Larry Swedroe: 10 Big Risks Threatening Markets Now

Take it from someone who's been managing or advising on financial risk for 50 years:

"Oh my God, I don't think I've lived through a time when there were more risks" to the stock market.

So says Larry Swedroe, principal and head of financial and economic research at Buckingham Strategic Wealth, in an interview with ThinkAdvisor.

He quickly identifies 10 big risks, from "geopolitical tensions" to "a … federal deficit [with] no end in sight."

What to do? Diversify, he insists.

In his new book, "Enrich Your Future: The Keys to Successful Investing," Swedroe argues that active investing is "the loser's game."

Swedroe, who was vice chair of Prudential Home Mortgage before joining Buckingham 28 years ago, says his aim is to "help prevent the wolves of Wall Street from shearing … investors as if they were sheep."

In the interview, he reveals what's in his own portfolio, more than 40% of which is alternative investments.

Here are highlights of our conversation:

THINKADVISOR: What's the difference between risk and uncertainty?

LARRY SWEDROE: You can measure risk, as life insurance companies do. But with the stock market, you don't know the odds of a bear market occurring tomorrow. Stocks are always about uncertainty of risk.

The best we can do is estimate the odds; nobody knows what the odds are exactly.

What are the biggest risks in the market right now?

Oh my God, I don't think I've lived through a time when there were more risks.

The only way I can address the future intelligently is to diversify [as usual].

Exactly what are the risks?

The geopolitical tensions are at extremely high levels around the globe.

The risk of nationalism is increasing: If [Donald] Trump wins the [presidential] election, almost certainly you'll see higher tariffs, which could lead to trade wars. U.S. manufacturers will raise prices, and inflation will go up.

There are huge problems on the budget side. We've got a 6% federal deficit, and there's no end in sight. That's inflationary.

The U.S. has a huge shortage of housing. I don't see how you can keep home prices from rising more and rent from going way up.

Inflation will be higher than people think.

What other risks?

We have the threat of a partial or even a much bigger shutdown of the U.S. government, let alone the risk of a default on our debt if Congress screws that up.

We've got a huge Social Security problem: [The S.S. Administration] will be able to pay only 80% or less [of scheduled benefits] in eight or nine years [when the S.S. trust fund is exhausted].

There's also the risk from the work-from-home environment. That means commercial real estate is in deep trouble; banks lending to them is a problem.

There's the problem of municipal finances that are under major pressure because of their policies on immigration and the decline in property values of offices.

There's the big risk of the Magnificent Seven and other tech stocks that antitrust legislation could be a big problem to some of their stock prices.

How will all that affect the market and economy, broadly?

I can't predict, but economic growth can be impacted.

Active investing is "the loser's game," you write. Why is that? Charles Ellis argued that in his seminal "Winning the Loser's Game," first published in 1985.

The odds of winning are so poor. Unless you get entertainment value from it, you shouldn't play.

Wall Street will never tell you that active management is a loser's game because it's not in their interest. They need you to trade a lot so they can make the bid-offer spread and get their commissions.

So then, you favor passive investing?

I don't like the word "passive." I prefer Nobel Prize winner Eugene Fama's description: no individual security selection — stock-picking — and no market timing.

All index funds are passive investments, but there are a lot of passive funds that are not index funds. I invest in passive funds, but none are index funds.

What's in your portfolio?

Probably more than 40% is in alternatives. They are, for example, from Cliffwater, Stone Ridge and AQR.

I use non-index but passive equity funds, which are systematic, transparent and replicable (no stock selection individually and no market timing). They're from Dimensional, Avantis and Bridgeway.

I own lots of things that aren't exposed much to the equity markets, and I'm not highly exposed to inflation. I own reinsurance funds, long-short funds, a life settlement fund, a drug royalty fund.

On the bond side, I own short-term municipal bonds of about one to three years.

What else should advisors know about alternatives?

The average retail investor in the U.S. probably has between zero and 10% in alternatives.

But thanks to the introduction of interval funds, investors can have access to what was [available to] only to big institutional investors and super-high-net-worth individuals.

Should people be investing in international stocks?

You have to avoid home-country bias because we don't know that the U.S. isn't the next Japan.

The only way to deal with uncertainty is with diversification.

You write that gold isn't a safe haven. Please elaborate.

It certainly isn't an inflation hedge except if your horizon is, maybe, 100 years!

It's an inflation hedge with no real asset return over very, very long periods. It tends to do well over very short periods when inflation is running way up.

But when the Fed comes in and drives interest rates way up and inflation down, it tends to get hammered and be terrible for 20 or 30 years till inflation rears its head again.

What's the issue with investors' preference for stock dividends?

It's completely illogical. People think when you get a dividend, it's income and that the IRS taxes it as such. It's not income. The income is the profits that the company earned, and they're already taxed on it.

They're returning that capital to you when they pay a dividend, and you now have to pay taxes on it.

It reduces the value of the shares one for one even before that tax impact.

You can't create money by paying a dividend. It's just a transfer from the company's coffers to your coffers.

Credit: Tom McKenzie