Larry Swedroe's "Reducing the Risk of Black Swans"

[kevink]

I apologize if I've missed discussion of this book, but thought its approach as well as Mr. Swedroe's previous iterations of his "reduced fat tails" portfolios would be of interest here (as they cerainly have been over on Bogleheads).

The book is a quick read - I downloaded it from Amazon and read it in less than an hour - and I find its conclusions as hard to argue with as I would find its recommendations hard to implement, precisely because of the need to be comfortable with major tracking error vs. the broader equity markets for long periods of time, which Swedroe addresses very clearly. Still, a portfolio with 30% or less equity allocation that has performed (and seems very likely to perform in the future) like a classic 60:40 equity:bond allocation but with much less downside risk seems tailor-made for ER. Any thoughts?

Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility: Larry Swedroe, Kevin Grogan: 9780615992976: Amazon.com: Books

 

[target2019]

I would also read about black swan theory.
Black swan theory - Wikipedia, the free encyclopedia

It may give you additional perspective to evaluate the ideas proposed.

 

[samclem]

The review of the book indicates Swedroe is suggesting that retirees consider buying 70% 5 year Treasuries and 30% equities with a heavy small/value tilt. The historic outperformance of small/value is supposed to allow the portfolio to perform as well as one with 60% equities, and having the lower equity %age allows lower volatility. I hope I've characterized that correctly--I haven't read the book.
I agree that value stocks have historically had lower volatility and better performance than growth stocks, and that a portfolio like this might have had lower volatility than a traditional 60%E/40%B portfolio. My portfolio has a small/value tilt for this reason. But I think the book's title may be misleading: All this fiddling and strategizing hinges on small/value stocks behaving as they have in the past. That's hardly a "black swan." If small/value doesn't continue to do well, then these 5 year Treasuries (bought at historically low interest rates) are not going to allow the portfolio to support a 40-50 year withdrawal window unless the withdrawal rates are quite low. And while the high US Treasury allocation would probably do a good job of protecting against a large dip in the equity markets, it might not help an investor much if the black swan is something else (really high inflation, etc).

 

[daylatedollarshort]

And while the high US Treasury allocation would probably do a good job of protecting against a large dip in the equity markets, it might not help an investor much if the black swan is something else (really high inflation, etc).

The matching strategies idea focuses on inflation adjusted TIPS instead of Treasuries for that reason:
Matching strategy - Bogleheads

 

[kevink]

samclem I'd suggest that the book is well worth reading, as there'a a lot more to Swedroe's strategy. What you describe is what became known (thanks to an old NY Times article) as "the Larry Portfolio," but he never recommended just one iteration. All of the portfolios discussed in the book have a high allocation to 5 year Treasuries while being strongly tilted not just to small caps but to value, international and emerging markets.

As for "the future is not the past" objection, that applies equally to any portfolio, including a plain vanilla 60:40 total stock market:total bond market one that has far higher downside risk (the fat tails that Swedroe's approach is all about avoiding).

As for the Treasury allocation, take a look at what happened during the most recent Black Swan event: the 2008 crash. The flight to safety meant Treasuries were what saved your portfolio if you had enough of them, while other bonds cratered along with the equitites. Indeed Larry's portfolios and Harry Browne's Permanent Portfolio were among the very few to survive that event in great shape, but it seems to me Larry's version, though it has the same tracking error issues as the PP, is surely more palatable than one that holds 25% each 30 year bonds and physical gold.

 

[samclem]

samclem I'd suggest that the book is well worth reading, as there'a a lot more to Swedroe's strategy. What you describe is what became known (thanks to an old NY Times article) as "the Larry Portfolio," but he never recommended just one iteration. All of the portfolios discussed in the book have a high allocation to 5 year Treasuries while being strongly tilted not just to small caps but to value, international and emerging markets.

