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Enrich Your Future 10: You Won’t Beat the Market Even the Best Funds Don’t
20th August 2024 • My Worst Investment Ever Podcast • Andrew Stotz
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In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 10: When Even the Best Aren’t Likely to Win the Game.

LEARNING: Refrain from the futile pursuit of trying to beat the market.

 

“Only play the game of active management if you can truly identify an advantage you have, like inside information, but you have to be careful because it’s illegal to trade on it. Also, play only if you place a very high value on the entertainment.”
Larry Swedroe

 

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 10: When Even the Best Aren’t Likely to Win the Game.

Chapter 10: When Even the Best Aren’t Likely to Win the Game

In this chapter, Larry illustrates why individual investors should refrain from the futile pursuit of trying to beat the market.

It seems logical to believe that if anyone could beat the market, it would be the pension plans of the largest U.S. companies. Larry lists a few reasons this is a reasonable assumption:

  1. These pension plans control large sums of money. They have access to the best and brightest portfolio managers, each clamoring to manage the billions of dollars in these plans (and earn hefty fees). Pension plans can also invest with managers that most individuals don’t have access to because they don’t have sufficient assets to meet the minimums of these superstar managers.
  2. Pension plans always hire managers with a track record of outperforming their benchmarks or, at the very least, matching them. Not the ones with a record of underperformance.
  3. Additionally, pension plans will always choose the manager who makes an excellent presentation, explaining why they succeeded and would continue to succeed.
  4. Many, if not the majority, of these pension plans hire professional consultants such as Frank Russell, SEI, and Goldman Sachs to help them perform due diligence in interviewing, screening, and ultimately selecting the very best of the best. These consultants have considered every conceivable screen to find the best fund managers, such as performance records, management tenure, depth of staff, consistency of performance (to make sure that a long-term record is not the result of one or two lucky years), performance in bear markets, consistency of implementation of strategy, turnover, costs, etc. It is unlikely that there is something that you or your financial advisor would think of that they had not already considered.
  5. As individuals, we rarely have the luxury of personally interviewing money managers and performing as thorough a due diligence as these consultants. We generally do not have professionals helping us avoid mistakes in the process.
  6. The fees they pay for active management are typically lower than the fees individual investors pay.

So, how good are these pension funds at beating the market?

So, how have the pension plans done in their quest to find the few managers that will persistently beat their benchmark? The evidence is compelling that they should have “taken par.” For example, Richard Ennis’s 2020 study found that public pension plans underperformed their benchmark return by 0.99%, and the endowments underperformed by 1.59%. He also found that of the 46 public pension plans he studied, just one generated statistically significant alpha, compared to the 17 that generated statistically significant negative alphas.

According to the study, the likelihood of underperforming over a decade is 98%.

Another researcher, Charles Ellis, declared that active investing is a loser’s game that is possible to win, but the odds of doing so are so poor that it isn’t prudent to try. In Larry’s opinion, it would be imprudent for you to try to succeed if institutional investors, with far greater resources than you (or your broker or financial advisor), fail with great persistence. This should make you feel cautious and less likely to take unnecessary risks.

Wall Street needs you to play the game of active investing

According to Larry, Wall Street needs and wants you to play the game of active investing. They need you to try to beat par. They know that your odds of success are so low that it is not in your interest to play. But they need you to play so that they (not you) make the most money. They make it by charging high fees for active management that persistently delivers poor performance.

Larry insists that the only logical reason to play the game of active investing is that you place a high entertainment value on the effort. For some people, there might be another reason—they enjoy the bragging rights if they win. Of course, you rarely, if ever, hear when they lose. Investing, however, was never meant to be exciting. Wall Street and the media created that myth. Instead, it is intended to provide you with the greatest odds of achieving your financial and life goals with the least risk. That is what differentiates investing from speculating (gambling).

Further reading

  1. Richard Ennis, Institutional Investment Strategy and Manager Choice: A Critique,” Journal of Portfolio Management (Fund Manager Selection, 2020, 46 (5).

Did you miss out on the previous chapters? Check them out:

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

 

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Andrew Stotz:

Hey, fellow risk takers this is your worst podcast hosts Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners, you can learn more about his story in Episode 645. Larry's unique because he understands the academic research world as well as the practical world of investing. Today, we are talking about chapter 10. In his recent book enrich your future the keys to successful investing, the chapter is talking about when even the best are likely to win. And again, this is part the first part of part two strategic patrol put us in petroleum again. I am the worst podcast host, Larry, strategic portfolio decisions, Larry, take it away.

