WCI #181: Evidence-Based Investing with Larry Swedroe

This is the White Coat Investor podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high income professionals stop doing dumb things with their money since 2011. Here's your host, Dr. Jim Dali. This is White Coat Investor podcast 181 evidence based investing with Larry Swedro. Did you know that the White Coat Investor not only has a podcast and a blog but but several books that will help you on your way to financial independence. These books cover topics such as asset protection and minimizing your taxes to keep more of your hard earned money. They discuss plans for insurance, housing spending, student loan elimination, investing and estate planning. You can learn how to become a millionaire within five to 10 years of leaving residency and how to invest in a sensible, low cost and effective manner with or without the assistance of a financial advisor. There's even a book geared directly toward medical and dental students so you can start optimizing your finances or early in your professional journey. Find the book that is right for you at the WCI store, at shop.whitecoatinvestor.com or on Amazon. You can do this and the White Coat Investor can help. Welcome back to the podcast. Thanks for what you do. I hope you're having a great October. I know I am. I had a wonderful time on the middle fork of the salmon. Wonderful time kayaking down there. Beautiful terrain. Got to see eagles and sheep and deer and elk and even some river otters. It was a wonderful trip. Then got to spend some time with friends at Lake Powell. Having some adventures. Great times down there. Both doing some jerry rigged parasailing as well as some canyoneering and the usual, you know, surfing and wakeboarding and skiing and that sort of stuff. So back at work now. Let's record some podcasts I guess. Meanwhile, thanks for what you've been doing out there. It's not easy work to be a doc. It's not easy work to be an attorney or a pharmacist or whatever you might do. And I wanna say thank you if nobody else has told you, thanks today. Our quote of the day today comes from Charlie Ellis who said investing in stocks helps keep us young. Obviously stocks have a long term return that you need to be around for the long term to collect. So in that way, you know, investing in stocks makes you try to stay alive longer. A little bit like buying an annuity that way. Today we have something special. We're gonna get into an interview here in just a minute, but before we get there, I want to make sure you are aware of a resource we have on the White Coat Investor site. If you go there and you go to the tab called the Books and go down to the bottom link there called Great Books by Others, it will take you to a page that I have titled the best Financial Books for Doctors. Reading books I think is one of the best ways to learn about investing. Not only do you avoid the short term information you see on CNBC and in the paper and on the radio, but when you write a book, you write differently than you do for the Internet. Your arguments are more, more coherent. The books are better proofread and better designed and better edited. I think it's a great way to get a foundation of financial literacy under you on that list. I have put together all kinds of books, both doctor specific books, books on personal finance, investing, advanced investing, behavioral investing, mortgages and real estate investing, taxes, contracts, estate planning and asset protection. All these subjects that I think you need to know about. And so if you're looking for good book recommendations, I would start there. That can be found@whitecoatinvestor.com Best financial books for and you can get that under the tabs there on the recommended place on the site there. All right, let's get into an interview. We have a special guest today, Larry Swedro. Let's roll it. Okay. Today on the podcast we have a very special guest, somebody I've been looking forward to getting on here for a long, long time, Larry Swedro, who is a definite expert when it comes to investing. Am I pronouncing that name right? Is a Swedro or Swedro is Swedro.

You got it right, Swedrow.

Absolutely. He has a long list of accomplishments with regards to investing in his life, not the least of which is having a significant impact on the way I invest. After reading his books, he's actually the author of eight books. Right. And a co author of eight more. Is that right?

It's a total of 18 and I'm currently working on three more. Wow.

Yeah, no wonder I can't keep up. Very prolific there. You serve as a chief research officer for your firm and a member of the firm's investment policy committee. You've been published in a number of journals, Journal of Accountancy, Journal of Investing, Personal Financial Planning Monthly, the Journal of Indexing. You've been on NBC, CNBC, CNN, Bloomberg, and write a regular blog on ETF.com as I recall.

Well, one, I'm really proud. I just co authored a paper for the Journal of Portfolio Management. So that's kind of moving up a notch. All like a doctor getting published in the New England Journal of Medicine. And I used to write for ETF.com but my writing goes way beyond ETF. So I now write for four different sites. I write for Advisor Perspectives, which is kind of an advisors industries publication. Directed more at them but the blogs articles are available I believe to everybody. I write for Evidence Based Investor, which is basically your everyday investor, I think the typical person following you, Jim and the Bogleheads, that kind of group. I write also for Seeking Alpha, which is I'm kind of the Antichrist, maybe for that website because I'm all about not seeking Alpha, but seeking different forms of beta which we could talk about. And I write for the geeks, the engineers and the mathematicians who are really interested in the deep science, the math of investing. I write for a site called Alpha Architect. So it just depends upon the article and what it's looking at, where I post there. And for those that are interested in following, the easiest way to do it is follow me on Twitter. Whenever article appears, I post there.

And that's Larry SWedroe on Twitter LarrySwedro.

That's right.

So you have a bachelor's degree in finance, an MBA in finance and investment. But I want to go further back. I want you to tell us a little bit about your upbringing and how it shaped your views on money.