Thanks for the recommendation, I'll research this idea further. But, in general, the more "pinpoint" the allocation categories/prescriptions as based on prior market history, the less robust it would seem to be in future conditions that vary considerably from that history--a true black swan.
Treasuries were good last time. If we see something twice in rapid succession, should we call the second one a black swan?

 

[NW-Bound]

I read Taleb's books a while back; Fooled by Randomness (2001) and The Black Swan (2007). The books predated the crash of 2008-2009. And I recalled that in an interview after the crash, Taleb said that this crash was not a Black Swan, meaning it was predictable by knowledgeable people, that there were plenty of warning signs.

On the other hand, "the rise of the Internet, the personal computer, World War I, dissolution of the Soviet Union, and the September 2001 attacks are examples of black swan events". See Wikipedia.

For what it's worth, but that was from the originator of the concept of Black Swans.

 

[donheff]

I follow Taleb on Facebook. Not a sunny outlook.

 

[eytonxav]

I follow Taleb on Facebook. Not a sunny outlook.

Just remember, no one is omnipotent, even Taleb.

 

[NW-Bound]

I have not read Taleb's work other than the above 2 books. If I recall correctly, his style of investing is to mark time with money made from options, then to jump in to make a killing when the sky falls.

I have always kept some large portion of my stash in cash (I-bond, stable value fund, CD, money market, etc...) to feel safe. And I was too chicken to jump "all in" at the bottom of the market, though I did buy a bit.

So, Taleb's strategy takes a lot of guts.

 

[kevink]

Getting back to Larry's book and investing approach rather than quibbling about what constitutes a Black Swan event, a lot of my interest in what he's saying comes from having ER'd in 2002. As many have pointed out, sequence of returns means everything to a retiree, and especially an early retiree.

Many of you are doubtless familiar with John Greaney's long-running ER site. He ER's himself in 1994 and recently updated his study of real-life retirement portfolio returns from then through 2014. There's some great comparisons here leavened by Greaney's usual irreverence (e.g. his comment about William Bernstein's MPT portfolio vs. a plain vanilla S & P/Bond one). But scroll down to where he looks at performance for those unlucky enough to retire in 2000 and the few portfolios that have remained in the black. The Larry portfolio and PP are just about the only success stories (and both are less impressive in his chart than they would be had he used the proper proxy ETFs):

http://www.retireearlyhomepage.com/reallife15.html

The only other comment I'd make is that for me a key take-away from both Swedroe's portfolios and the PP is that market crashes (whether we call them Black Swans or something else) show which assets are truly correlated and which aren't. Complex slice-and-dice value-tilted equity and bond portfolios (e.g. Merriman's) or, for that matter, conservative allocations like Wellesley, don't offer any real protection in a market crisis. Intermediate or longer Treasuries have. TIPS haven't and didn't during the 08 crisis.

Taleb these days would cast doubt on any governement's bonds as a safe haven and has increasingly been arguing for holding real assets, from timber land to income properties that are at least one step removed from the financial market's reach. That sounds way too much like real work to me, but I can certainly see his point.

The other thing I really appreciate about the Swedroe book is the metrics he provides for looking at equity valuations and likely returns going forward. It just underlines why so many of us think that there's no good, let alone great, choice in the current economic environment, with equity valuations quite high, bonds returning less than nothing after inflation and commodities in the toilet.

 

[NW-Bound]

... so many of us think that there's no good, let alone great, choice in the current economic environment, with equity valuations quite high, bonds returning less than nothing after inflation and commodities in the toilet.

So, why not stay diversified and wait to see how the chips fall?

 

[MooreBonds]

Getting back to Larry's book and investing approach rather than quibbling about what constitutes a Black Swan event, a lot of my interest in what he's saying comes from having ER'd in 2002. As many have pointed out, sequence of returns means everything to a retiree, and especially an early retiree.

Intermediate or longer Treasuries have. TIPS haven't and didn't during the 08 crisis.