Larry Swedroe:

Yeah, Andrew, it's good to be back, as you know, like to start off each chapter with a story or a legend or a myth or something to help people understand a difficult concept that they can get the concept and an area they're more familiar with, then it's easy to understand that in finance, so in this case, we tried to ask the question, what do you do when even the best aren't likely to win? Okay, so the story I came up with is a wizard appears. Wales's magic one, and makes Andrew Stotz, the 11th best golfer in the world. And being the 11th best golfer in the world, you get invited to the legends of the golf world annual tournament. That's the good news. The bad news, of course, is the other 10 players have the 10 best players in the world. Now to make this a little bit fairer, or competition, or to give Andrew a handicap. What the rules say is this. Andrew, you get to sit in a clubhouse while each of the players goes out and plays a whole one at a time. And you don't get to watch. You know how they play, but you get the their scores. And once you hear all 10 player scores, you have a choice you can make. You could take par and don't have to play or you could decide to play and get whatever score you get. Okay. Now, first of all, is a PA for eight of the 10 players shoot a bogey five, one shoots PA and one shoots a birdie. What's your strategy? And

Andrew Stotz:

so it seems like I should take par? Because that was a damn hard poll. It seems like from just those patients. Right? If

Larry Swedroe:

you take par you want you're ahead of eight of the 10 players, you're tied with this, the ninth and you're only behind one stroke to the tennis player.

Andrew Stotz:

I mean, second play.

Larry Swedroe:

Yeah, you're in second place, or at least tied for second. And unless I mean, if every hole played out that way, unless the same player got the birdie, you would likely win the tournament. So what's the thinking here? Why do you choose not to play? Because here you're playing against the 10 best players in the world. And you don't have any advantage over them. So why would you try to succeed when they have failed? Now let's change the situation. They play on day one. And it's a windy miserable day winds the ball and 30 miles an hour, or brings us soaked making it very slick and difficult. You get to play the next morning when it's absolutely beautiful out, sun's out of courses dried, well then you might say I've got a big advantage. Maybe they got those bogeys, because of the difficult conditions, right? So there you see an advantage. And if you're having an advantage over the best, okay, then you might choose to play the game. What does this all have to do with investing? So the way I think about it is this, who are the people most likely to succeed in the world of investing? I would suggest one hypothesis would be the big large pension plans that manage 10s of billions of dollars, the Harvard's and the Yale's of the world and big corporations. You know, they also have plans that you know, manage 10s of billions of dollars, and every one of the great money managers in the world are clamoring to get the fees to try and manage that. So

Andrew Stotz:

let me stop you there just for people that may not understand the pension system and all of that, you know, we have Public mutual fund companies like Vanguard, we've talked about him fidelity and those types that are offering public funds to the public. But here you have money that's pooled from retirement investment accounts for government employees. And this is a huge pool of money. This is not a small pool of money. And therefore, what you're claiming is that, because this is such a huge pool of money, and they have a high obligation through ERISA requirements, and all of that, that these men and women have the resources to be at the absolute top of the game. And we'll also add one other thing, their time horizon is super long. So they also have the ability to make maybe some unconventional decisions, some more odd or alternative allocations. So it seems like they would have all advantages continued. So I listed six

Larry Swedroe:

advantages. My memory serves, that they had one is they have access to all these great managers, not just the vanguards of the world, and other good families, BlackRock and tra, dimensional fund advisors, but they have access to all these big private vehicles that you and I wouldn't have access to, because we don't have 10s of billions of dollars, and they don't want to bother with you. Number two is they pay much lower fees because of their scale, you might, if you're even had access to a big pension plan, fund manager, they might charge you 80 basis points and charge them 30. So that's a big advantage that they have. I think we can also agree, Andrew, that it's not even remotely possible that any one of these pension plans is ever hired a manager with a bad track record, would you hire a manager with a bid, right? Not gonna happen. So also safe to say that they hired only managers who made great presentations to their due diligence committees, right, they showed how smart they were explained this strategies, they also have an advantage that you and I don't have these managers get to meet with all of these managers and the big companies doing due diligence meeting with them personally, right that you and I don't have to, you know, we don't have access to. And another advantage they have is many of them, if not most hire world class consultants, like Sei, and Frank Russell and Goldman Sachs, to help them do this due diligence and hire only the very best, right? So, you know, if you can't think of an advantage, then you shouldn't play and what advantage could we possibly have over them? Alright, so that's the problem. So what's the analogy? Well, you could take par simply by investing in systematic strategies that access certain factors, or total market funds, run by fund families like Vanguard, which runs index funds, or systematic factors, strategy funds, run by companies like dimensional and AQR and Avantis. These are big world class firms hiring, you know, the best mathematicians and scientists in their field to help them and you don't have to pay big fees, you don't have to try to outperform you could take par. And when you do that, is what the evidence says. There have been a bunch of studies done on pension plans. I think it was Richard and if my memory serves, did a study found something like 2% of them succeeded in outperforming appropriate risk adjustment benchmark, which is consistent with the studies that we've talked about before on choosing active finance. So if you're 98% likely to fail, and you don't have any advantages, factor disadvantage, you're paying higher fees, etc, then you shouldn't play the game. So that's all moral of the story unless you can identify an advantage that you have like you get to play on a sunny day versus a rainy day. Right? Then you shouldn't try to play

