ISMS 24: Larry Swedroe – Confusing Skill and Luck Can Stop You From Investing Wisely

Jun 1, 2023

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In this episode of Investment Strategy Made Simple (ISMS), Andrew and Larry discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this fourth episode, they talk about mistake number 7: Do you confuse skill and luck? And mistake number 8: Do you avoid passive investing because you sense a loss of control?

LEARNING: When gauging a fund manager’s performance, consider risk-adjusted performance. If you’re a passive investor and use a systematic strategy, you’re 100% in control.

“You have to accept that you can only control what you can control; you can’t control the unpredictable things that happen.”

Larry Swedroe

In today’s episode, Andrew continues his discussion with Larry Swedroe, 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 a chapter of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this fifth series, they talk about mistake number seven: Do you confuse skill and luck? And mistake number eight: Do you avoid passive investing because you sense a loss of control?

Missed out on previous mistakes? Check them out:

Mistake number 7: Do you confuse skill and luck?

According to Larry, investors don’t know statistics well enough to differentiate skill from luck. To understand if an outperformer is outperforming because of skill and not luck, look at risk-adjusted performance. So, for example, over the very long term, value stocks have outperformed growth stocks, and small stocks have outperformed large stocks. So somebody who outperforms simply because they owned lots of small and value stocks more than the market isn’t outperforming on a properly adjusted basis. Other factors than size and value, such as momentum, profitability, or quality, can also drive the return. Larry recommends Portfolio Visualizer, a tool that shows how much exposure an active fund has to those factors. It also reveals the alpha or the remaining performance that cannot be explained.

The second thing you need to consider is whether the fund’s assets are growing. If they’ve grown, the odds are pretty good that that outperformance will disappear. The other thing you can look at is the metrics of the stocks they’re holding. If they’re invested in hot stocks and their values have gone up, that’s a sign not to chase the outperformance.

If you want to outperform by picking managers, Larry advises choosing the largest pension plans because they hire great consultants. They also have the best databases and do thousands of interviews yearly, so you can be sure they’ve asked every question you can think of while doing their due diligence. But still, evidence shows their ability to predict future winners doesn’t exist.

Mistake number 8: Do you avoid passive investing because you sense a loss of control?

In active investing, individuals perform stock selection and/or market timing. Passive investing doesn’t involve any of that. It defines its universe and then buys and holds all the securities that meet that definition.

With passive investing, the problem comes in when the markets are experiencing uncertainties like the Ukrainian war, the COVID-19 pandemic, etc. The investor wants to be in control but with an index fund, the markets are in control. So many people consider active management a way of giving them control. They’re either in control of buying individual stocks, choosing the fund manager, and when they go in and out of the market. The problem is all the evidence shows that control costs you money, and you’re more likely to make mistakes and end up underperforming.

Larry also advises investors to understand that when you’re passive and use a systematic strategy, you’re 100% in control. But you have to accept that you can only control what you can; you can’t control the unpredictable things that happen. Make sure your portfolio design doesn’t take more risks than you have the ability, willingness, and need to take. You should also be hyper-diversified to withstand the shocks that happen to every asset class.

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.

ISMS 24: Larry Swedroe – Confusing Skill and Luck Can Stop You From Investing Wisely

Mistake number 7: Do you confuse skill and luck?

Mistake number 8: Do you avoid passive investing because you sense a loss of control?

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