ISMS 35: Larry Swedroe – Great Companies Are Not Always High-Return Investments
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Quick take
In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Today, they discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this twelfth series, they discuss mistake number 22: Do You Confuse Great Companies with High-Return Investments? And mistake number 23: Do You Understand How the Price Paid Affects Returns?
LEARNING: Great companies are not always high-return investments. Understand how the price paid affects returns. Rebalance your portfolio regularly.
“Rebalancing forces you to do the opposite of what most people do, which is dumbly chasing returns and ignoring the historical evidence. They ignore the fact that typically, over the longer term, prices tend to revert to some mean.”
Larry Swedroe
In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this twelfth series, they discuss mistake number 22: Do You Confuse Great Companies with High-Return Investments? And mistake number 23: Do You Understand How the Price Paid Affects Returns?
Did you miss out on previous mistakes? Check them out:
- ISMS 8: Larry Swedroe – Are You Overconfident in Your Skills?
- ISMS 17: Larry Swedroe – Do You Project Recent Trends Indefinitely Into the Future?
- ISMS 20: Larry Swedroe – Do You Extrapolate From Small Samples and Trust Your Intuition?
- ISMS 23: Larry Swedroe – Do You Allow Yourself to Be Influenced by Your Ego and Herd Mentality?
- ISMS 24: Larry Swedroe – Confusing Skill and Luck Can Stop You From Investing Wisely
- ISMS 25: Larry Swedroe – Admit Your Mistakes and Don’t Listen to Fake Experts
- ISMS 26: Larry Swedroe – Are You Subject to the Endowment Effect or the Hot Streak Fallacy?
- ISMS 27: Larry Swedroe – Familiar Doesn’t Make It Safe and You’re Not Playing With the House’s Money
- ISMS 29: Larry Swedroe – The Shiny Apple is Poisonous and Information is Not Knowledge
- ISMS 30: Larry Swedroe – Do You Believe Your Fortune Is in the Stars or Rely on Misleading Information?
- ISMS 34: Larry Swedroe – Consider All Hidden Costs Before You Invest
Mistake number 22: Do You Confuse Great Companies with High-Return Investments?
According to Larry, if you ask most investors if they’d rather own companies that have had an average return on assets of roughly 9% and a higher growth rate in earnings or companies that have an average return on assets of about 4% and lower earnings growth, 99% of investors would choose the high return and fast growth companies. One of the most persistent and incorrect beliefs among investors is that “growth” stocks have provided (and are expected to provide) higher returns than “value” stocks. But that shows a lack of understanding of how markets work.
Larry says you should buy the safer investment unless the expected return from the worse investment is much higher to compensate for the extra risk because the market is pricing for risk. He reminds investors that just because value companies have lower growth in earnings and lower returns on their assets doesn’t make them bad investments. It just makes them less glamorous and attractive companies.
When you identify a great company, that’s only one bit of the story. Larry says you have to ask yourself, what’s the price you’re paying? What do you know that the market doesn’t know? And suppose the answer is nothing, which it almost certainly is. In that case, the price already reflects all that great information, which means the PE ratio is likely high, meaning the expected return generally will be lower. If you’re going to buy growth stocks or small stocks, make sure that you’re screening out the ones with high investment but low profitability because they’re not burning cash with high investment, and they can turn around.
Mistake number 23: Do You Understand How the Price Paid Affects Returns?
When forecasting investment returns, many individuals make the mistake of simply extrapolating recent returns into the future. Bull markets lead investors to expect higher future returns, and bear markets lead them to expect lower future returns. However, you need to understand the price you pay for an asset impacts future returns.
Larry says the best investment strategy is not to try to time the markets but instead rebalance. When you do well, and the PEs are going up, you’ll put less into equities and more into bonds or even sell some stocks to buy bonds. And when the PEs are low because stocks have done poorly, you’ll put more money into stocks or even sell bonds to buy stocks. Rebalancing will give you an astronomical diversification benefit.
About Larry Swedroe
Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.