I remember some people saying that there simply wasn't as great demand for TIPs compared to flat-rate treasuries; although, there's also the fact that with TIPs, you get a flat rate plus inflation. During a true crisis, demand will likely fall - which usually brings about very subdued inflation (or even deflation). Which would naturally force the overall TIPs interest (payments and inflation adjustment capital gain) down to a relatively low number. Meanwhile, the flat-rate traditional treasury bond will still pay out the higher rate, which would bring about much higher capital appreciation.

 

[daylatedollarshort]

Our current plan is to spend < pensions, SS, hobby income and interest/dividends. We have CD and TIPS ladders we never sell, just let mature and roll over. TIPS mature at principal or inflation adjusted principal, whichever is greater, so with usually buying at auction we aren't too concerned about prolonged deflation.

For inflation protection we have SS benefits, one partial COLA pension, a 30 year fixed mortgage offset with non-COLA pensions and nominal treasuries paying more than the mortgage rate, I-bonds, TIPS ladders and the house, which has historically appreciated at twice the rate of inflation. We won't make a killing on our portfolio, but we also won't go broke, and if all goes according to plan we hope to improve on our net worth a bit still through continued savings.

I am sure there are unknown unknowns that could still sink us, but this is so far the best plan we could come up with to insulate us from Black Swans or market turmoil. I guess it won't help if there is a government collapse or asteroid strike.

 

[Zorba]

The review of the book indicates Swedroe is suggesting that retirees consider buying 70% 5 year Treasuries and 30% equities with a heavy small/value tilt. The historic outperformance of small/value is supposed to allow the portfolio to perform as well as one with 60% equities, and having the lower equity %age allows lower volatility.

As kevink notes, you can get an idea of how well the Swedroe portfolio does relative to others by looking at John Greaney's comparisons from 1994 to 2014. Just doing a simple Chi-by-eye shows that Swedroe's portfolio performs as well as many of the others by with much less volatility.

I did this quickly by looking at the drop between 2007 and 2008. A 75/25 portfolio dropped 30%, while a 60/40 dropped 24% and a Berkshire Hathaway dropped 26%. I would guess that not many people would hold at a 4% SWR in the face of a 25% year-to-year drop in their portfolio.

A Swedroe portfolio dropped only 8% during the same time. That is even a slightly smaller drop (8.9%) than the (poorly performing) pure fixed income portfolio.

 

[kevink]

There's a thread that I think is quite relevant to this discussion on the Permanent Portfolio discussion forum. I'm just linking to the last two pages but you may find the entire thread of some interest. The most recent post compares one of Swedroe's portfolios with the Permanent Portfolio. The earlier charts in the thread by an Excel whiz named Tyler speak volumes about why these approaches (PP and Larry portfolios) trounce a plain vanilla 60:40 portfolio - especially for retirees:

Worst 3 year PP performance ever? - Page 2

 

[samclem]

The earlier charts in the thread by an Excel whiz named Tyler speak volumes about why these approaches (PP and Larry portfolios) trounce a plain vanilla 60:40 portfolio - especially for retirees:

Worst 3 year PP performance ever? - Page 2

Nice charts to look at, but they hide a lot of data due to the ">" and "<" in the color key. This helps the low volatility PP look better (lots of green!) and doesn't give sufficient "credit" to the high volatility, high return TSM portfolio (e.g. from 2012 through 2014, the VGD Total Stock Market had a total return of 72%, or approx 20% CAGR. The chart just shows it did "better than 9%" Yeah--LOTS better).

Tyler's charts go out just 10 years. The PP has just 25% stock, the rest is in bonds and gold. If that mix is going to lose ground to inflation compared to the more conventional 40-60% stock, 40-60% bond portfolio, it might take longer than 10 years.

I think what most ERs want is enough sustainable long-term growth to stay ahead of inflation. Low volatility is a plus, but if it comes at the expense of a greater likelihood of losing out to inflation over 20-40 year periods, then somewhat higher year-to-year volatility is preferable. In my opinion . . .

