Guest post by Contributing Editor, Matthew Amster-Burton, Mint.com.
Recently, I wrote a three-part series on how to start investing.
Today, I want to look at an advanced topic. Generally, I avoid advanced topics in investing, for two reasons:
- Most people don’t even have a grasp of beginner-level investing yet.
- The vast majority of “advanced” investing techniques can’t beat a simple, diversified portfolio over time.
Today, I want to look at a possible exception. It’s called the Larry Portfolio, developed by a guy named (you guessed it) Larry Swedroe and presented in his short and readable new book, Reducing the Risk of Black Swans, cowritten with Kevin Grogan.
Like momentum investing, which I explored last week, the Larry Portfolio is a way to attempt to capture more return from your portfolio without taking more risk—the holy grail of investing. Spoiler alert: it’s a promising idea that may or may not be appropriate—or possible—to implement in your own investments.
This is fairly technical stuff, although I’ll leave the math out of it. If you’re interested in investing as a hobby, read on. If you just want a simple portfolio that will beat your stock-picking friends, that’s fine. Go back to my original series.
One kind of risk
Smart investors like to take smart risks.
Investing in just one company is a dumb risk. That company might go bankrupt in any number of unexpected ways. Investing in lots of companies (aka diversification) is a smart risk: you’re no longer exposed to the risk of one company flaming out.
You’re still exposed to the risk of the market as a whole, and that’s the risk that investors can expect to get paid for over time.
Investors call this total-market risk beta. Beta measures the volatility of the stock market as a whole. Generally speaking, to get more return, you have to take more risk: Treasury bonds have low beta and low expected returns; stocks have high beta and higher expected returns. A total stock market portfolio has a beta of 1. (Let’s talk about low-beta stocks another time, please!)
So you might imagine that the best possible portfolio would look something like this:
- Low-risk bonds (Government bonds from stable governments, high-quality corporate bonds, CDs)
- A total world stock market fund
Mix them in whatever proportion suits your risk tolerance. One popular formula is 60/40: 60% stocks, 40% bonds.
Many kinds of risk
Then, in the early 1990s, two professors at the University of Chicago, Kenneth French and Eugene Fama, took another look at the data. They found that beta couldn’t explain all of a portfolio’s returns.
Two other factors seemed to be important, too. A portfolio taking these factors into account could, some of the time, beat a total-market portfolio without being riskier. These factors are:
Size. Small company stocks tend to have higher returns than large company stocks.
Value. “Value” stocks, essentially stocks with low prices, tend to have higher returns than growth stocks. How do you decide which stocks are value stocks? Use a measure like price-to-earnings ratio.
Value stocks are essentially stocks in mediocre, boring companies. This seems like an odd way to make money, but it’s a highly persistent effect. (Value is believed to be a stronger effect than size.)
You can now easily buy mutual funds concentrating on small or value stocks, and many investors choose to “tilt” their portfolios toward these factors, hoping for bigger returns without bigger volatility.
It’s a reasonable hope, because beta, size, and value have low historical correlation. When you have multiple stocks in your portfolio that are exposed to different risks, we call that diversification. The same can be said for having multiple factors in your portfolio.
The Larry Portfolio
Now, what if the stock portion of the portfolio was made up of entirely small value stocks?
That would give plenty of exposure to beta (because small value stocks are still stocks, and correlate with the wider stock market), and also maximum exposure to the small and value premiums. It’s also reasonably well-diversified, because there are thousands of stocks that fit the profile.
This sounds like a risky stock portfolio, and it is: high risk, high expected return.
Larry Swedroe’s insight was: what if we mix a little of this very risky (but intelligently risky) stock portfolio with a lot of very safe bonds? Say, 30% small value stocks and 70% bonds?
The result is the Larry Portfolio, a portfolio with similar expected return to to 60/40 portfolio I described, but lower risk, because the portfolio is mostly bonds—the kind of bonds that did just fine during the Great Depression and the recent financial crisis.
Swedroe warns in the book that there are no guarantees in investing. “[A]ll crystal balls are cloudy—there are no guarantees,” he writes. The research behind the Larry Portfolio may be sound, but “we cannot guarantee that it will produce the same returns as a more market-like portfolio with a higher equity allocation.”
Is it for you?
I took a look at my portfolio. It looks almost exactly like the portfolio Swedroe describes in the first part of the book, a diversified 60/40 portfolio with plenty of exposure to beta but no exposure to the size or value premiums.
So I asked him the obvious question: should I have a Larry Portfolio?
“There is no one right portfolio,” Swedroe told me via email. “The biggest risk of the LP strategy is the risk called Tracking Error Regret.”
Tracking Error Regret is a nasty thing. Here’s what it means.
Inevitably, the Larry Portfolio will sometimes underperform a 60/40 portfolio. If the stock market is soaring, it might underperform it for years at a time. A Larry Portfolio holder might look around and say, “Dang, everyone is making a ton of money but me. This portfolio sucks.”
Then you jump off the Larry train and back into a 60/40 portfolio—probably right before a market crash that decimates your stock portfolio. (That’s the Black Swan in the book title.) “Oh no—Larry was right!” you conclude, and buy back in, but it’s too late: now you’re selling cheap stocks to buy expensive bonds.
There really isn’t any cure for Tracking Error Regret. You can write an investment policy statement (IPS) to remind yourself that you’re a long-term investor and shouldn’t be watching the market too closely, because it’ll only raise your blood pressure.
The worst way to address the problem is to assume that you’re too smart or tough to experience it.
Can we build it? Maybe we can
Finally, there’s one other reason the Larry Portfolio might not be for you: it requires using mutual funds that might not be available in your retirement plan.
If most of your money is in a 401(k) plan, and that plan doesn’t have a US small value fund and an international small value fund, you can’t really build a Larry Portfolio. You might be able to build a watered-down version, but it won’t have the same risk-return characteristics as the real thing.
I haven’t decided yet whether the Larry Portfolio is for me. If you’ve read this far, however, you’ll probably enjoy Swedroe’s book. And if you already use a Larry Portfolio or are considering one, please let me know in the comments.
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