Tag Archives: CDs

Investing: What the heck is a Larry Portfolio?

PortfolioGuest 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:

  1. Most people don’t even have a grasp of beginner-level investing yet.
  2. 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.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Mint.com is not affiliated with Folio Investing or The Portfolioist.

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Is the Fed Really “Stealing from Savers”?

Federal ReserveIn a recent article on MarketWatch, Chris Martenson asserts that the Fed’s low interest rate policy and quantitative easing in recent years is deliberately stealing from savers. This article has elicited a big response, with almost 800 comments and almost 2000 likes on Facebook. The key point of the article is that the Fed’s policy of holding down interest rates to stimulate the economy has reduced the income provided by Treasury bonds, savings accounts, and certificates of deposit (CDs) to extremely low levels. In this way, the Fed’s policy can certainly be viewed as harmful to people trying to live on the income from bonds and other very low risk investments. This Fed-bashing rhetoric is far from the whole story, though.

The total impact of very low interest rates on savers and conservative investors is somewhat more complex than the MarketWatch piece suggests. Subdued inflation in recent years, one of the reasons that the Fed cites for keeping interest rates low, also means savers are seeing lower rates of price increase in the goods and services they buy. With very low current inflation, you simply don’t need as much yield as when inflation is higher. It would be wonderful for conservative investors to have low inflation and high yields from risk-free accounts, but that situation is effectively impossible for extended periods of time.  All in all, low inflation is typically a good thing for people living in a fixed income.

Another effect of continued low interest rates is that bond investors have fared very well. The trailing 15-year annualized return of the Vanguard Intermediate bond Index (VBMFX) is 5.4%, as compared to 4.5% for the Vanguard S&P 500 Index (VFINX).  Falling rates over this period have driven bond prices upwards, which has greatly benefitted investors holding bonds over this period.

One interesting related charge leveled by the MarketWatch piece (and also in a recent New York Times article) is that the Fed policy has exacerbated income inequality and that the wealthy are benefitting from low rates while less-wealthy retirees living on fixed incomes are being hurt. Low interest rates have helped the stock market to deliver high returns in recent years and it is wealthier people who benefit most from market gains. In addition, wealthier people are more likely to be able to qualify to refinance their mortgages to take advantage of low rates. The implication here is that less wealthy people cannot afford to take advantage of the benefits of low rates and that these people, implicitly, are probably holding assets in low-yield risk-free assets such as savings accounts or CDs. This is, however, somewhat misleading.  Poorer retired households receive a disproportionate share of their income from Social Security, which provides constant inflation-adjusted income.

While investors in Treasury bonds, savings accounts, and CDs are seeking riskless return, money held in these assets does not help to drive economic growth, and this is precisely why the Fed policy is to make productive assets (in the form of investments in corporate bonds and equity) more attractive than savings accounts and certificates of deposit. So, the Fed is attempting to drive money into productive investments in economic growth that will create jobs and should, ultimately, benefit the economy as a whole. One must remember that the Fed has no mandate to provide investors with a risk-free after-inflation return.

It is certainly understandable that people trying to maintain bond ladders that produce their retirement income are frustrated and concerned by continued low interest rates and the subsequent low yields available from bonds.  Given that inflation is also very low, however, low bond yields are partly offset by more stable prices for goods and services. It is true that the Fed’s policies are intended to get people to do something productive with their wealth like investing in stocks, bonds, or other opportunities. It is also the case that older and more conservative investors world prefer to reap reasonable income from essentially risk-free investments. Substantial yield with low risk is something of a pipe dream, though.  Investors are always trying to determine whether the yield provided by income-generating assets is worth the risk. We may look back and conclude that the Fed’s economic stimulus was too expensive, ineffective, or both, but this will only be clear far down the road.

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The Strange Case of Apple Stock and Structured Products

Jason Zweig at the Wall Street Journal published a disturbing article that deserves more attention.  The basic story is this.  A number of banks sold a complex financial product to retail investors who have subsequently lost quite a bit of money.  Here is the basic pitch that was apparently made to individual investors in 2012.  You are going to buy an investment product that is currently invested in bonds and is producing 8% in income per year.  The performance of this product is tied to the stock price of Apple, however.  In exchange for the high income, you take on the risk of a decline in Apple’s stock price.  These products were sold when Apple stock was soaring, so a fair number of people apparently saw this as a favorable bet.  With the stock down more than 30% from its peak, many of these investors have lost a considerable amount of money.  Read Zweig’s piece for more details.  These products have a number of variations and he discusses one specific structure.  Here is another.  The title of Zweig’s article, How Apple Bit Bondholders, Too, gives the impression that bonds were responsible for these losses.  This is not the case, but the title serves to illustrate the subtlety of the problem.  Continue reading