Yeah, well, I grew up. I didn't know we were poor. I grew up, I would say lower middle class in the Bronx. Grew up. First few years of my life, sleeping in the kitchen. Eventually shared a bedroom with my brother and sister in a one bathroom apartment. We didn't have a car, but we had a great life. And I can't think of a better childhood growing up. Great public school education. In those days, the New York City public school system was fabulous, at least in the area where I live. Had a great public school education, basically free college. I paid about $50 a semester. The books were more expensive than the tuition because I had a limited Regent Scholarship. And then I went to NYU for my master's. And interesting enough, I wanted to be a security analyst and portfolio manager. That's what my training was for. And I mentioned I'm sort of the Antichrist for that group today. Just coincidence, one of those things like there's a movie, I think it's called Sliding Doors. You miss a train and you don't get on it, just missing it or if you did make it, what happens in your life. But I got out of school. And despite graduating at the top of my class from one of the better MBA programs in the country, it was at the wrong time because it was right in the middle of the big recession caused by the oil embargo. There were lots of firms on Wall street going bankruptcy because of the ending of the fixed commission era. At the same time, Wall street firms were able to hire People with 10, 20 years experience for almost the same price. They would get an MBA right out of school. So I was finding it difficult to get a job. So I decided to go try an interview with whoever I could. I was getting married, needed a job. I ended up going for an interview with CBS only because they owned the Yankees and I was a diehard Yankee fan. And I thought, I don't care, I'll drive a bus. But I knew nothing else. I had no interest in the news or anything else about cbs. So as I get on the subway, I pick up the headline in the New York Times that morning and it said CBS sells the Yankees famously to George Steinbrenner. But I figured I'm all dressed in my suit, I might as well go anyway. Ended up working for them. But if CBS hadn't owned the Yankees or if it had been at sale a little bit early, I probably wouldn't have gone. And who knows where I would have been. I did have a job offer. 5 BM to sell computers for them. Strange how things happen in life. And I certainly didn't end up seeing myself writing books because when I went for my PhD I was going for a PhD. But one of the reasons I chose NYU is they had an MBA program that didn't require you to write a thesis. You could participate in a game program. It was the first of its kind running a company on a computer. So I thought that's great, I don't want to write a thesis. I did choose NYU partly for that reason. And here I've now written 18 books. So the world's a funny place. Strange things, little coincidences, sliding doors, whatever. And for the last 25 years I was at Buckingham. But a quick recap of the career, as you asked. So, first two years at cbs, helping them manage international financial risk, exchange rates, interest rates. Then I went to Citicorp to help other companies because this was a new era, floating exchange rates. Brent woods had broken up recently dealing with all those risk issues. And I was all of two years experience. But in Land of the Blind, the one eyed man is king. So they hired me to help other companies. I did that for two years. And then Citicorp sent me out to San Francisco to help start a West coast investment bank for the treasury part of the bank. And I had to run a foreign exchange trading room. I had to fund an offshore bank, never ran a trading room before, as well as sell our international financial services, act as an economist, if you will, and forecast and stuff. Did that for 10 years and then joined Prudential Home Mortgage, which eventually became the largest mortgage company in the country. So I was now involved with managing credit risk and interest rate risk for the largest mortgage company. And then I joined Buckingham to help individual investors. I joined up with a group of people who were financial planners and I brought the investment and risk management skills.

Awesome. So 18 books. Which one's your favorite and which one sells the best?

My personal favorite is Wise Investing Made simple, which was a collection of 27 tales I called it to enrich your future. But they're using stories related to cooking and gardening and movies and sports history to make these sometimes difficult concepts in finance easy for people to understand. And I believe I was the first person to ever write a book like that. Didn't sell all that well, but I got great feedback from people. We used it a lot in our company to help teach and train at clients to be good investors. I'm actually working on putting that book back together again. I've re gotten the rights to publish it myself and I'm updating the stories and that's one of the projects I'm working on. The one that sold the best was the first book, which I did a second edition of seven or eight years later. The only God you'll ever need to A Winning Investment Strategy. And that book sold in its two versions about, I think 75,000 copies.

Awesome. Well, congratulations on that success. That's great.

Yeah. There's an interesting story for your listeners, Jim, here. You'll like this a little. So the first book that was not my title, I called it, I thought a clever title of what Wall street doesn't want you to know. The publisher loved the book but said he didn't like the title at all. So he asked me to go create another title. I went to the. There were bookstores in those days and so I visited Barnes and Nobles and several of the other bookstores and I came up with a list of like 15 titles and combinations and they created this super long title which wasn't my choice. The only guide you'll ever need to the winning investment strategy.

Little bit of a play off Tobias book.

Yeah, a little bit of Play on that. Yeah. And two years later I wrote a second book. So I liked the first title. What? Well, she doesn't want you to know. So I kept that title. The same publisher, I sent it to him, he said, I love this title, it's fantastic. And that became the title to the second book. Shows you how strange the world is.

Yeah, that is interesting. So tell us about your newest one out.

The newest one out is the second edition of the Incredible Shrinking Alpha. One of the big themes that you hear from the active industry is as more and more people move to passive investing and you yourself have helped fuel that trend, it'll become easier for active managers to outperform because there's less price discovery going on. My colleague and I, Andy Birkin, believe that story is exactly backwards. And we present the logic and the evidence showing that as the trend to passive investing has increased, the percentage of active managers generating statistically significant alpha has collapsed. When I wrote my first book, about 20% of active managers were generating statistically significant Alpha. That was 1998. Now that number is about 2%. And of course that's before taxes. And because taxes are the largest expense, typically for a taxable investor in a mutual fund, higher than the expense ratios even than the typical high expense active fund, that number is probably more like 1%. So all the things you hear about passive investing making it easier for active manager and they continue to repeat that story, is just a big lie. Like much of what you hear from Wall Street. We wrote a second edition to update the data. It was five years. But also the one critique about that book, the first version was, Larry, this is great information, but what do we do with it in terms of building portfolios? So we added a whole bunch of chapters on portfolio construction, recommended funds, and a couple of appendices or several on key issues that we think are important that investors make mistakes on, like focusing on dividends when you should be. Not only you should think dividends are irrelevant, but if you're a taxable investor, you should try to avoid them where possible, all else equal, because they're a tax inefficient way to receive returns. And so many investors get that wrong.