Andrew Stotz:

you know, the most obvious question that comes up in my mind and from I'm sure plenty of the listeners and viewers is then why does it continue on? Why are pension funds doing that? and over and over again, given this compelling, overwhelming evidence,

Larry Swedroe:

yeah, well, I know number one is, sadly, certainly in the United States and my speaking to investors all around the world, their education systems have totally failed the public, despite its importance, money issues, even savings and learning not to use credit cards, except as you know, an payment that you can make for convenience, and you're going to pay it off learning how to keep a checkbook, and you know those things, let alone investing, it just isn't taught. And where it is taught. It's somebody from Morgan Stanley, or Merrill Lynch comes in and is pitching their active strategies. That's problem one, unless you take an MBA in finance today, it's likely you haven't taken a single course, in capital markets theory. So unless you've read my books, or others, like John Bogles, of William Bernstein's, you're going to be unaware of all of this information. The second part, there is what I would call a conspiracy among the active managers in the media, who want to make sure the public is unaware. So they don't have to, because they need you to tune in and watch this show. So they could sell commercials, and the active managers need you to believe that they're likely to win. So they can collect the big fees, so they don't want you to know. And finally, there's all kinds of behavioral biases. Even when people are aware of the studies, they think, Well, I'm a doctor, I'm clearly smarter than average, I can outperform. And so they're overconfident of their abilities, which is an all too human trait. And even though 98% fail, I can succeed. The only logical reason I think, to play the game of active management is if one, you can truly identify an advantage you have, like you really have inside information, but you got to be careful because it's illegal to trade on it. And the other is, you place a very high value on the entertainment. Like some people like to go to Las Vegas, why don't you go to Las Vegas and take 500 or 1000 bucks, if you can afford to lose it and have as much fun as the guy who bets a million dollars in Las Vegas. You don't need to spend the million dollars. So if you want take one or 2% of your portfolio, golf play, but expect to lose.

Andrew Stotz:

And one of the counter arguments to what you said is the idea that well, okay, there hasn't been a lot of education. But the people running the pension funds have certainly been educated now, in Thailand, what you can see is, and I'm sure it's all the same around the world, but whose money is that pension money? Well, it's the average worker and employee of the government and the like. So we have a government pension fund here we have a Social Security fund in Thailand. And what you find is that the people on the committee representing the beneficiaries have no knowledge at all of finance, and they're perfectly political

Larry Swedroe:

appointees who don't know finance. And number two, who's taken them to the golfing events and the big dinners and sporting events. It's not Vanguard, or dimensional. It's Morgan Stanley, and you know, their equivalents.

Andrew Stotz:

Yes. So therefore, you can say these leaders of pension funds are under pressure. That is maybe illogical, unreasonable pressures, but they have to bow to them. That one,

Larry Swedroe:

also, or they just enjoy those expensive steak dinners in the Gulf at beautiful country club. Well, as

Andrew Stotz:

a sell side analysts, I traveled to the US quite many, many times, you know, in my career, to visit the amazing offices in San Francisco and Los Angeles in New York and all the different pension fund offices and the perks that go with it. So yeah, it's it's an interesting one. But I think, you know, what, you're summing it up of all of that. I think the conclusion out of all this is that the best best equipped best advantaged guys, men and women at the top of that don't outperform, as you said, the research, I couldn't find this particular research, but I'm going to keep looking for it and see if I can put it in a link to it in the in the show notes. But the research basically shows that pretty much they never outperform over the long run.

