This article is provided by Bogleheads® forum members Steve Thorpe and Dan Griffin. We have formatted the article for the blog medium.
Meeting 15 of the Research Triangle Park Bogleheads was held at Bull City Coworking in Durham. We had a wonderful meeting, with a number of firsts for our local chapter:
- Our featured guest was renowned Boglehead author Larry Swedroe, who was fabulous as you would expect.
- The meeting lasted 2.5+ hours, longer than any other we’d had.
- We went high-tech with a geographically distributed meeting enabled by Skype video (Larry joined us remotely from St. Louis, and chapter member Lee joined us remotely from Lancaster, VA)
- Our sponsor was Bull City Coworking, an awesome shared workspace in a gorgeous historic building in the heart of Durham, NC. If you are seeking to get your work done in a quiet, convenient, affordable space with a great vibe then I urge you to check this place out.
- Our attendance reached well into the double-digits. I believe we had around 20 or close to it, whereas in all of our prior 14 meetings we had at most 10.
Interview with Larry Swedroe
Here are some of the main points from Larry’s responses to our questions.
Avoid treating the unlikely as impossible: There is no way to estimate the likelihood of absolute catastrophes. You want to build a portfolio that protects you from these types of unforeseen events, but there are trade offs. Never treat the likely as certain.
Risk is when you know (or estimate) the odds. Uncertainty is when you have no idea what the odds are. In “Fooled by Randomness” the author¹ talks about envisioning what’s the worst that can happen. There’s no way to even estimate the odds of something like attacks and the like. Probabilities of outcomes shouldn’t count for much. It is the consequences that should dominate your thinking.
This is one of the reasons that the equity premium exists. Because in order to take risk where you can’t even estimate the odds, you need to be paid well for it. But for a lot of people, they attempt to meet their goals without taking those kinds of risk. In avoiding equity risk they likely will have to reduce needs and work longer to meet goals.
Regarding the ability, willingness, and need to take risk. You might have the ability to take 100% equity risk, but that doesn’t mean you should. Your working capital can be viewed as a bond that pays out over many future years. You better have the need to take the risk, or you shouldn’t be taking it. Otherwise it is foolish.
First look at marginal utility of wealth.With a high marginal utility, you can take more risk. Once you have won the game (whether 1 million or whatever), you should take chips off the table. You have to think about the consequences. It doesn’t matter what you think is likely, you want to build protection against any possible occurrence.
Concentrate your equities and then buy the safest possible fixed income to get the highest Sharpe ratio.
Bill Bernstein has put thought into this. Bill thinks you are making a suckers bet by putting money in long-term bonds at this point. When the economy recovers, if the fed doesn’t remove the stimulus, we will get inflation. But the fed isn’t dumb, they are concerned about the risk. They are thinking of unwinding this sooner.
If you have a high equity allocation, you can have a longer duration bond portfolio because the volatility of the portfolio is going to be dominated by the equity side. A good idea is 5-year maturity with duration a little lower. Therefore you can earn the ‘term premium’ without affecting the portfolio risk. If you are going to go long, you shouldn’t own corporate bonds. There isn’t evidence that you get rewarded for that. Low grade junk bonds and mortgage backs have no role in your portfolio. They do not add anything to a diversified portfolio.
So the fix is to buy bonds without calls in them. This would include Treasury Inflation Protected Securities (TIPS), government bonds, and bank CDs. (Bank CDs are sometimes higher than treasuries and have low early redemption penalties.) You can go very simple on the bond side. David Swensen agrees with this. A barbell approach works perfectly well. These bonds dampen the volatility of the portfolio.
On total bond market index funds
He wouldn’t own a total bond market fund ever. The duration of the TBM fund is only estimated — assuming rates stay where they are. Due to mortgage securities one can’t predict what will happen if rates go up. If no one moves because they don’t want to get a new mortgage, that extends the duration.
Duration is irrelevant when it comes to TIPS, because it is a real return asset. You should only care about duration on a nominal return bond.
The higher the TIPS rate goes, the more you want to allocate to them. Then your need to take risk is lower because you are locking in a return on the TIPS. You’d be getting equity like returns. The other option is short-term high quality bonds.
There are short-term TIPS funds. Or you can buy individual TIPS and save the fund expense.
Commodities and real estate are his favorites. International bonds are fine as long as they are hedged for currency risk. You do get more diversification but you have more costs.