Yeah, that's a good segue into my next question. Let's talk about what you think are the most important principles when it comes to portfolio construction.

Yeah, that's a really good one. I do a presentation now and have been doing it for the last year called what do you do when a strategy performs poorly? There's a big mistake that people make is they make the mistake I call confusing strategy with outcome. So what I mean by that is, Jim, you take your IRA account and you buy a lottery ticket and you win the lottery. That doesn't mean the strategy was good. You can have a bad strategy and a good outcome. Conversely, you can have a good strategy and a bad outcome because risk showed up. Or I'll use an extreme example. Are you married, Jim?

I am.

Children?

Yes. Four children.

Four children. Do you have life insurance?

I do.

You do. At your age. And as a doctor, I assume you know the odds of your dying, say in the next 10 years are about 1%, right?

Maybe two, maybe a little higher, given my habits. But I agree it's very low, very low.

And yet with 98% or 95% certainty at an extreme, you're willing to transfer profits to insurance companies. And 10 years from now, today you haven't died. You don't look back and say, boy, that was a dumb strategy. But if you diversify, and thus keeping it simple and own international investments and they happen to do poorly for a decade, investors make the mistake of confusing a good strategy of diversification with a bad outcome. A strategy in a world where no one has clear crystal ball should only be judged based on the quality of the process you went through in making your decision, never on the outcome, or you'll make mistake after mistake or mistake by confusing luck with skill. So that's an important message of that talk. In that talk, I open it with, Here are the three core principles. All investment strategies, in my view, should be based on, and this is at Buckingham, we live by these principles. The first is we believe the markets are highly but not perfectly efficient. That means that the market's price may not be the right price. We don't know that. We don't have perfect foresight. But it's the best estimate of the right price. And the evidence is overwhelming that we see passive or systematic or indexing strategies generally significantly outperformed. And therefore you should be a systematic index type of investor because of that. If you believe that markets are efficient even if they're not perfectly so. There are some anomalies in the literature, but you should act as if they're pretty much efficient. If you believe that, Jim, then the only logical thing you can conclude is that all risk assets must have very similar risk adjusted returns. That doesn't mean similar returns, it means similar risk adjusted returns. So we know, for example, that say, small value stocks are much riskier than the large growth stocks in the S and P doesn't Take a genius to know that. You can go online, check their historical standard deviation and you'll see it's about twice that of the large cap growth stocks, the great companies of the world. So clearly they're riskier, so they should have higher expected returns. You cannot believe, if you think markets are efficient, that small value stocks don't have higher expected returns. It doesn't make any sense. But it also doesn't make sense to believe they have higher risk adjusted returns, because if they did, then money would flow out of the large growth stocks lowering their prices. You don't change their earnings, and lower valuations mean higher returns for the same earnings. And you would be driving up the prices of small value stocks until they had higher valuations and lower expected returns until we got this equilibrium. So when people ask me, is small value a better investment? No one has more risk and a higher expected return. And today emerging markets and developed markets outside the US have much lower valuations, therefore they have much higher expected returns in the U.S. that doesn't make them better investments. The perception is U.S. stocks are safer and therefore they have higher valuations, which means they must have lower expected returns. So if you believe markets are efficient, you have to believe that all risky assets have very similar risk adjusted returns. Once you account for all risks, including not just volatility, but what's called the second and third movements here beyond volatility. So things like skewness and kurtosis, how big the tails are, the bigger the potential losses. So you have fat tails, that makes something more risky. Because people are in average risk averse, so they hate that. So they're going to require a higher expected return for an asset that has a bigger fat left tail. So that's a risk. Liquidity is a risk if you need it. So if you have an illiquid asset, you should have a much higher expected return. You might use a rule of thumb a 2% plus for the same assets. That's in a public security most people don't know. For example, if you pool a group of say high quality credit cards, you may have a yield as a security argument's sake of 8% if you own that same thing in a public security, not in a private security, instead of 8%, the yield might be 6, exactly the same risk. So for somebody who needs liquidity, they're willing to give up the extra 2% because they might need it for someone who doesn't need it. And almost all of your listeners probably have some portion of their portfolio that they could give up liquidity they don't need it. Most of our clients, for example, don't take more than their R and D, which even at age 75 might only be 5 or 6%. So if you don't need more than that, then you can obviously put some of your assets, but not all in less liquid assets. So if you believe in those two principles, markets are efficient, all risk assets have similar risk adjusted returns. And the only logical thing you can conclude is you should diversify your portfolio, of course, as many unique sources of risk that you can identify that meet whatever your criteria are. Andrew Burkin and I in our book your complete guide to factor based investing we established five criteria beyond having a risk premium. It's got to have that or you wouldn't take risk. Number two, it has to have evidence that that premium is persistent over very long periods of time. It's pervasive all around the globe across industries and sectors. It's robust. The various definitions. So value works. Whether you look at price to earnings, cash flow, price to sales, dividends, it doesn't matter. It works. It works in every asset class you look momentum works whatever the holding period, information period. These are metrics you want to or characteristics you want of persistence, pervasive robustness as well as implementability. So you don't want to have a 4% premium that costs you 6% to trade and you want to have a logical reason why you think it'll persist. You want those things to make sure that the outcome you found of a premium isn't the result of a data mining exercise where correlation doesn't mean causation. A famous exercise in this field was an economist took the UN econometric database and found the best predictor of The S&P 500 was butter production in Bangladesh. Now you and I would not put our money on the S and P going up or down based on that. So you have these criteria and yet we see so many investors make the mistake of home country bias, putting all their assets in the US ignoring these principles. They have all of their assets or many of them in only market beta and ignore other sources of risk. And we think it's more prudent to diversify across these sources of risk and then that creates its own risk of what we call tracking variance regret, which nobody should care about, but people do.

