Larry Swedroe: Risk Warrior in Action

By Janet Levaux

Analysis March 26, 2019 at 01:00 PM

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Larry Swedroe had the "honor" of speaking dead last at this year's Inside ETFs conference near Miami. Still, his Feb. 13 talk drew a large crowd, who listened attentively as he explained ways of creating efficient portfolios that reduce the risk of "black swan" events.

About a dozen or more advisors, reporters with recording devices in hand and other fans hovered around Swedroe after his dense 40-minute presentation, despite the hubbub of meeting staff tearing down booths and removing equipment in the background. The post-talk groupies clearly were thrilled to meet this financial rockstar in person, ask him to sign a book or two, and probe his thinking on a variety of portfolio issues.

Swedroe, 67, is director of research for the Buckingham Family of Financial Services, which includes Buckingham Strategic Wealth and the BAM Alliance of RIAs. A native New Yorker, he's been with the St. Louis-based group since 1996. He published his latest tome, "Your Complete Guide to a Successful & Secure Retirement," with co-author Kevin Grogan a few months ago.

Though he isn't quite the household name that Warren Buffett is, he combines the Oracle of Omaha's humility with a deep knowledge of investing and an open approach to finance — sharing the secrets of his approach to portfolio building without hesitation.

"Larry knows more about investments research than most academics. He's a practitioner with a mind of a first-rate scholar, and it follows that his investment philosophy is based on a careful reading of the newest empirical studies on investment performance," said Michael Finke, chief academic officer of The American College of Financial Services.

"He's been a critic of fad investing practices that aren't based on sound evidence, and an equally strong proponent of strategies such as low beta and factor investing that have the most support among financial economists," Finke explained.

"Whenever Larry writes something about investing, I always make a point of reading it," he added. "It's one of the reasons we interviewed Larry, in addition to academics like Bill Sharpe, for our new wealth management designation (the WMCP) at the College. Larry knows how to build a real-world portfolio using the best science."

The Big Picture

Here's an innovative way Swedroe frames the complex process of portfolio diversification, for instance. "This is how I try to explain it," he said just after his talk at Inside ETFs. "You are taking a trip from New York to San Francisco, and each leg of the journey you are going to go halfway. In other words, the first leg you drive 1,500 miles, and the next leg 750 and so on. You get closer and closer, but you never really get there. Well, diversification works the same way."

In his view, you start the journey with a domestic equity portfolio "and then you add bonds, which gets you to St. Louis. Next is international diversification, which gets you to Kansas City. Then you add small and value, and you are in Denver. By the time you have added two or three others, you are on the Bay Bridge. You are probably at around 98% [diversification] … with five or six funds, and you do not need much more than that."

(Among the many funds Swedroe uses for diversification and that he lists in his latest book are the iShares S&P 600 Small Cap Value, SPDR S&P 600 Small Cap Value ETF and Vanguard Small Cap Value, along with funds from Bridgeway Funds and Dimensional Fund Advisors.)

In addition to the importance of portfolio diversification, Swedroe emphasizes the related topic of risk. "Nothing has really changed on that front, since I wrote my first book — 'The Only Guide to Winning Investment Strategy You'll Ever Need.' We had the same issues of the ability, willingness and need to take risk into account," he said in a recent phone interview.

"Then I helped write another book, 'The Only Guide You'll Ever Need for the Right Financial Plan,' and like the earlier one, this did not focus on retirement, but it did get into the same three issues involving risk," Swedroe explained.

"The one thing I think that may have changed somewhat is the fact that, let's say, the two pieces are tied together, which is why I talk about them in the latest book 'Your Complete Guide to a Successful and Secure Retirement' in a section of the introduction called 'The Four Horsemen of the Retirement Apocalypse.'"

The horsemen are historically high equity valuations and low bond yields, along with longevity and the expected need for long-term care due to Alzheimer's and other forms of dementia, with the latter two most impacting risk and retirement. (A fifth horseman is the failure of government to fully fund Social Security and Medicare.)

"We are living a lot longer, and so that means you need a bigger pot of money. Your money has to last longer," Swedroe said. "And the incidence of Alzheimer's and cognitive decline increases greatly, especially after age 85, and that can be very expensive."

Underestimating both the possible need for and cost of that care is risky. "Living in facility that deals with cognitive decline can cost you $100,000 or more a year in some cities. So, you have to consider this over a longer period, and you have to take into account the increased risk of very expensive care."

These and other issues, like elder abuse, are important in portfolio management, according to Swedroe. "They don't look like they have to do with investing per se, but they are related. It's not an investment strategy that we are talking about exclusively, but it is a strategy of dealing with these other risks. That's why the book really focuses on the need for integration of not only an investment plan but estate planning, taxes, withdrawal strategies, etc."

Risk Conundrum

With this outlook for both longevity and long-term care, do investors have the luxury of taking less portfolio risk as they age, as is generally argued?

"If someone has $30 million in the bank and spends $100,000 a year, they can just put their money in CDs and TIPs, take pretty much no risk at all and be fine. They won't likely run out of money," Swedroe said.

"But if you are the average person, you probably have to take some risk. This is why we go into this topic in the chapter on asset allocation and talk about the need to take risk," he explained. "What rate of return do you need from your portfolio to give you a good chance of not running out of money?"

When answering this question, don't use historical averages. "Stock prices today are much higher, and that means expected returns are lower. And certainly bond yields are much lower today than their historical average."

The idea that a traditional 60/40 portfolio of an S&P 500 stocks and five-year Treasuries will give investors 10% a year is no more, according to most financial economists. "There is no way that you are going to get 10%. It's probably going to be more like in the area of 4-5%. So, again, you need a bigger pot of money," he said.