Larry Swedroe:

Yeah, there's a bunch of papers turned around. Our university Arizona professor who's now works with Avantis Um, I forgot his name Suhail, perhaps, but he's done work on pensions. My other books have cited studies on pension plan performance. So you can look in those books. And they'll cite those studies. And they're all consistent. You know, what's really important to keep in mind is neither your eyes are saying it's impossible to outperform. That's what keeps the hope alive. There's always somebody out there who outperforms. The problem is, it's a loser's game, meaning while it's possible to win, the odds of doing so are so poor, you shouldn't try unless you're placing a very high amount of value on the entertainment aspect. And you get to brag at the 18th or 19th, all with your friends. Oh, I beat the market. Now, of course you never tell him the other 40 years in a row you underperform. But you'd get that tell at one store?

Andrew Stotz:

Yeah, I think what I tell my students now after having these discussions is that when you see someone out performing, do you must first absolutely assume it was because of luck?

Larry Swedroe:

Because the odds are, I would say it this way, the odds are great, that it was likely luck, doesn't mean it wasn't skill. Right? We know there have been a handful of managers over time who have evidence skill. Warren Buffett, certainly, but his skill disappeared, because everyone figured out the secret sauce. You know,

Andrew Stotz:

that's what on page 70? You at the end of one portion of it. You say, Warren unless when you look in the mirror, you see Warren Buffett staring back at you, it doesn't seem likely that the answer to these questions is yes. At least it won't be yes. If you're honest with yourself. In other words, we don't have an advantage. And you've already taught us that. Yeah, Warren Buffett even lost that advantage because of the competitiveness of the market for the last 20 years. So

:

bingo. Well,

Andrew Stotz:

that was a great one, Larry. And I think I want to just wrap up this, this this one by talking just briefly about Yeah, about this, the concept of why are we talking about portfolios, as opposed to originally in the first section we were talking about, you know, the efficient market and understanding about stock picking, just just give us a little foreshadowing and anything else you want to add as we wrap up?

Larry Swedroe:

Yeah, we talked about portfolios here, because we're big believers in the benefits of diversification, of course, unique asset classes that have premiums, but are uncorrelated or lowly correlated, so we don't put all our eggs in one basket, that traditional line is, diversification is really the only free lunch in investing. And so we want to encourage you to eat as much as possible of it. While on that subject of those a brand new paper that just came out, I wrote it up this morning. And I think it will highlight an important issue for your listeners. So one of the things we know investors do is they get caught up in the hype of something new when exciting, right herd mentality. And we have something today, which is been a repeat of many incidences in the past. And today that is hype around AI and what it can do to change the world. While we had similar things around the turn of the century with the internet, and that we had in the 60s, tronics revolution in the 20s. It was all about you know electrification, TV, radios, airplanes, all of this stuff, right? And we had bubbles in every case prices weren't crazy. This paper looked at what happens to the performance of stocks that enter the 10 largest companies on the US stock exchanges. Okay, and the period after they get become a top 10 In the period before they become a top 10. So if you look at the data, I'm gonna do this from memory, but since I wrote it this morning, I think we're pretty safe here. I think it was the 10 years before they entered their returns were only slightly better than average, like 11.8% In the five years before they got their returns were unbelievable. 20% and in the three is it's 27.8%. So what that's how you get

Andrew Stotz:

even in the three years prior, prior to

Larry Swedroe:

becoming a top 10. Okay, now people everybody knows these companies. They're now the stars. They're written up in the media. Yeah, they're in the Mac seven. And we love these kind of money chasing them fear of missing out is the key word here as well. And so this study then looked at, okay, what happens in the period after that? And

Andrew Stotz:

it's interesting bit just for people that don't understand these types of studies, I believe this would be called an event study where the event yes be the entry into the index as let's call that time zero.

Larry Swedroe:

So, in this case, it's not an index, it's the entire course universe. Right? Okay. And three years, before, a sorry, after they entered, they lost 50 basis points a year, in the five years after they lost one and a half percent a year. This isn't relative to the market, this is outright returns. And then on the 10 years, they lost I think it was 1.9% a year. So they most people didn't get those early, great returns, because no, they waited, now it's safe. These are great companies, they're in the top 10. Surely they're safe. And they go on, that's what we would call creative destruction. Originally, they were the destructors. And but you don't own and then tend to, and then then they get destructed by change, etc. And I looked at it just in writing it up. I thought I would look back and say 10 years ago, what are the top 10 companies that started this year? And what were the top 10 companies in 2014. And so we have 40% turnover for the top 10. Today, we're not in the top 10, just 10 years ago, and none of the top 10 Today, not a single one was in the top 10 in 1994. So none of those companies are a top 10 companies in 1994. Were in that these were world class, everyone thought were the greatest companies in the world, the IBM's.