One of your kind of teachings that you've had over the years that affected me and certainly affected my portfolio was to take your risk on the equity side, advocating for very high quality short duration fixed income.

Well, let's say Short to intermediate, short to intermediate.

Why have you advocated for that? And does that advice change with interest rates at their current historical lows?

The answer to the second question is no. The advice doesn't change because rates don't can go lower, number one, and the risk can still show up. But the answer to your first question is the reason we recommend that is because correlations are time varying and investors, many of them fail to understand that. So they look at, for example, something like a high yield bond fund and they say it might have a correlation, maybe 0.4, 0.5, something like that with equities. And they say, okay, that's a low enough correlation. That's a good thing. The problem is when the risk of equities show up and they get hit, you want the other portion of your portfolio to be doing well. Now the reason is twofold. One, that means that your entire portfolio isn't collapsing at the same time. So you're trying to figure out what's the maximum loss you could take. You have to account for the riskiness of all the assets. Number two is you want to be able to rebalance. And if stocks are down, you want to be buying it with something that's gone up. So you're selling that high, right? You're not selling that also at distressed price. Well, the correlation of things like junk bonds and MLPs and preferred stocks, things that lots of advisors recommend because of the high Yields, you get an 08. And while an intermediate bond fund, treasury only, which is what we tend to buy, they went up double digits and that pulled the left tail of your portfolio way in because instead of going down, the market went down. Call it, let's round it to 40%. At the bottom it was probably 50 or 60, but it was down for the year 37 on a calendar basis. But your five year treasury portfolio was probably up 10. But if you own junk bonds, even say Vanguard's fund, a high yield, which isn't junk, I think it was down about 25%. High yield, pure high yield was down like 50. Emerging market bonds were maybe down 60 or 70. Preferred stocks got slaughtered, REITs got slaughtered. All these are on average low correlation got slaughtered. You want to own something that will tend to do well, so it dampens the risk of your overall portfolio to acceptable level. Another reason why we want to own it is we have found that the evidence shows very clearly that credit risk has generally not been rewarded well. It will shock your listeners, but the default premium between long term Treasuries and long Term corporates has been about 20 basis points, that is before the expenses of your fund or trading costs. And you can easily outperform that by buying CDs which yield more than Treasuries. So why would you want to own that when there's no evidence of a long term premium? And if they. What you really own is, what people don't understand is when they own say a high yield bond, they really own a combination of equities and treasuries. That's really what you're owning. And the correlations there shift at the wrong time. So when the market's going up, let's just say on average it's 50, 50, just to pick a simple number, the market's going up, it looks more like equities, but when it's collapsing, it also looks more like equity. And so you might calculate that I'm willing to take a 30% loss on my portfolio, that's the most because I would panic and sell beyond that. And if you own 60% stocks and 40% five year treasuries, you probably okay with that. But if you own 40% high yield bonds and preferred stocks and MLPs now, your risk could easily be for a much bigger loss than 30%. So we believe the right strategy, if you're going to take risk, take it where it's been rewarded well, and things like illiquidity. And if you don't need illiquidity, if you don't need liquidity, for you it's at least a free lunch or close to it.

Now in medicine we have evidence based medicine. It's really important to us to look at the data and change our practice according to it. You've been a fan for a long time of evidence based investing, which doctors can relate to well. But our data set is pretty limited in comparison to physics or other more scientific fields. How can you tell how much you can rely on this retrospective data going forward?

