Enrich Your Future 18: Build a Portfolio That Can Withstand the Black Swans

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 18: Black Swans and Fat Tails.LEARNING: Never treat the unlikely as impossible. Diversify your portfolio to withstand black swans. “If you build a portfolio that can withstand the black swans and is highly diversified, then psychological or economic events won’t force you to sell.”Larry Swedroe In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. 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 Chapter 18: Black Swans and Fat Tails.Chapter 18: Black Swans and Fat TailsIn this chapter, Larry explains the importance of never treating the unlikely as impossible and ensuring your plan includes the near certainty that black swan events will appear. Thus, your plan should consider their risks and how to address them.Understanding the risk of fat tailsIn terms of investing, Larry says, fat tails are distributions in which very low and high values are more frequent than a normal distribution predicts. In a normal distribution, the tails to the extreme left and extreme right of the mean become smaller, ultimately reaching zero occurrences.However, the historical evidence on stock returns is that they demonstrate occurrences of low and high values that are far greater than theoretically expected by a normal distribution. Thus, understanding the risk of fat tails is essential to developing an appropriate asset allocation and investment plan. Unfortunately, Larry notes, many investors fail to account for the risks of fat tails.History of the black swansWith the publication of Nassim Nicholas Taleb’s 2001 book Fooled by Randomness, the term black swan became part of the investment vernacular—virtually synonymous with the term fat tail. In his second book, The Black Swan, published in 2007, Taleb called a black swan an event with three attributes:It is an outlier, as it lies outside the realm of regular expectations because nothing in the past can convincingly point to its possibility.It carries an extreme impact.Despite its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.Taleb went on further to show that stock returns have big fat tails. Their distribution of returns is not normally distributed, and fat tails mean that what people think are unlikely events are much more likely to occur than people believe will.To illustrate this, Larry uses an example: if you take stock returns, and in the last 100 years, you cut out one best month per year, which is 1% of the distribution, the assumption is that you wouldn’t lose all that much of the returns. But the fact is, you lose most of the returns. So that’s the good fat tails. Similarly, if you avoid the worst months, your returns become spectacular.Do not try to time the marketHowever, Larry cautions investors that trying to time the market because of unpredictable events is the wrong strategy. The fact that you have fat tails in the data doesn’t mean you should try to time the market or engage in an active management strategy because evidence shows that it doesn’t work.What it means, very simply put, is that your investment strategy, investment policy, and asset allocation decisions must take into account that these fat tails exist; they’re unpredictable, and therefore, don’t take more risks than you can stomach. Further, Larry adds, you must be prepared to rebalance the portfolio to take advantage of those drops and buy more when things are down.Active management will not protect you from fat tailsThe existence of fat tails doesn’t change the prudent strategy of being a passive buy, hold, and rebalance investor. Active managers have demonstrated no ability to protect investors from fat tails.However, the existence of fat tails is significant because of their effect on portfolios. The risks of black swans and the damage they can do to portfolios, especially for those in the withdrawal phase, must be considered when designing your asset allocation. With that in mind, Larry offers the following advice:Make sure your investment plan accounts for the existence of fat tails.Don’t take more risks than you have the ability, willingness, or need to take.Never treat the unlikely as impossible or the likely as certain.Further readingNassim Nicholas Taleb, Fooled by Randomness, Texere, 2001.Javier Estrada, “Black Swans and Market Timing: How Not to Generate Alpha,” November 2007.Nassim Nicholas Taleb, The Black Swan, Random House, 2007.Did you miss out on the previous chapters? Check them out:Part I: How Markets Work: How Security Prices are Determined and Why It’s So Difficult to OutperformEnrich Your Future 01: The Determinants of the Risk and Return of Stocks and BondsEnrich Your Future 02: How Markets Set PricesEnrich Your Future 03: Persistence of Performance: Athletes Versus Investment ManagersEnrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?Enrich Your Future 05: Great Companies Do Not Make High-Return InvestmentsEnrich Your Future 06: Market Efficiency and the Case of Pete RoseEnrich Your Future 07: The Value of Security AnalysisEnrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market ReturnEnrich Your Future 09: The Fed Model and the Money IllusionPart II: Strategic Portfolio DecisionsEnrich Your Future 10: You Won’t Beat the Market Even the Best Funds Don’tEnrich Your Future 11: Long-Term Outperformance Is Not Always Evidence of SkillEnrich Your Future 12: When Confronted With a Loser’s Game Do Not PlayEnrich Your Future 13: Past Performance Is Not a Predictor of Future PerformanceEnrich Your Future 14: Stocks Are Risky...