'Mistakes Even Smart Investors Make And How To Avoid Them': Larry Swedroe And The Zen Of Passive Investing

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Larry Swedroe is principal and director of research for both Buckingham Asset Management, LLC, a Registered Investment Advisor firm in St. Louis, Mo, and BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. BAM Advisor Services currently has 130 participating firms. Buckingham currently has $3.5 Billion in assets under management, while the BAM network of advisors has an additional $10.9 Billion in AUM.

Swedroe was among the first authors to publish a book that explained passive investing in layman’s terms — The Only Guide to a Winning Investment Strategy You'll Ever Need. He has since authored or co-authored 10 more books including 2011's The Quest for Alpha and most recently, Investment Mistakes Even Smart Investors Make and How to Avoid Them.

Seeking Alpha's Jonathan Liss recently caught up with Swedroe to discuss a handful of the 77 common mistakes he touches on in his latest book and delve deeper into how investors can gain enough self-awareness to avoid repeating these mistakes time and again. Excerpts from their lengthy discussion follow:

Jonathan Liss (JL): Your previous book The Quest For Alpha was one dimensional in that it really just looked at the 'active vs. passive' question and didn't really delve into practical investing strategies. You get a lot more into the practical side of things in Investment Mistakes Even Smart Investors Make - And How To Avoid Them. What would you say your main goal was this time around?

Larry Swedroe (LS): It's relatively easy to pick up the necessary knowledge to design an investment plan (For example, I wrote about this topic in The Only Guide You'll Ever Need To The Right Financial Plan). Executing your plan is an entirely different story. As Warren Buffett has been quoted as saying, "Investing is simple, but it's not easy." So the purpose of this book is to at least make investors aware of the emotional mistakes that are most commonly made.

If you're honest with yourself and realize you keep on making these same mistakes, you may want to hire an advisor to help avoid committing these common emotional errors. Any good, honest financial advisor will admit that they're a better advisor than investor. Because with your money, they're able to remove emotion from the process. With their own money, they are subject to the same kind of mistakes everyone makes, though hopefully they do a better job managing their emotions.

JL: Reading the book, it seemed to me that just about all of the 77 investing mistakes you discuss can be placed on one of two sides of the emotional spectrum: mistakes that result from greed and ones that result from fear. So on one side you have people being greedy, trying to beat markets when almost all evidence demonstrates just how unlikely they are to achieve that over the long run. On the other, you have investors routinely selling low, after a huge sell-off, even if intellectually they know that that's the best time to buy. And it seems it's not only retail investors but many financial professionals that fall into this emotional trap as well.

Since humans are by and large emotional animals, how can investors remove emotion from their investing process?

LS: I think there are two things that are needed. The necessary condition for success is to have a well thought out plan. Without that you have zero chance of success, without just being lucky. You need to put your asset allocation plan into writing. Then you have to know your financial history in developing that plan.

The world is filled with crises - we have them all the time. I recently listed 17 since 1973 alone for clients. If you go back to 1926, roughly 30% of the years have been negative in the 86 years since. We've had great depressions. In 1973-74, U.S. stocks were down roughly 50%. Same in 2000-2002. We were down about 55% at the low in 2008-09. So you have to know with almost complete certainty that we will see that sort of event again and be prepared in your asset allocation plan for it to happen.

Of equal importance, you have to have the discipline to stick with your plan. That's the harder part. Can you rebalance (which in practical terms means increase your allocation to equities following a sell-off) in the midst of a bear market? You have to be honest and know if you can do it yourself, or if you need help. In my experience, most people, even if they have the skill set to develop a proper asset allocation plan, don't have the discipline to stick to it. Even on the 'Bogleheads' site, I wonder how many of them actually stuck to their plan in 2008? And these are people that are committed to passive investing strategies.

We are very meticulous in educating our clients about risk, showing the worst year for equities, the worst three-year periods. And my non-precise estimate based on talking to our advisors (in the BAM Advisor Services network) is that 30% of our clients didn't let us rebalance in 2008. They said, "I know I'm supposed to but my stomach can't take it." And they allowed themselves to drift away from their desired asset allocation. I said to them, "You don't want to rebalance, fine. But at least admit your committing the minor misdemeanor of not rebalancing." Of course, that's far better than the major felony of panic selling.

JL: Morningstar just put out its 2011 mutual fund report and it showed a slight uptick in the use of passively managed funds, from 12.3% at the end of 2010 to 12.9% at the end of 2011. I saw another report from a mutual fund industry group recently that 85% of new mutual fund sales were in active funds. Why do the majority of investors keep piling into active funds, despite overwhelming evidence that the great majority of these funds underperform passive index funds?