Avoid peer-to peer lending. You want your fixed income to be super safe. Take your risk on the equity side. In a year like 2008, peer-to-peer would get crushed. How do you rebalance? He would stay away from all of these things. They are not needed. You can get all of the risk you want/need on equities. Avoid junk bonds. Junk bonds do well when the bond covenants are strong, but right now we are starting to see rather weak covenants.
You don’t buy commodities for higher returns, you buy it for portfolio insurance. Accept a lower expected return as cost of insurance. Likely 50-75 bps. If you own commodities and have a fixed rate mortgage ( both do well in inflation) you have less of a need for [insurance against unexpected inflation?]
Correlation is only a tendency — unless the correlation is 1. The correlation jumps around from year to year.
A good example of correlation:
Assets A and B. Every year for 10 years they reverse order where A earns 12 and B earns 8. Then it flips. When one is above average, the other is below average….so they are negatively correlated. But over a longer period …..?????
If you look at the period we have data for, there is a tendency for commodities to do well when stocks do poorly. But sometimes they go down together.
There are 2 reasons bond/interest rates go up: inflation or GDP is increasing. In that type of environment, the commodity prices are going up. There are 2 reasons interest rates fall: the economy is weak or inflation is going down. So ideally when bonds do well, commodities do poorly. There is not a year on record where bonds and commodities moved in the same direction. Therefore if you are going to own long term bonds, you need some commodities.
On indexing and passive management
The index trend is only moving at about 1% per year. Today 13-14% of individual money and 40% of institutional money is indexed. So it is still a fairly small percent. We have a long way to go before this becomes a problem.² However, this may become a problem in the future. The acceleration into indexes is speeding up. Oddly enough, trading volumes have soared in the last decade even though indexing has grown.
One of the flaws in indexing is that they announce changes to indices and that active traders can trade ahead of the index funds and get an advantage. Vanguard is trying to correct this by going with MSCI.
Larry believes that DFA core funds are a brilliant strategy. Think of a 4 component US stock allocation (large, large value, small, small value) with 25% in each. The problem with this is that you have to rebalance and trigger tax and have trading costs. It is more tax efficient to own 25/25/25/25 in one fund.
You also have the same issue if a stock market goes out of one category into another. The emerging market has to sell Israel, and the developed market fund has to buy it. Much more efficient to hold international stocks in one fund.
What he doesn’t like about RAFI and Wisdom Tree is that they reconstitute once a year whereas the more efficient way to do it is to reconstitute every day.
A high dividend strategy is a very bad one. You may get lucky, but the long-term data shows under performance.
Larry’s biggest investing mistake
In the very early 1980’s, Larry bought shares of a small bank expecting consolidation. Then there was fraud in the bank, and the bank went under. If he had just bought a regional bank fund, he would have done well. But he concentrated on one bank and lost a lot of money (10% of his net worth!). Just another lesson in putting too many eggs in one basket.
Thank you plaudits
- To Larry Swedroe who kindly shared many words of wisdom for 2+ hours… it was a non-stop flood of information and I recorded 16 pages of handwritten notes!
- To Robert Petrusz who graciously donated use of the Bull City Coworking facility.
- To Gayle Johnson who shared lessons learned from her and her husband’s recent experience with the insurance industry after an accident last fall. Gayle, after your helpful guidance I am definitely going to be reviewing my coverage limits!!! Another shout-out to Gayle: thanks for bringing along the chocolate chip cookies!
- To Travis who made printouts of our “Larry questions” and distributed them to the group.
- To Dan who electronically recorded some excellent notes.
- To everyone who contributed to Larry’s appreciation gift. The engraved clock plus postage is covered, plus I think there’s enough left over to cover another case of PBRs for a future meeting!
- To Lee who joined our group without even leaving his home which is ~3 hours up the road. We are lucky to have you participate this way!! I hope at some point, we can meet you in person but this is certainly a great option for when that’s not possible.
- To our first-time attendees Henry, Lee, Reed, Jack (and others? Please excuse me if I am missing anyone). It is always a joy to meet new Bogleheads in-person, and I hope you can join us at a future get-together!
¹ Nassim Taleb is the author of “Fooled by Randomness“.
² If too many people start indexing, will it become a bad idea? In wise investing made simple, Larry has a chapter called “what if everyone indexes.” In that case price signals are lost. For example, we’re seeing a flood into high yield funds, that is pushing the price up and the yields down. The first sign of a bubble is when credit starts to be loosened. When the bond market is telling you one thing and the stock market tells you the other, listen to the bond market. The stock market is moved much more by emotion.