 

[kevink]

Who holds 100% TSM and can live with its volatility without changing their allocation samclem? Probably no one. For that matter, how many DIY investors with plain vanilla 60:40 allocations stayed the course during a three year long loss of 31% of their portfolio value?

If you're looking at total returns, the PP has had a CAGR of 9.22% from 1972-2014 with a standard deviation of 7.96% and a worst single year loss of 6.13%. A 60:40 Total Stock:Total Bond portfolio over the same time frame has a CAGR of 9.66% and a worst year loss of 20.20%.

I think what most ERs want is sustainable growth WITHOUT huge swings that cause most to not stay the course. The PP and other low fat tails like Swedroe's offer the returns of a high-equity portfolio without the wild ride.

 

[samclem]

If you want low volatility, then the PP is a fine choice for you.

P.S. Regards "staying the course": I don't know if investors in the PP do much better than anyone else. They have to be willing to put up with long periods of underperformance (compared to more conventional portfolios), and that can be very unsettling. Take a look at flows out of PRPFX (The Permanent Portfolio mutual fund--admittedly not precisely the same as Harry Browne's design, but the closest institutional product we have to look at). Investors have not "stayed the course": the fund had $18B in assets in 2012, since then $12B has been withdrawn by investors. Patience and discipline is needed with any asset allocation, and I don't see evidence that the PP provides a ready "fix" to the foibles of human nature.

 

[mathjak107]

the permanent portfolio fund has had very little in common with the 4 part basic philosophy. .

the fund has basically become weighted for inflation and prosperity and in that respect no different than any other fund that bets on a particular outcome. their bet was higher inflation that didn't happen and the last 5 years was awful for the fund.

but the 4 part diy is not the same thing..

prpfx was down in 2008-2009 while the 4 part basic diy was up .

i used to do it it for decades but to tell you the truth i gave it up not because of performance but out of boredom , it was like watching paint dry.

it may be the way to go once again retirement with a portion of the portfolio money..

 

[samclem]

i used to do it it for decades but to tell you the truth i gave it up not because of performance but out of boredom , it was like watching paint dry.

See?! You couldn't "stay the course" either!

It would be interesting to see a FIRECalc-type run of the "classic" 4 assett Harry Browne portfolio vs a more conventional 60S-40B portfolio with 3% to 4% withdrawals and the long historical data set (i.e. not starting in the 1970s). How would median available spending rates compare over 30 year timeframes using the "4% of year end portfolio value" withdrawal method? While gold has sometimes "comes through" to help portfolio values, it doesn't always do it at the right time, and overall it is a considerable drag on overall performance (when compared to the stocks it displaces--those dividends can be darn handy and gold ain't paying any).

IMO, the strongest case for the PP is in a real disaster (international depression, bank system failure, loss in confidence in the currency, hyperinflation, etc). A real "black swan" in the classic sense--an event that most people agree is impossible/extremely unlikely. And even Harry Browne's classic portfolio assumes US Treasuries will stay "solid", something that the more hard-core "financial preppers" would not agree with today. Harry liked Swiss instruments back in the day--I wonder what he'd think of the more recent Swiss proclivity to link/delink their currency with the euro. And why exactly 25% to each "pot"--seems suspiciously like TLAR*. Maybe 10% - 15% gold is enough to cover contingencies--where did 25% come from? Or maybe Harry was just being honest: TLAR is the best any of us can do, implying more precision in our AA given the real data set and huge assumptions may be just kidding ourselves.

Protecting against "black swans" may reduce a portfolio's ability to perform well in normal circumstances--the ones most likely to happen.

*TLAR: That Looks About Right

 

[kevink]

If you did want to read more about the PP samclem - it doesn't really sound like you do - the recent book on it by Craig Rowland and J.M. Lawson answers all of the questions you asked and many more. There are good reasons for the 4 x 25% allocation and the performance speaks for itself. As for backtesting it, or any other portfolio, it gets to be a mirage in all cases since most of the assets we can invest in today haven't been available to ordinary investors long enough for the statistics to mean much. One couldn't purchase stocks, bonds or treasuries in small amounts without paying high commissions and front-end loads until the early 1980's. Sector stock funds (e.g. small caps, international, value, emerging markets), commodity funds (including paper gold, which has certainly distorted that market), etc. are also quite new.

