I continue to read the 2018 edition of Reducing The Risk Of Black Swans by Swedroe and Grogan, and I'm thoroughly enjoying the intellectual exercise.
Today, I'll share my latest A-ha moment.
When designing a portfolio, we often use the terms risk tolerance or risk aversion. The caveat to using these terms is that investors don't have a terrific way of accurately quantifying such concepts, and attempts to do so often fail miserably when an actual recession or major correction occurs.
Benjamin Graham, a Columbia University business professor and Warren Buffett's mentor, famously endorsed a maximum exposure of 75% stocks based on his experience with investor risk aversion.
I wonder if perhaps the problem is with the term. Investors are not risk averse so much as they are loss averse. The literature of behavioral economics, brilliantly investigated by Kahneman and Tversky, demonstrates that it pains humans more to lose a buck than to gain one. The logical implication is that investors are more likely to stick with an equity allocation as long as they can reduce their down side risk.
Here's where Swedroe and Grogan re-enter the discussion, suggesting you can reduce portfolio volatility (and thus down side risk) without reducing expected returns by making two interesting, counter-intuitive moves:
- Reduce your overall allocation to stocks.
- Alter your stocks to tilt heavily in favor of the Fama and French factors, small size and value, so that the portion of stocks you hold have an increase in expected return.
Okay, your mind is reeling. Mine is too. Let's review some pertinent fundamentals before we flesh this out a little more.
Great Moments In Finance
Following is an abbreviated primer of influential moments in understanding investment theory. I'll favor brevity at the expense of detail, so please forgive the lack of nuance:
- 1952: Harry Markowitz publishes a paper introducing modern portfolio theory, where he shows that an individual stock's risk and expected return is not important; rather, it's the contribution it makes to the portfolio as a whole. He gives birth to the idea that adding uncorrelated assets to a portfolio can optimize return while minimizing risk - also know as the efficient frontier. He later wins a Nobel prize for this concept.
- Capital Asset Pricing Model: defines the relationship between risk and return through a single factor, market beta. Market beta measures volatility relative to the market. Thus stocks have high market beta (their values are more volatile than the market as a whole), while T-bills have low market beta.
- Over a long time horizon your expected return can be explained by the proportion of stocks to bonds (high market beta to low market beta investments) you hold.
- 1992: Fama and French introduce a three factor model, demonstrating that stock returns can be explained not just by a stock's market beta but also by its size (stocks with smaller capitalization, i.e smaller companies) and value (stocks with low prices relative to book value, i.e selling at a discount). Size and value are independent risk factors, and provide exposure to different risk than market beta does. Thus size, value, and market beta are poorly correlated over long time horizons. This is believed to be because small and value companies carry greater risk, and the market rewards that increased risk with greater reward.
- Over a long time horizon your expected return can be explained not only by the proportion of stocks to bonds (high market beta to low market beta investments) you hold, but also by any increased exposure to value or small stocks which account for an independent additional risk premium.
Enter the Larry Portfolio, so dubbed in a 2011 NY Times article based on Larry Swedroe's unorthodox investing strategy: reduce the proportion of stocks you own, but increase the risk (and commensurately increase the expected return) to preserve the expected returns you project will help you meet you investing goals.
To understand what the Larry portfolio accomplishes, think of the bell-shaped curve that encompasses statistical distributions on either side of the arithmetic. When you invest, you are creating your own bell curve around your expected return. The potential range of outcomes dispersed on either side of the mean is represented by the standard deviation, a frequently used measure of investment volatility.
Bonds have a narrow dispersal range, corresponding to a low standard deviation. An all bond bell curve is narrow and tall.
Stocks, in contrast, have a wide dispersal range, corresponding to a high standard deviation. An all stock bell curve is broad and short.
What the Larry portfolio does is modify the shape of the bell curve to specifically narrow the dispersal (reduce the standard deviation) of the overall portfolio. Even though the Larry portfolio includes some highly volatile components (small value stocks), it contains them in small enough quantities that the overall bell curve has the narrow dispersal range more characteristic of bonds while possessing the increased expected returns characteristic of stocks.
To illustrate the principal, let's make some reasonable mathematical assumptions based on historic returns to use in assembling your theoretical portfolio. (It should go without saying that past performance does not guarantee of future results.)
- Total stocks have a 7% expected return
- Small value stocks have an 11% expected return
- Bonds have a 5% expected return
Let's also assume you are an investor who, after factoring in your annual contributions and expected age of retirement, needs to achieve 6.5% returns from your investment portfolio as a whole in order to retire at a spending level that will support your lifestyle.
A 75/25 stock/bond portfolio has an expected return of (75%*7%)+(25%*5%) = 6.5%. The price of an expected return meeting our stated goal is significant volatility from the high stock allocation. The bell curve is broad and short. Considering that stocks may lose 40-50% of their value during a severe bear market, many investors will not tolerate such high volatility and will seek a more conservative allocation.
Compare that to a less risky 50/50 stock/bond portfolio which has an expected return of (50%*7%)+(50%*5%) = 6%. The bell curve is narrow and tall. The reduced volatility of this portfolio means you'll fall short of your goal.
Let's look at what happens if instead you decide on a 50/50 stock/bond portfolio where stocks are split evenly among a total stock market index fund and a small value stock index fund. In this case the expected return is (25%*7%)+(25%*11%)+(50%*5%) = 7%. You've juiced up your expected return while maintaining the lower volatility that comes with a 50/50 portfolio. You now exceed your target, and the bell curve is narrower and taller than it would be with an all stock portfolio, but broader and shorter than it would be with an all bond portfolio. We've created a weird and wonderful hybrid with desirable attributes of both curves.
Finally, let's reduce your risk even further by choosing a 40/60 stock/bond portfolio, again splitting stocks evenly among a total stock market index fund and a small value stock index fund. This yields (20%*7%)+(20%*11%)+(50%*5%) = 6.6%. Still meets our target, with the benefit that volatility is further reduced (this bell curve is narrower and taller than the 50/50 portfolio above).
Reduced volatility in a portfolio means that investors who struggle with loss aversion (i.e., all of us) will feel less pain and thus be less likely to sell stocks in a downturn - the classic investing mistake that undermines even the best thought out investment policy statements.
The gift of reducing volatility while maintaining higher expected returns needed to meet retirement investing goals is the gift of the Larry portfolio. Psychologically, reducing down side risk makes you likelier to stick with your plan.
In the end, the Larry portfolio is about playing a mind game to induce you to act in a manner aligned with your interests. Kind of a neat party trick!
If you are navigating a personal or professional crossroads and seek assistance, I'd be grateful if you'd consider my burnout coaching service. Thank you.