It's a really important great question. That's why Andy Burkin and I wrote that book, you, Complete Guide to Factor Based Investing. Investing was pretty simple. Back in the late 60s 70s we had what was called a one factor model, a capital asset pricing model or CAPM. So all you had to know is what was the market beta of your portfolio? Market beta is a measure of the risk of your individual stock, a mutual fund or your portfolio relative to the risk of the market. So if you have a beta of more than one, you have more risk and a higher expected return doesn't mean better Right, but higher risk, higher expected return. And if you own stocks like supermarkets and drugstore chains, utilities, they have low betas, they have less risk in the market, so they may have a beta of say 0.8. Well, if the market goes up 10%, you should only expect to go up 8. Doesn't mean you underperform. You got rewarded for the risk. If you own a bunch of high flying tech stocks with a beta of 1.2, you should be up 12%. And if you didn't get 12, you got 11. In some active fund when your alpha was negative, you actually underperformed. Then Fama and French came along and we added the size and value factor and then momentum and then some others today in the literature it can be confusing. And John Cochran, my opinion, our best financial economist. I'd recommend everyone follow his blog, which I read daily. He called this a zoo of factors. We have over 400 in the literature. I've read one estimate as high as 600. So Andy and I try to figure out how do you navigate your way around the zoo? And to answer your question, how do you know this isn't the result of data mining? So we said we want to see evidence of this premium and it has to be over long periods of time, through economic cycles. So in the US we now have good data, 90 plus years. So that's pretty good for this stuff. But we also want to make sure that it wasn't just a lucky outcome. What if you lived in Germany or Japan, did you get the same outcome? That's an out of sample test. So we look all around the globe to see if the factor meets that criteria. We also look, does it work in every sector or industry or the vast majority of them? Each time you add one of these tests that are out of sample, you're dramatically reducing the risk of a data mining outcome. Right, because you're doing more tests that are unrelated to each other. And then we said, what about across asset classes? Well, if it works across, as I said, value, buying what's cheap and selling what's expensive, does it only work in stocks? Well, it works in bonds and commodities and currencies. So now the odds, if it works in every one of them and in almost every country in the world, and it works on various definitions, your odds of it being a data mining outcome are close to zero. They're never zero, but you're putting the odds greatly in your favor. And then we added those other two. It has to be implementable, so it has to survive your transactions cost. And we Want to make sure there's a reason you should believe it should persist. So we prefer a risk based explanation. We all believe emerging market stocks are riskier than developed market stocks for a whole bunch of reasons. So that's a reason there should be an emerging market premium. There's dozens of papers providing sound economic intuitive reasons why value stocks should have higher expected returns. But there are also some behavioral explanations. We know that dumb naive retail money overpays for stocks that have distributions of outcome that look like lottery tickets. So the vast majority of them have God awful returns and a few of them go on to be Microsoft. Well, people like that bet they buy lottery tickets. And the problem is the costs and the risks of shorting make it very difficult for professional investors to correct those mispricings. Especially when these very small stocks that are thinly traded so those mispricings can persist. Now I've written about that you should just avoid buying those stocks that'll improve your returns to some degree. But those behavioral reasons continue to persist because even after we know about these anomalies, these limits to arbitrage, as they're called, prevention sophisticated investors from completely correcting this pricing. So if you can identify a behavioral anomaly, you have to be able to show why it would persist. It's unlikely to persist in large caps because they're much easier to short and plenty of securities around to borrow. And you can generally borrow them very cheap. But there's still a big risk of unlimited losses on those stocks. And a lot of people are even prohibited from their charters to go short. But in small stocks, these tiny micro caps, I mean sometimes you can't even find stock to borrow. So it makes or the cost of shorting is so high that these anomalies can persist. So we wrote in our book, we found five factors for stocks and two for bonds. And once you have those seven, you can ignore the other 500 or whatever there are because they don't meet all of this criteria. And you may find that you believe more in one than the other. For example, I have less faith in momentum because it's purely behavioral. So I will overweight value and size and I'll have less in momentum. But I won't ignore it because the evidence is overwhelming that over the long term it has benefited portfolios. So the key is here, it's not black or white, but you should, I think, be putting your weight of your assets where you have the most confidence and what the data supports.

Now a lot of investors and even a lot of advisors engage in A process they like to call tactical asset allocation. Rather than keeping their percentages of each asset class fixed, they change them in reaction to valuations or market events or political events. What do you think of that practice?

Well, let me say it this way. The evidence shows from tactical asset allocation funds that try to do this, their abysmal track records. That's the best evidence that you can have. And we see that in looking at the records of active managers in general, if they could shift asset classes between value and growth and shift countries and stuff, it would show up. And they're persistent. So the evidence is overwhelming that you should not try it. And simply engaging in rebalancing forces you to do what every investor dreams of, which is to buy low relatively, and sell high. That's the dream. That's the hard part, because it's easy to buy when things are going up. It feels good and it looks safe. It's much harder to buy when the only light at the end of the tunnel looks like a truck coming the other way, as it did in March of 2009 or in March of 2003 or whenever the. I think 2002, at the end of that year we started to recover there. So what I advise people is do not engage in tactical asset allocation, as a good general rule. And if you're going to sin by trying to time the market because of valuations, sin only a little. So maybe you move an allocation by 5%. I wouldn't do it. I've only done it in my career, basically once. One major move which occurred in the late 90s, I believe that growth stocks were in a huge bubble based on valuations. They were at stretch levels. This was in 98. I, of course, was wrong for about two years, which was difficult for a lot or would have been for a lot of people. But I believe that markets are rational in the long term. And the next eight years, from 2000 to 07, were the largest value premium in history. I believe we are setting up likely for that exact same event to occur now, because valuations today are as bad or worse for growth stocks as they were then relative to value stocks all around the world. So I made one big change. I decided I would get out of growth stocks altogether in 98, 90, moved everything to value, and eventually, over time, as I was able to absorb tax impact, I moved to small value and developed a portfolio that was much more of what's called a risk parity portfolio. One where it had low allocation to beta, market beta, but a high allocation to the size and value premiums and other premiums. So I was creating this portfolio that was built on this principle, not having all my assets only in market beta. And that's one thing investors don't know. If you own a total market fund, you have exposure to one factor. So even though 20% of your portfolio is small stocks, sorry, is our value and about 10 is small stocks, you have no exposure to these factors. You need to tilt your portfolio more than the market is. So you would need to be more than 20% value and more than 10% small to have exposure to these factors. So that was the only trade I made, really. I made one other Minor as the US valuations have gone up and now where the US is 50% of the market, I've moved the other way a little bit. I used to be 50% US but valuations have gotten so stretched, relatively speaking, that I'm sending a little, and I'm adding a little bit more to my emerging markets and international in the last few months. Just a little bit. I can't resist a little bit. But I would tell the average investor, don't do that. Just stick with your plan. But if you're going to send, send a little bit.

Now, you've been a fan of alternative asset classes in the past, wrote an entire book on the subject. Are there any alternative asset classes you saw as viable in the past that you no longer recommend, such as commodities, peer to peer loans, et cetera?

