you’ll lose all your money, consider Warren Buffett’s stage two thinking remedy for market corrections; consider why everything may not be as bad as it seems. Think about previous similar circumstances to disprove your catastrophic fears.
For example, during the economic recession during 2008 and 2009 the U.S. lost its AAA rating, there was the Greek debt crisis, Middle East turmoil, the mortgage meltdown and other bad news. In spite of the negatives, the stock markets advanced more than 200 percent since 2009.
Use stage two thinking to talk back to catastrophic fears and respond with reason. Don’t panic and lock in your losses by selling during a market drop.
There is a preponderance of evidence in favor of passive investing with index funds. Why are there still so many active managers and investors?
According to a recent study, the average actively managed fund underperformed its benchmark by 1.75 percent per year before taxes, and by 2.58 percent per year on an after-tax basis. To put the results another way, just 22 percent of funds beat their benchmark on a pre-tax basis. After taxes, only 14 percent of funds outperformed their index — the risk-adjusted odds against outperformance are approximately 17:1.
With this type of compelling research supporting an index fund approach, why would investors choose an active manager or fund?
People are ignorant, not stupid. They may not be aware or educated in the current investment research. There’s an inherent conflict of interest between Wall Street and Main Street. It’s not straightforward to understand capital markets and the great number of media outlets and investment firms have a financial interest in making investing seem complicated. These industries want to keep investors coming back to buy more magazines and trade more stocks and bonds. Consequently, investors need to take action to educate themselves about investing and take media recommendations with a grain of salt.
[See: Investors Should Reconsider Target-Date Funds.]
What is the Larry portfolio?
The Larry portfolio was coined in 2011 when New York Times columnist Ron Lieber wrote about my personal investment strategy. In short, the Larry investment portfolio can be described as a low-beta/high-tilt (to small-capitalization and value stocks) portfolio. The idea behind this unique approach to portfolio allocation is the attempt to reduce black swans, an unpredictable event with extreme negative consequences.
Historical investment returns favor small-cap and value stocks. Since 1926, the Standard & Poor’s 500 index returned approximately 10 percent annualized, with bonds in the range of 5 to 6 percent per year, whereas small-cap and value stocks returned an annualized average return in the area of 14 percent. But the drawback to the higher annual returns of small-cap and value stocks is greater risk or standard deviation. These specific classes had a standard deviation of 35 percent, when compared with the 20.23 percent standard deviation of the S&P 500 from 1926 through 2015.
The Larry portfolio isn’t a fixed percentage asset allocation model, but one that for the stock portion of the portfolio overweights small-cap and value stocks and balances out the additional volatility with a large percentage of assets in low risk cash and/or fixed assets. There are several ways I might configure a ‘Larry portfolio’. For example, you could go with 30 percent stocks and 70 percent bonds in an attempt to capitalize on the historical outperformance of small-cap and value stocks. The 30 percent would be invested in these risker equity asset classes, yet the 70 percent allocation to fixed holdings would substantially reduce the portfolio risk.
What investment practices do you practice in your personal portfolio that you would advise others to avoid?
It is infrequent that I might deviate from how I advise others to invest. For example, when valuations become way out of line with average levels, and as an investment professional I recognize this situation, I might take action. For example, in 1998 when the markets were extremely overvalued, I sold all of my growth stocks and reinvested in value stocks. Although I was correct in my assessment, I was also two years too early in this plan, as growth stocks continued to climb for the subsequent two years before falling.
[Read: Hidden Mutual Fund Fees That Are Robbing Your Portfolio.]
I advise the average investor to understand that no one knows where the market is going, develop an investment policy statement, create an asset allocation plan, to know after what percent of value change they will rebalance their portfolio, and that they stick with their plan.
What is your advice for millennials regarding investing for their future?
Do your homework before investing by educating yourself. There are many excellent investment education books including those by John Bogle, William Bernstein and my own books. Study the differences and research the underpinnings of an active versus passive investing approach.
Develop an investing plan before committing money into the markets. Build the right asset allocation for your own personal situation and risk tolerance. Decide whether you can do-it-yourself or prefer to hire an advisor or robo-advisor for assistance.
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Interview: Two-Stage Thinking Helps Investors Weather Volatility originally appeared on usnews.com