As a result, investors "cannot load up on just fixed income" and need to consider using annuities, Swedroe says. "I like the idea of deferred annuities, because they help you overcome the psychological problem of giving up assets if you die early."

Buying a deferred-income annuity that pays $36,000 a year at age 85 might cost a 65-year-old male $100,000, for example. "But you would have to pay a lot more for one that starts to pay you at 65," he pointed out.

Swedroe describes insurance as a tool "to hedge the risks of the unexpected, not the expected." People buy car insurance, for instance, for major accidents and not to cover the costs of oil changes or fender benders — which you should budget for.

"The same thing should apply when you are thinking about annuities. You should budget for your life expectancy, and that would be your deductible. And you can use a liability-hedging strategy for that time period," he said.

"This is one way to improve your odds of success and not take so much risk, and there are other ways … ," Swedroe explained. "We have to keep in mind that logically if you do not have your labor capital to replace losses, you should be taking less risk. And you cannot wait out a bear market, because you have to spend money to live on as you withdraw from the portfolio. This means you have sequence risk — since you cannot recover what you spend."

Not All the Same

Turning to equities, the investing guru brings up the fact that "if the equities you own have higher expected returns than the market, then you can own less equities in a portfolio."

Historically, over the past 90 years or so, the S&P 500 grew about 10% a year on average, while small-value stocks have provided about 13% and bonds 6%. "While you could get to 10% returns, in hindsight, by being 100% in equities, you could also have gotten there by, say, being about 60% in equities," he said.

By holding less equities, of course, the value of a portfolio does not fall as much when there's a big market drop like in 2008. "In the book, we give the example of a typical 60/40 portfolio as proving the same returns and similar volatility as a 40/60 portfolio with small-value equity holdings. But, we would want to globally diversify that portfolio, as well," Swedroe explained.

Another Option

There's also another risk dampening option — alternative investments, which he describes as tools of "financial innovation," such as interval funds (referred to by some as unlisted closed-end funds).

"Interval funds allow you to invest in less-liquid investments and get compensated for that risk, like the Harvards and the Yales of the world have done for decades," Swedroe said.

"Now you can do that, too. When you're going to hold these — which are tax-inefficient investments — in your IRA, you don't really need the liquidity anyway," since most investors are not likely to take out a huge chunk of assets from their IRA in a given year.

"If you own a reinsurance fund with equity-like expected returns for the risk you are taking, they are totally uncorrelated with the market, and you are getting paid for that risk — including giving up that liquidity for at least a year or possibly longer," he explained.

These funds cannot be structured like a traditional mutual fund as they involve a one-year contract. "And you can't get that money back [during the year], which is why they were not available until a few years ago," when the interval structure was introduced.

"Because of the low correlation of their returns [to equities], that dampens the left-tail risk [of poor returns]. But the tradeoff, which you have to recognize, is that you cannot get the good right-tail [returns] that you get when you hold more equities," Swedroe said.

While in a bad year (i.e., every seven to 10 years or so), stocks might go down 40-50%, they may go up 40-50% in a good year, he says. With reinsurance, a bad year could mean a loss of 10-15%, a good year might mean a gain of 10-12%, and a great year could bring earnings of 15%.

"You cannot get the up 30 or 40 or 50%, but you shouldn't care," Swedroe explained. "That is the tradeoff you make, and that's why it's important that investors look at charts in which we show the distribution of returns being tighter."

This portfolio, based on a "low risk/high tilt" strategy, is what most investors choose, he says, because "they are willing to give up the opportunity for the great returns to minimize the risk of the bad tail — so very critical for retirees."

It's possible to take the concept even further, by adding more sources of risk that have low correlation with each other and that also have risk premiums. "There are four alternative investments which we believe have equity-like expected returns, but with far less volatility and far less downside risk, while also having low to no correlation of their returns to either stocks or bonds," Swedroe explained in his latest book.

These investments are funds focused on alternative lending (of consumer, small business and student loans), reinsurance, variance risk premium (with puts and calls for contracts across stocks, bonds, commodities and currencies) and alternative risk premium (for long/short exposure to factors like value and momentum across a mix of asset classes).

Stone Ridge Asset Management, AQR Capital Management, Amundi Pioneer Asset Management and RiverNorth are among the firms that offer such products.

Monte Carlo Time

To bring these different portfolio options, their risks, expected returns, volatility and related issues together for investor clients, advisors have a friend: Monte Carlo simulations. "You need to do the math and see [where] you end up better," Swedroe said. "People tend not to do that."

Monte Carlo programs generate sequences of random returns using data for average respected returns and volatility, represented by the standard deviation measure. They "allow investors to view the outcomes of various strategies and how marginal changes in asset allocations, savings rates and withdrawal rates change the odds of these outcomes," he explained in his recent book.

The simulation might show investors the best time to buy an annuity in order to decrease their odds of not running out of money. "It helps take the emotion out of the process…, and that is why Monte Carlos are such valuable tools. Numbers shown visually can help people overcome their instincts or emotions, which drives so much of our decisions," the financial expert said.

Plus, these programs shift the thinking to a goals-based approach and help advisors and investors strike the right balance between risk taking and achieving goals, he adds. Low-volatility portfolios could lessen an investor's chance of funding a successful retirement, while higher-risk portfolios might have unacceptably high odds that the investor might outlive his or her assets. "Never treat the unlikely as impossible," Swedroe cautioned.

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Janet Levaux is editor-in-chief of ThinkAdvisor.com and Investment Advisor. She can be reached at [email protected].

(Photo: Tom McKenzie)