Yeah. Well, let's begin. I'm a fan of some alternatives. In fact, most of them I'm not a fan of. The book that was called you'd only guide to alternative investment you'll ever need. It had a list of 20 of them. I think there were five or so good ones. A couple of good, bad, flawed and ugly. There were a few flawed, like preferred stocks. And most of them were in the bad and the ugly category. So there are a few that have to pass all of these tests. And one comment here before I'll go into and I'll touch on commodities, which is the one that I have not. I originally had significant investments like 3 or 4% of my portfolio, which is typical for me. I'll divide my alternatives across a series of them. But like any good investment can become bad based on valuations. And this is what gets tricky for individuals. And so it's a problem if you're going to not be able to stay the course or you're unwilling to consider valuations. For many people, this is a difficult thing. So for example, the NASDAQ was trading at a PE ratio of over 100 in March of 2000. There was no way those stocks would ever provide a good return. And prices had to eventually collapse, which they did. Even the large cap growth stocks in general got hammered. And we had the largest value premium ever. I, as I told you, got out a bit too early, but certainly it proved to be the right strategy in the long term. So what happened is with commodities, there's a very good logical argument because while they are not there for high return, I believe that the fund I recommended we thought would provide about a 1% premium over the risk free rate. And that was related to the fact that it invested in tips, which were then yielding much higher than the T bill rate. And that would provide the real expected return. The reason you wanted to invest in it is it provided combined with the T TIPS inflation hedge on one side. So if inflation spiked because of rising commodities, stocks and bonds both tend to do poorly. And this would do well. It would also provide a supply shock if you had like an oil embargo or a war or hurricanes or earthquakes that blew up. Things like the Japanese earthquake that we almost created a serious problem when their nuclear plant was hit by that. So you see the fund, you would expect it to do well in those periods. Now, we also knew it would not do well if you had a demand shock, meaning like a Covid crisis. Demand collapses, economy collapses. So stocks would go down and your commodities would go down. You had to recognize that risk. So we told people, if you're going to own commodities, you should extend the duration of your bond portfolio at the same time, because that mixes well. You're now going to pick up a term premium between short and longer term bonds. And if inflation picks up, then your commodities are hedging your bond position as well as maybe hedging stocks. And if inflation is no worse than expected, you got the bond term premium, you got it anyway, so it gave you a good hedge. That's one of the mistakes a lot of people make when they criticize the performance of commodities. They never looked at the two pieces together. And despite the poor performance of commodities in and of itself, which is much worse than is expected, as I'll get into in a moment. If you did both things, commodities had virtually no impact on your portfolio for any reasonable level 3, 5%. And I wrote about that and showed that several times. But here was the problem with commodities and why I sold out after having the position for I think, I think it was maybe four, five years. The assumption was, and this Is always an assumption that over the long term, the futures prices relative the spot would average about zero. So there would be no backwardation or contango. So if spot oil today was trading at 40, next month would be also 40. In the real world, it goes up and down. It could be in contango and it's trading at 41, or it could be in backwardation at 39. The historical evidence showed that it wandered. On average it was about zero or slightly backwardated. When it's in backwardation, the evidence showed you how to tailwind. Because if the spot, say is 40 and you're buying the future at 39, well, you're making that $1 and you make it every month. So even if prices go down, but not as much as the backwardation, you're ahead. On the other hand, if you pay 41, even if it goes up to 41, you make nothing. It has to go up more than that and it can go down. The literature is filled with strategies that show that when you buy stuff that's cheap in backwardation and sell what's expensive in contango, you come out ahead. And there have been funds that trade that in commodities, they go long, commodities in backwardation, short them in contango and have no net position. It's also called a carry type of trade, works the same way. So what happened was commodities became highly popular because of the publication of the research and lots of institutions became investors and money flowed in and that drove the futures prices into what looked to me to be a permanent contango or could be for a long time. My assumption going in, which turned out to be wrong, is that couldn't persist because if it did, people would see losses and money would flow out right, and the contango would disappear. Just like big backwardation over time would disappear because everyone would jump in to buy this great investment. Well, it didn't happen. And I said, all right, we're seeing this persistent tango. I think there are now better alternatives as well. It gives you diversification, inflation, hedges, et cetera. When I saw the persistent contango, that's when I decided to sell out of that position because it was a big headwind and I would wait until that went away. And it never really has gone away. It disappeared for a month or two here or there over the last few years. But right now, for example, we're trading at an annualized one month premium for oil at 9%. So if you have a fund cost, for argument's sake, of even 50 basis points and you're paying 9% premium, the price has to go up more than nine and a half for you to break even for getting even. Any trading costs inside the fund, to me that's too big a risk to pay for that could go up more than that, of course, but I think there are better alternatives. So that's why what I've learned from that is some people who can't change and don't watch and you probably don't belong in an asset where that can happen. But that's true actually of every single asset, right? Look at the large growth stocks and their valuations. Today they're trading at Nifty50 levels. And tech stocks, I wouldn't own them at all today, but I would recommend investors don't put in money into something they can't stay with for the very long term.

Now, if you had to pick one or two alternative asset classes these days, which ones would you pick?