LS: For starters, many 401(k) plans push active funds very hard. They aren't really transparent and don't offer people proper choices. The companies that market these plans often even waive plan fees to make sure the money ends up in (more expensive) active funds. Same problem in pension funds, where there's a committee being paid to study all the different active funds. If you go passive, they're all out of a job.

Second, the media and Wall Street are in a 'conspiracy' (and I'm putting that term in quotations) to keep the public believing that active management is the best strategy, because it's the winning strategy for them. If everyone switched over to passive funds, there'd be no CNBC, no need to buy Money Magazine to tell you which were the hot funds, and most of Wall Street would disappear because they wouldn't earn these big fees.

Third, the education system has totally failed the American public. Unless you've gotten an MBA in finance, the odds are you've never taken a single capital markets course.

What we are seeing is that at least the trend (towards passive investing) is right. So from 1977 when Vanguard was founded until today, we've at least gone from 0% in passive funds (among retail investors) to 13%. In that same time frame, the institutional world has adopted passive funds even faster. They've gone from maybe 15% in the 70s to perhaps 40%. The reason for that is that they're much more aware of all the academic research.

And then, there's always the triumph of hype and hope over wisdom and experience. And of course there is the all-too-human error of overconfidence, another mistake discussed in the book. While most will admit that it is difficult to beat the market, they believe, or convince themselves, that they will be one of the few to do so.

JL: I'd like to now go through some of the specific mistakes from the book and flesh them out a bit more.

Mistake 21: "Do you fail to consider the costs of an investment strategy?"

All over CNBC and the web, you see people touting active strategies where they even seem to be able to provide data, at least on a pre-tax basis, that they are outperforming benchmark indexes. The success of certain momentum strategies is one example that comes to mind. I'm sure you have people confronting you all the time saying, "It's not true that passive investing is better. I have a surefire active strategy that has worked for me." How do you respond to these sorts of claims?

LS: First let's back up and respond to this momentum question. There is good literature - at least before expenses - that momentum outperformance does exist, and it exists across the spectrum of currencies, commodities, equities, bonds, almost any asset class. The question going forward is now that the data on momentum is well known, can the outperformance continue to persist?

Another point to consider is that momentum is generally a long-short strategy and going short something can get very expensive, especially with equities. You can design a long-only momentum strategy, but then the premium gets much smaller.

Finally, momentum strategies tend to be high turnover. You can have 200% or even 300% turnover so you better be able to trade at very low costs. Also, with that much turnover, such a strategy is almost certainly going to be very tax inefficient, though there are some offsets as momentum tends to produce lots of short term losses and more long term gains.

I've looked at the work that firms like AQR/Cliff Asness have done and any reasonable estimate of trading costs still seems to show that there are returns there after expenses. It's important to decide whether you think that will still be the case going forward, with so many people chasing this strategy.

Now it is possible to do momentum in a passive strategy. That's what AQR does. The only thing they are adding is some algorithmic trading that keeps trading costs lower. But they're not (actively) deciding which stocks to buy so it's definitely a passive strategy. DFA has also been using long-only momentum strategies in its funds since 2003.

Getting back to the original question (regarding active strategies that do seem to work), here's a good example of trading costs: what was called the Valueline enigma. Stocks that were given the top rating by Valueline far outperformed the market. This raised a serious question: if markets are efficient, how can this be? For some time it couldn't be explained. So Valueline went and it created funds to try to exploit this. And the funds underperformed.

What a study found was this was what was happening: Valueline would come out with its ratings on Friday night. The outperformance was measured from Friday's closing price. By the time you could buy those names on Monday when the market reopened, the prices had been driven up already (basically as soon as the first trade went through). So while the outperformance may have been there on paper, there was no way to exploit it.

You really have to be careful to measure the true costs of a strategy. Strategies have no costs, but implementing them does. Bid-offer spreads, market impact costs, trading commissions, and especially taxes all weigh into whether a strategy is actually profitable in the real world, and not just on paper.

JL: Mistake 31: "Do you believe hedge fund managers deliver superior performance?"

I'm not sure if you've seen anything on Simon Lack's new book, The Hedge Fund Mirage. In it, he produces an astounding statistic:

Between 1998 and 2010, even on favorable assumptions, hedge fund managers earned an estimated US$379bn in fees, out of total investment gains (before fees) of US$449bn. In other words, they took 84% of the investment profits their funds made, leaving just 16% for the investors.

Why do seemingly intelligent people, that have clearly been successful in some other area of their lives, continue handing over money to hedge funds, despite the preponderance of data showing that they are likely to underperform or worse yet, see their initial investment wiped out completely?

LS: Here's the hedge fund data we've been tracking via the HFRX Global Index from 2003-2011. Last year (2011) that index lost 8.9% (after fees). If you took a passively indexed, globally diversified 60/40 stock/bond portfolio (using 5-year Treasuries) that was equally weighted across 10 asset classes, you would have been down 0.4% in 2011. From 2003 to 2011, the HFRX global index was up just 1.4%, underperforming every major asset class including 1-year treasuries.