That said, I'm far from being a PP purist myself and I raised some of the questions you asked (and a bunch more) in the thread on the PP site I linked to earlier. Harry Browne changed the components of his portfolio during his lifetime and I very much doubt he'd recommend the 4 x 25 allocation today without further tweaking, given, as you point out, the fact that "full faith and credit of the U.S. Government" is arguably as much threat as promise given our politiician's willingness to use it as a political bargaining chip, the obvious manipulation of gold prices and - last not least - the growth of non-U.S. equities to ~55% of investable assets.

Realistically I think other reduced fat tails approaches make more sense going forward, but what Swedroe (and Harry Browne long before him) are pointing out is that money you can't afford to lose belongs in something other than an accumulation portfolio like the 60:40. I was just reading Rick Ferri's latest blog post and came across this piece, which I think puts the percentages in pretty clear perspective:

The Center of Gravity for Retirees

 

[samclem]

If you did want to read more about the PP samclem - it doesn't really sound like you do - the recent book on it by Craig Rowland and J.M. Lawson answers all of the questions you asked and many more.

Thanks for the lead. I'm not sure why you'd think I don't want to learn more about the PP--I'm not an expert, but I did read one of Harry's books cover to cover, which probably indicates I'm more interested than 95% of people.

.

I was just reading Rick Ferri's latest blog post and came across this piece, which I think puts the percentages in pretty clear perspective:

The Center of Gravity for Retirees

Thanks. We had a good discussion on Ferri's new position a few months ago, you might find it interesting. It's here. I did not find his reasoning to be very convincing or appropriate for ERs, which was a disappointment. There are some good charts and info in that thread--in a nutshell, 30% stocks is just too low to support the withdrawal rates (3.5% to 4%) most ERs expect/need for the long term (30 years+), given historical inflation rates.

 

[daylatedollarshort]

what Swedroe (and Harry Browne long before him) are pointing out is that money you can't afford to lose belongs in something other than an accumulation portfolio like the 60:40.http://www.rickferri.com/blog/investments/the-center-of-gravity-for-retirees/

The PP still uses a diversification strategy, not a hedging and insuring strategy as in the matching strategies. According to the Boglehead wiki, matching strategies only work with fixed income and insurance products. The basic idea is "stocks and mutual funds cannot be used in matching strategies. For the money you ‘must’ have, use matching strategies and for the money you would ‘like’ to have, use diversification and risky assets."

 

[kevink]

Thanks for that link samclem. It's an excellent discussion and I particularly appreciated the posts about a "glide path" based on Wade Pfau's approach (and wish I'd known about it when I ER'd in 2002, on the heels of one market implosion and just six years before a much bigger one!).

I agree with you that Ferri isn't talking about ER's with that allocation, but Swedroe certainly is. The difference - and this is what's missing in the Ferri thread - is that folks on this board are talking about a 30% Total Stock Market or S&P allocation while Swedroe's talking about only having small value, international small value and emerging markets in that 30% equity calculation.

Running the numbers from 2000-2014 on PortfolioAnalyzer.com (time frame chosen because it's a recent and really stretch for the markets), when I compared a 60:40 Total Stock:Total Bond to 15% SCV, 7%IV, 8%EM and 70% Intermediate Treasuries I get a CAGR of 5.61% for the plain vanilla portfolio with a SD of 11.22% and a worst year result of -20.20%. The Larry portfolio has a CAGR of 7.42%, a SD of only 4.20% and a worst year loss of 2.63%.

Swedroe's book shows quite conclusively that the small cap and value premium is consistent through any 10 year cycle you want to look at. That's backtesting of course and who knows what the future will bring, but any way you look at it having a 30% allocation of the right equities beats living with 60% allocated to the wrong ones.