Well, the most logical one to me without question is reinsurance. Everyone can understand that there are a couple of funds out there. Stone Ridge runs 1s, r r I X and also another fund family. Unfortunately, the name has escaped me, but it's X I, L S X is the fund. They're both available. Warren Buffett owns one of the largest reinsurance companies in the world. People don't write reinsurance without expectation of premiums. And if you have losses which happen, if there were no losses, guess what? The premiums would collapse. Right? There has to be risk. 2005, 2004, we had big losses in reinsurance. The next 11 years we had almost no losses, massive profits. We've now had three years in a row of losses. So people think this is a bad investment. That's as logical as thinking the S and P is bad because we had three years of losses from 2002. Or forget the 13 years from 2000 to 12 when the S and P underperformed totally riskless treasuries by 40%. But people don't give up on that idea. But if you have reinsurance losses for three years, I don't know, maybe 25%. Oh, that's a disaster. This is bad. It's really hard to find a dumber argument than that. Warren Buffett and reinsurers are increasing their exposure because they know the premiums have jumped. In fact, the no loss return to Stoneridge's fund three years ago was about 15%, say 8% expected average losses. Seven T bills were about 2. Nice. Expected risk premium 5, about the same as you would expect from equities and totally uncorrelated. Right. Losses in one don't cause losses in the other. So that's exactly what you want. It's completely logical. You know, when you're buying insurance, you're likely transferring a risk premium to the insurance company. Now that no loss return is 22% and going up, which means if you have average historical losses of 8, you're going to get low double digit returns. Now some people think it's higher losses, maybe climate change. So 50% increase from 8 to 12, you would still get close to a double digit return in the fund. So to me this is the most logical. The other ones I really like are middle market lending, if it's done conservatively. Cliffwater runs a fund called cclfx, makes loans to middle sized, high quality companies who aren't big enough to issue their own public debt. So you're getting a big illiquidity premium which basically covers the cost of the fund. I think that's about 7.5 to 8% right now. That's a 7.58% premium higher than expected return to US stocks I think by a good margin and much less risk. The volatility of that fund I think is about 5 or less. Historical defaults over 20 years, about 1%. Now you would expect in an 08 that fund might lose 8 or 10%, but that's a lot better than the minus 60 that the S and P had at the bottom. And you're getting a lot less volatility. Now on the other hand, you can't get 20 or 30% on the upside, right, because the best you can do is get the yield which is about say 10 or 11. So that. And the other is a fund run by Stoneridge called lendex Consumer and Small Business Loan now done through fintech companies. That expected return now is about 7%. So big risk premium. That fund has done exceptionally well, had a higher Sharpe ratio than even we thought years ago and despite the COVID crisis. But in 08 again we might expect it to lose 8% or so. But that's a lot better than the down 60 stocks had. And yet the volatility of this fund is historically we think about five. It's been much lower than that since inception. So those would be the three funds I'd recommend people look at or look for others similar to those. They're simple, not complex, easy to understand, very intuitive. But you have to understand that these are not mutual funds. They're not going in the sense they're not going out and buying public securities which could be done cheaply like an index fund. They're actually running a business, if you will. So lendex is like running a bank and you can't run a bank for 10 or 20 or 30 basis points. It's built into the expense. But I'm giving you the net expected returns there and reinsurance there. Stoneridge is literally running a reinsurance company for you. So you're going to see higher expenses than you would more similar to what a reinsurance company does. So the mistake people make is they say, oh, this is a high expense fund. No it's not. When you understand and pull apart the expenses into an income statement and look at it as if you're running a business and am I getting a good expected return from that business?

We're running a little bit short on time, but I wanted to talk just a little bit about retirees. What would be your recommended strategy for spending down assets for someone retiring with 25 or 30 or three to 33 times their annual sales spending? What would the strategy be?

Yeah, so the first thing in my book, you Complete Guide to a Successful and Secure Retirement. We talked about this 4% rule. So 25 times your money is what you should have. That rule we think doesn't work. It doesn't make sense anymore for a bunch of reasons. One is stock valuations are much higher than their historical average. We got 10% returns to stocks because PE ratios averaged about 16. Today PE ratios are much higher, so you have to expect lower future returns. Second, bond yields averaged about 5. They're now 1. So your bond portion of your portfolio is going to be lower. And the third problem is you're now living quite a bit longer than the people who were retiring 30 years ago. It's about, I think seven years longer now than it was then. So your money has to last longer and you're getting lower expected returns from your investments. That's a problem. And as you age and we're living longer, the risk of needing long term care, which is very expensive, also increases. So those are the four horsemen of. We called it the retirement apocalypse, which you need to plan for. We think the new safe withdrawal rule should be 3% and even that's not 100%, nothing is. But it should be good enough for most people in terms of withdrawals. One thing is really important is any plan should be a living document and be adopted to the circumstances at the time. And if any of your assumptions change, then you need to change your plan. For example, if you're still working and planning Retirement, you get laid off and you can't go back to work. You no longer have as much ability to take risk. Your labor capital is gone. You need to lower your equity allocation. All else equal, you get an inheritance now you have less need to take risk. You may want to lower your equity allocation or your allocation to risky assets. In my book youk're A Complete Guide to Retirement, we have a chapter on withdrawal strategies which specifically gives case studies to help people figure out how to withdraw. So the one general rule I'll mention is that you want to generally take money out of your taxable assets first, out of your IRA second, and your Roths last. You want to use up the lowest tax brackets always. So you know if you can withdraw money but don't need it, but if you're doing it at the lowest brackets, do that. I fully believe regardless of who is president or controlling Congress, you know, over the next few decades, tax rates are going to have to go much higher because of the budget deficits we've accumulated and the obligations and Social Security, Medicare. So Roth conversions. Now, when your tax rates may be lower, especially in a year like this, maybe people have losses and have low incomes, you should be using Roth strategies as well. And now you may have. For the wealthy people listening, I would urge, especially as it looks like a Democratic victory in the presidency and likely maybe even the Senate. Now, anyone who has assets of any real significant size should be getting with their estate planning attorney and moving assets into irrevocable trust before the end of the year. Because once the new year turns, even if they don't act immediately, they can make it retroactive. Today you have almost $23 million you can get excluded from an estate as a couple, and I'm urging everybody to get those. If you have assets of more than say a million each, so say 2 million. Oh, I doubt it would go that low. Why take that risk for a few hundred bucks or a few thousand? Get an estate plan and you could save millions in taxes if you're very. You're a high net worth individual. So those are a few key points I would make.