As I see it, hedge funds are like Rolex watches and Gucci bags. A Timex $50 watch tells time almost as well as a $20,000 Rolex. People buy the Rolex because it projects prestige, sophistication and status. It's the same reason they invest in hedge funds. To convey all of those things. It's ego driven. It's the same reason people invested with Madoff - to be a member of an exclusive club (Groucho Marx's famous line about not wanting to belong to a club that would have him as a member is appropriate here).

I deal with a lot of high net worth individuals in my practice and so much of what they do I believe is ego driven. They want to invest with Goldman Sachs, because they think they're the smartest guys in the room. I did a performance analysis of Goldman's mutual funds. They're one of the few fund families I've seen that underperformed a group of simple DFA funds in every single asset class - and miserably! It's hard to do that on purpose.

Clearly there are some hedge funds that have done well. But the data shows there's no persistence in performance. One reason is once you crowd into a strategy because it works, the alpha disappears. So they have to always be ahead of the curve.

JL: Mistake 44: "Do you believe diversification is the right strategy only if the investment horizon is long?"

In the asset allocation chart in that chapter you recommend a maximum allocation of 0% to equities if your time horizon is 3 years or less. Yet the crux of this chapter seems to be that investors make the mistake of tightening up too much when the time horizon is shorter when what they really need is exposure to non-correlated assets - probably more so over shorter periods than over longer ones.

For example, William Bernstein, in The Intelligent Asset Allocator, recommends some nominal stock allocation for investors already in retirement - I believe it's 7%. Same for investors with a very long time horizon - Bernstein still recommends a nominal bond allocation to both smooth long-term returns, and offer the best long-term returns while lowering the overall level of portfolio risk. Why then the 0% equity allocation for those with a horizon of 3 years or less?

LS: We know there are periods when stocks do well and bonds do poorly, and vice versa. We also know that stocks have low correlations with safe fixed income instruments like CDs, Treasuries, High Grade Munis and High Grade Corporates. So there's an undeniable benefit in diversification.

I generally tell clients that if their horizon is long enough, the data shows they should actually have more than a nominal amount in equities - more like 20% or even 30% (depending on an investor's risk tolerance) - and that should be diversified globally. That way you don't end up in Japan in 1990 and your entire equity position is in the Japanese market (the Nikkei Index is still down about 75% from its high of more than two decades ago).

If we look at equity returns in the various asset classes, maybe the spread between the highest and lowest return is 7 or 8%. So U.S. Large Growth returns roughly 7% vs. Emerging Market Value which returns 15% or whatever the exact number is. It's not that big a gap. Now if you compound that annually you get a big number. But the difference in annualized returns isn't that big.

However if you look at any one year, the return gap can be huge. So in 2011 the S&P 500 was up 2% and Emerging Market Value was down 26%. That's a huge difference in performance. In short periods you can have massive gaps in performance.

Another example: In 1998 the S&P 500 was up 28% while Small Value was down 10%. In 2001 the S&P 500 was down 12% while Small Value was up 40%. If you own some of each, your year to year returns are less volatile. When is that most important? In retirement. We know volatility is especially bad in retirement, because when you withdraw funds, you don't get the rally on the way back up. Even very conservative investors should globally diversify their allocation to equities across asset classes to dampen volatility.

And speaking of retirement, people make the mistake of thinking "I'm 62, my end date is in 3 years." Retirees need money to last them 25 or 30 years with life expectancies being what they are these days so certainly someone approaching retirement would want a fairly significant allocation to equities.

Getting back to the 0% equity allocation for horizons of less than three years, the reason for that is if you absolutely need the funds, say to buy a home, or for college tuition, the risk of losses is too great to have any equity allocation. What I recommend is that for all large and known expenses you create a separate investment policy statement with its own asset allocation, adjusting the equity allocation downward as the expenditure date approaches. What you might call a bucket approach.

JL: Mistake 66: "Do you confuse indexing with the exclusive use of an S&P 500 fund?"

Speaking of index selection, why compose the asset allocation models you recommend for clients with cap-weighted indexes? Why not instead use equal-weighted indexes, which on a more granular level adhere to the same principle of 'rebalancing' you advocate on a portfolio-wide level? After all, by equal-weighting within an index, you are forced to buy low and sell high, unloading positions in stocks that have run up over a set period (6 months for example) and buying more in names that have experienced a sell-off over that period. Now I recognize that to a large extent the outperformance premium seen in equal weight strategies is just a reflection of the tilt to smallcaps and value but along the logic of what you suggest on a portfolio-wide level, equal weighting seems like the logical extension of this concept, i.e. regular rebalancing on a more granular, index-specific level.