Andrew Stotz:

of the world.

:

Yeah, yeah,

Andrew Stotz:

that's interesting. And, you know, for anybody, you know, listening and viewing, you know, just follow Larry, and you'll see is publishing of all of these, I do want to mention a book. Now that you've talked about the AI revolution, that I found, I have a stack of books about seven books that I consider to be like, life changing for me or mind changing. And this is one of them. It's called Future hype. And it's called the myths of technolog technology change. And it's written by a guy named Bob seidensticker. And he basically wrote, here's a just a quick review. Everyone knows that today's rate of technological change is unprecedented. With technological breakthroughs, from the internet, to cell phones, to digital music and pictures, everyone knows that the social impact of technology has never been as profound. But everybody is wrong. And that is the beginning of how he it's listed on Amazon. But I'll

Larry Swedroe:

give you two things that I've learned over time. One is that, and this is what it is typical, that the big beneficiaries of the technology are often not the creators, but the users. Would you rather be the person who uses cell phones? Or would you rather be of company and had stock and kept it in Blackberry? Or Nokia? Right? The airlines, cute Emily over their life. I've lost money, I believe. And yet that changed the world. And I don't know if that author cites this story, but this is the one that sticks with me the most. So you read about in 1850s 1860s. You I took about maybe it was seven to 10 days for a letter to get from New York City to California with using a stagecoach, maybe it was even longer. And if you sent it by boat, it might have been like three weeks, you know, around the Cape of Good Hope. Okay, good. Okay, porn, whichever one it is there. And then they invented the telegraph. And then it's there in seconds. There's no technology today that you can invent that changed the world to that degree going from. So now you can get it in a millisecond instead of two seconds versus three weeks. Right?

Andrew Stotz:

He does. He does talk about that. And one of the stories that I love reading the memoirs of civil war generals, which I've met read many of them, but the memoir of William to come to Sherman, who happens to be the name of my great grandfather, by the way. But William Tecumseh Sherman basically was was sent out to San Francisco, by the by the US military, and he had to take a boat, and that boat now if he was sent out in the 1700s, he would have taken a boat, yes, around all the way, you know, around on the South America and South America. And then after that, he would have come up, and that would have taken about six months to get there. And then, and then, you know, they cut that by, you know, 75% by opening up the Panama Canal Canal, which is what he went through in his story, as he talked about this harrowing journey. And he arrives at the Monterey Bay, and his ship just disintegrates as it hits upon the rocks, and they're trying to evacuate the ship. This is 18, let's say 1845, something like that. Maybe and he arrives right in Amen. The

Larry Swedroe:

Panama Canal wasn't built yet. So they went overland across they had

Andrew Stotz:

a cat. Yeah, they had to go Overland. Exactly. And then he talks about how the Panama Canal was built. And then he talks about how the stagecoach sorry, how the railroads were built. And then he goes on to the advancement. And he's just saying, there's nothing in this world that is accelerating at that pace, and there probably never will be. And that is just a shocking thing. Because as he says, We all think that the pace of technological change is you know, so fast. He says his MO, since

Larry Swedroe:

we're having fun telling these great stories, my favorite of all time, is you know, how Baron Rothschild, the English brother of the famous watch our family, made his fortune, his big forts, and they were already successful. What's my carrier pigeons? That's exactly right. They knew that Napoleon was defeated before everybody else that was panic on the London Stock Exchange, British bonds were collapsing. And he got his carrier pigeon sent from his brother in France. And he knew and he got up and put every penny to buy British bonds. You know, made a fortune. Now think about trying to do that today getting an advantage over a high frequency trader who's moved their computer systems, like a mile closer to be at beat yours by a millisecond. Right. Yeah, and

Andrew Stotz:

what knows carrier pigeons were beating people that were traveling by horseback, you know, in boat and all of that to get there. So it's incredible the pace in those days. Yeah. Well, Larry, that was a fun discussion and a great lesson and a great kickoff for this portfolio section. I want to thank you again for this. And I'm looking forward to the next chapter that we've got. And the next chapter coming up, ladies and gentlemen, is the demon of chance.

Larry Swedroe:

We'll give everybody a little lead. We're going to talk about the great success of the Larry swedroe Investment Trust. Wow.

Andrew Stotz:

Yeah, wait, well follow Larry on Twitter and also on LinkedIn. And you'll get all of this. This is your worse, podcast host Andrew Stotz saying. I'll see you on the upside.

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