Well, we better wrap this up, but this podcast will be listened to somewhere between 30 and 40,000 high income earners, mostly doctors. What else have we not covered? You think they ought to know?

Well, I wrote a book called Investment Mistakes Even Smart People make and how to Avoid Them. It actually covers 77 mistakes. It was a sequel to my book Rational Investing in Irrational Times, which only covered 52. Over the next five years, I learned that there were 25 more. If I had to do it today, I could probably come up with another 10. So I recommend people read that book so they can see themselves and the mistakes. I'll mention two of them that I think are the most common made one is this idea of recency. So here's my advice. What I've learned is that when it comes to judging the performance of a strategy asset class mutual fund, most individual investors and even institutions think that three years is a long time, five years is very long and 10 years is an eternity. Any good financial economist will tell you when it comes to judging the performance of a risk asset, 10 years is noise and should be completely ignored. And if anyone doubts that, here's a statistic that would shock most people. The s and P 500 has endured three periods of at least 13 years where it underperformed totally riskless treasury bills. That's 29 through 43, 15 years, 17 years from 66 to 82, and the 13 years from 2000 to 12, that's 45 of the last 91 years. Now, of course, the other 46 years you had massive premiums, almost 20% maybe, right? But the only way you got that is if you had the discipline to wait out those very long periods. But when it comes to the performance of, say, value or reinsurance or anything else, real estate, they think three years is a disaster. It's noise. It has to be ignored. And that's what differentiates Warren Buffett from the average investor. He understands this and he runs to the poor performance. I think if you ask your listeners what's the single equity that they would avoid around the world now would be Japanese stocks, right? No return for 30 years. Warren Buffett just loaded up on Japanese stocks, biggest investment he's made in years because their valuations are dirt cheap. And he understands buying cheap is likely but not certain to give you better returns. So have a plan, stay the course, ignore the noise, rebalance. The other one is this. Investors, almost all of them that I meet make the mistake of confusing what I call information with value. Relevant information. Information is what you hear, like from Jim Cramer on TV, here's 12 reasons to buy a stock. Well, you and I could agree those all make sense. And I tell people it's irrelevant. What do you mean it's irrelevant? There's 12 good reasons. I asked them, are you the only one who knows this? You just heard it on national television. You think Goldman Sachs and Morgan Stanley and Renaissance Technology and all these big hedge funds and pension plans are unaware of that. If they thought the stock price should be higher because of that, it would already be higher. They wouldn't be sitting on their hands watching a stock trade at 40 that they think is worth 60, they would be buying it until it got to 60. So whenever you think you have value relevant information, you should ask this question, am I the only one who knows it? The obvious answer will be no. Which means the only way you can profit from it is if you can interpret it better than the Warren Buffett, the Goldman Sachs, the renaissance technologies of the world. And the odds of your doing that persistently, in my opinion, are asymptotically close to zero. So have a well thought out plan, diversify globally across many sources of risk, stay the cost rebalance and tax manage.

Thank you Larry. I appreciate you coming on the podcast.

My pleasure. Good to be with you, Jim. Happy to come back anytime. All right.

I hope you enjoyed that interview. Larry makes for a great guest. He's obviously got a big interest in investing and evidence based investing. I've known him for a long time online. This is the first time we've actually chatted. I guess it's zoom, but face to face in that respect. First time I've ever heard his voice and so I enjoyed that and I hope you did too. Did you know that the White Coat Investor not only has a podcast and a blog, but several books that will help you on your way to financial independence? These books cover topics such as asset protection and minimizing your taxes to keep more of your hard earned money. They discuss plans for insurance, housing spending, student loan elimination, investing and estate planning. You can learn how to become a millionaire within five to 10 years of leaving residency and how to invest in a sensible, low cost and effective manner with or without the assistance of a financial advisor. There's even a book geared directly toward medical and dental students so you can start optimizing your finances early in your professional journey. Find the book that is right for you at the WCI store, at shop.whitecoatinvestor.com or on Amazon. You can do this and the White Coat Investor can help. Be sure to check out our recommended books. As I mentioned at the top of the show, a lot of Larry Swedroe's books are also excellent books to broaden your financial literacy. Thanks to those of you who have left us a five star review and told your friends about the podcast. Our most recent review comes in from ER Doctor who said Great show. Listen to Jim. This guy will help you add a couple of commas to your net worth. One tip. Listen on 1.5 speed speed as he talks a little slow. This will make him sound normal as guests sound slightly manic. Man, I've never been accused of talking slow before. That's kind of a funny review, but I appreciate the 5 star review nonetheless. Keep your head up, your shoulders back. You've got this and we can help. We'll see you next time on the White Coat Investor Podcast. My dad, your host, Dr. Dahl, is.

A practicing emergency physician, blogger, author and podcaster.

He is not a licensed accountant, attorney or financial advisor. So this podcast is for your entertainment.

And information only and should not be considered official personalized financial advice.