LS: Let's drill down here, because the point you raise is an excellent one. The first index funds only date back to 1973. When John McQuown at Wells Fargo went to create the first S&P 500 index fund, he looked over the data and originally wanted to create a fund that was equal-weighted, because the historical returns were better than on the cap-weighted version (we didn't realize this better outperformance was the result of the size and value effect until Fama and French came along in the 1980s). But where strategies have no costs, implementing them does. It would have been too expensive to rebalance the fund daily. So McQuown switched to a market cap-weighted S&P 500 fund, where rebalancing is unnecessary and the costs of implementation are much lower as a result.

In the portfolios we design for clients, we choose how much to tilt to risk factors like small cap and value by using cap-weighted funds. So we can tilt as much to these factors as we like. We specifically like using passive cap-weighted funds from DFA and Bridgeway, because they have tax managed funds for use in taxable accounts, and utilize certain index optimization and trading strategies that keep overall costs very low for our clients.

JL: I'm always amazed at how recent all of these studies and events like the creation of the first S&P 500 index fund are.

LS: It's all because of computers. Before computers it would have been impossible to study all of this data. Or prohibitively expensive. And now computers are so fast you can just dump databases into them and torture the data until it confesses.

JL: So it seems computers have made the Efficient Market Hypothesis a self-fulfilling prophecy to some extent.

LS: Not just to 'some extent' - to a very large extent. No question about it. Anomalies (in performance) are now discovered and exploited very quickly, making them disappear much faster. In general, information travels much faster.

JL: There seems to be somewhat of a catch 22 built into the Efficient Market Hypothesis and the types of modern portfolio theory that result from it. We touched on this in a previous interview when I asked you what would happen if everyone became passive indexers?

Put differently, the only reason markets are efficient is that so many people are trying to exploit any inefficiency that it becomes impossible to beat the collective wisdom with any regularity. Isn't this price discovery process, borne out through active strategies that constantly try to beat the market (generally to no avail), necessary for markets to remain efficient? Theoretically if the pendulum shifted and most investors became passive indexers, wouldn't markets suddenly become a lot less efficient - and a lot more easy to exploit via active strategies - as a result?

LS: For starters, it's important to differentiate between 'price efficiency' and 'information efficiency'. When there are more traders, more people doing research, the quality of information is better and markets become more efficient. They also become liquid. As a result of this liquidity, the cost of exploiting market inefficiencies is relatively low but information efficiency is so high that it becomes very difficult to beat the market. That's not to say no one can do it. There have been (very) few individuals who have proven they can do it consistently. But if you look in the mirror and don't see Warren Buffett, odds are you're not going to be the one to do it.

On the other hand, if there are less people trying to beat the market, less traders and research specialists, the odds of discovering a pricing anomaly go up. Subsequently, with less active traders in the market, liquidity dries up. Bid-ask spreads and market impact costs go way up, making it that much more difficult to beat the market after costs.

As an example of how we know this is true, we already see this connection between informational and pricing efficiency demonstrated in certain markets. Much fewer people track some tiny micro cap name than Johnson & Johnson (NYSE:JNJ). Yet, we don't see any evidence of microcap managers outperforming markets with any persistence. Even though these managers track markets that are far less informationally efficient, the costs of their funds tend to be considerably higher, because the price of implementing their strategies via higher trading and research costs are elevated relative to more efficient markets, like U.S. Large Caps. We don't see any evidence of persistent outperformance in emerging markets either - they are clearly also informationally less efficient than your typical developed market. But the cost hurdles you need to overcome are higher as well.

The general rule of thumb is as markets become less informationally efficient, price inefficiencies become more expensive to exploit. In the end it all balances out.

One thing remains a constant though: Wall Street thrives on the illusion of being able to create alpha. They will always win when they're pitted against the retail investors that buy their funds.

One final story. I met with a well known hedge fund manager who has a very strong math background. All the people he hires are also a bunch of rocket scientists. And he was headed towards a career in scientific research when the hedgies got him. So I asked him, "Why keep on playing the game? I understand, you made more money than you ever could have imagined. Once you reached $20 or $30 million, why not go back to scientific research and contribute to society in some meaningful way. Cure cancer. At this point (in your finance career) you're just shifting the pieces around, extracting wealth from others." His reply was basically, "You're right Larry. But there's always the challenge to prove that you're still the 'biggest swinging dick in the room'."

It's one of the biggest tragedies in our society that the smartest people aren't out curing disease, or making the world a better place in some way. They're shifting money around for their own personal gain. And it's as much about ego as greed. When you invest passively, you have time to do what's really important in life. It allows you to spend your time on the things you really love, and with the people you really love, instead of spending your time trying to beat some system that is unbeatable for most people anyway.

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