ISMS 38: Larry Swedroe – The Self-healing Mechanism of Risk Assets
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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 Larry’s recent piece, The Self-healing Mechanism of Risk Assets.
LEARNING: Don’t engage in resulting because there will be periods when an investment will underperform and others when it outperforms. Resist recency bias. Avoid performance chasing.
“You don’t want to engage in resulting because there will be periods when an investment will underperform and others when it outperforms.”
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. Today, they discuss Larry’s recent piece, The Self-healing Mechanism of Risk Assets.
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
- ISMS 35: Larry Swedroe – Great Companies Are Not Always High-Return Investments
- ISMS 36: Larry Swedroe – Two Heads Are Not Better Than One When Investing
- ISMS 37: Larry Swedroe – Pay Attention to a Fund’s Proper Benchmarks and Taxes
Common biases in investing
One of the biggest problems Larry has found working with advisors and investors is certain biases that lead to mistakes. One is recency bias, which is the tendency to extrapolate the recent performance of assets into the future as if it’s inevitable.
Resisting recency bias is critical to earning the premiums available from all risk assets, including reinsurance. Wise investing, as Warren Buffett noted, is simple but not easy. That’s because investors must overcome all the behavioral biases, with recency among the most powerful. It’s tempting to sell out of an investment that has suffered losses because it’s easy to think losses will keep happening.
Another bias is performance chasing. This is buying after periods of strong performance when valuations are higher and expected returns are lower and selling after periods of poor performance when valuations are lower and expected returns are higher. What disciplined investors do is the opposite—rebalance to maintain their well-thought-out allocation to risky assets
Larry identifies engaging in resulting as another big issue. This is making the mistake of judging the quality of a decision by the outcome—which is unknown—versus judging it by the quality of the decision-making process.
The self-healing mechanism of risk assets
Problems usually arise when stocks or any asset class perform very poorly, and investors flee the costs of these mistakes that they make. However, Larry points out that they fail to understand that a self-healing mechanism is generally in place.
An excellent example of the self-healing mechanism at work is that value stocks underperformed by wide margins during the late 1990s technology/dot-com boom. For example, from 1995 to 1999, the S&P 500 Growth Index returned 33.6% per annum, outperforming the Russell 2000 Value Index by 20.5 percentage points per annum. That outperformance led to valuation spreads widening to historic levels. Over the following eight-year period, 2000-07, the Russell 2000 Value Index returned 12.6% per annum, outperforming the S&P 500 Growth Index’s return of -1.7% by 14.3 percentage points per annum. Over the full period, the Russell 2000 Value Index outperformed the S&P 500 Growth Index by 2.2% percentage points per annum (12.8% versus 10.6%).
The self-healing mechanism works not only with stocks and value versus growth but also with bonds, credit, insurance, and virtually any risk asset. Thanks to the self-healing mechanism, Larry cautions investors against engaging in resulting because there will be periods when an investment will underperform and others when it outperforms. Instead, he advises that they understand why certain investment vehicles are in their portfolios in the first place.
About Larry Swedroe
Larry Swedroe is 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.