[00:02:26] Larry Swedroe: Alpha is outperformance against an appropriate risk-adjusted benchmark. So, for example, to keep it simple, if you outperform treasury bonds by buying junk bonds with higher yields because they have more credit risk, that’s not outperformance. If you outperform a high-yield index, then that would be more like alpha and not beta.

[00:02:47] Larry Swedroe: Beta would be exposed to credit risk in that. You could outperform by buying small stocks versus large stocks over the long term. Small companies have outperformed large companies, so that  isn’t really alpha. You would have to outperform a small-cap index that would be an appropriate benchmark, something like the S&P 600 index, not the S&P 500, which benchmarks against that.

[00:03:12] Larry Swedroe: What academics have been doing, and the way I like to explain it, is they look at the great performers, managers like Warren Buffet, and they try to see if they’re doing something that’s systematic and replicable and not skill-based, which may not be record.

[00:03:30] Larry Swedroe: So, are they buying stocks that have certain traits and characteristics that they could replicate just by buying all the stocks with that characteristic? And then if they could match, say, Warren Buffett’s performance, then Warren Buffett’s genius was in identifying those traits, not in individual stock picking or market timing.

[00:03:50] Larry Swedroe: We have to distinguish between what is alpha, which we know is a very unique skill set that very few investment firms have [00:04:00] been able to generate over the long term, and beta, which everyone can access through various index funds or other factor-based or what’s now called, well, I don’t like the term “smart beta” indices.

[00:04:13] Larry Swedroe: So, what happened originally is a good way to think about it is, we know that Warren Buffett has greatly outperformed the market, especially in his first 40 or 50 years, right up through around 2010 or so. Now, he told people exactly how he was doing it. He was buying cheap companies that were relatively profitable as well. Okay? And he wrote about this every year in his annual shareholder letters.

[00:04:42] Larry Swedroe: So, what the academics did is, they could think about reverse-engineering and see if they could identify what types of stocks Buffett was buying. And the academic research in the ’80s found a couple of unique characteristics, if you will. One was smaller companies.

[00:04:59] Larry Swedroe: They have identified, outperformed larger companies over the long term, and the other was cheap companies. They were selling at low price to earnings, low prices to book value or other metrics at measure value, and they left. And in 1992, professors in French wrote a famous paper, the course section of expected Returns that summarized that research, and they found that once you account for three factors, Or three unique betas.

[00:05:34] Larry Swedroe: One is exposure to the market. Number two, so some stocks have high beers. If the market goes up 10%, maybe they’re 30% more exposed to markers, so you’d expect them to go up 13%. And then you have other stocks say like a stage utility. Or a grocery store that would be less volatile. So if the mark goes up 10, maybe the beta is 0.7, they would only [00:06:00] be expected to go up 7%.

[00:06:02] Larry Swedroe: The second one was the size factor, and the third was the value. Okay. And they found that once you accounted for these factors that explained well over 90% of the differences in returns of diversified portfolios. With that funds like Vanguard and Dimensional and others created systematic funds that bought cheap stocks and small companies.

[00:06:29] Larry Swedroe: And you could no longer claim Alpha simply by owning value in small Sox, because I could replicate that. So a big part of Warren Buffett’s alpha disappeared because now individual investors like you and I could go buy mutual funds and now ETFs at very low cost. That replicated that. Now Buffett still was generating some significance.

[00:06:57] Larry Swedroe: More academic research followed and identified what was called the momentum factor, which means that stocks or bonds, commodities, currencies that have outperformed in the last year tend to continue to outperform over another short period of time. Then in 2013, a fellow named Robert Novi, wrote a paper that really uncovered Buffett’s second secret, if you will.

[00:07:25] Larry Swedroe: He found that highly profitable companies outperformed lower profitable companies, and so now you could buy value stocks that were also more profitable. Then after that, a team at a Q R expanded on that profitability factor. And created what’s called the quality factor, which looks at more than just quality being profitable, but do you have low financial leverage, which would make you less risky?

[00:07:55] Larry Swedroe: For example, do you have more stable earnings now? All these things are  now incorporated into many different mutual funds and ETFs that we can access. So here’s the. 20, 30, 40, 50 years ago, if you bought the kinds of stocks that Warren Buffet buys small, you know, value, profitable quality companies, you could claim legitimately alpha.

[00:08:23] Larry Swedroe: Today, you can’t do that anymore because you can buy funds run by companies like Dimensional and Avanti and many others that replicate that. And having done so, Warren Buffett’s Alpha has virtually disappeared. Now, it doesn’t take anything away from his genius. He figured this stuff out 50 years before the academics.

[00:08:46] Larry Swedroe: But we can all benefit from that today. We don’t have to pay active managers to identify which stocks that are cheap value and profitable. We can just buy them all in an ETF or an index fund.  And Buffet has had no alpha for the last 15 or 20. Once we adjust appropriately for exposure to these factors, there continues to be academic research into these errors, but we now know that we can identify well over, say 95% of the differences in returns of diversified portfolios simply by identifying what factors your fund is exposed to, and that makes it very hard.

[00:09:28] Larry Swedroe: Proactive managers to outperform because we’ve removed their ability to outperform simply by investing in these factors of trade. 

[00:09:39] Rebecca Hotsko: Yeah, and I wanna clear something up here because the shrinking alpha refers to, as you mentioned, an active manager’s ability to achieve more than a respective benchmark, but it’s not necessarily the market returns.

[00:09:52] Rebecca Hotsko: So it’s not saying that they’re underperforming the market, it’s just that they’re respective benchmarks. They’re not  outperforming that. So is it the case that they could still be beating the market, but they’re just not doing better than their particular benchmark? 

[00:10:08] Larry Swedroe: Well, that’s exactly the right way to think about it.

[00:10:11] Larry Swedroe: But you don’t wanna pay an active manager to outperform the market if they’re taking more risk by doing so, and you could do exactly the same thing by investing in a lower cost etf. Or mutual funds. So you wanna make sure they’re generating true alpha for which you would be willing to pay a somewhat higher fee to get.

[00:10:36] Larry Swedroe: In other words, skills should be rewarded, but just investing in a pure index fund or other type of systematic strategy that shouldn’t require a big. So it would be like saying, I outperformed the market by investing in private equity, which is illiquid. You may be locked up for 10 years, concentrated in portfolios.

[00:10:58] Larry Swedroe: That’s not a fair benchmark. You wanna compare it to an appropriate risk adjusted benchmark. 

[00:11:06] Rebecca Hotsko: Are there rules around what benchmark managers have to choose, or are there cases where they use an inappropriate benchmark and they’re like, look, I beat it. 

[00:11:15] Larry Swedroe: Yeah, that’s actually, that’s a really good question because unfortunately the SEC has very liberal rules about what can be chosen, and there is academic research showing that they actually choose benchmarks as you would expect, that are easy to beat.

[00:11:34] Larry Swedroe: Let me give a simple example. The Russell 2000 was a really poorly designed index, and it was very easy to beat because every June when they reconstituted the index, which is the top 3000 stocks by market cap, and then you buy the bottom 2000, that’s their small. Which means it isn’t even  really small, number one, because there are a lot more stocks than 3000.

[00:12:05] Larry Swedroe: In fact, in 2000 there were about 8,000 stocks. Today it’s about 3,800, I believe. So you’re not really small. You’re more mid-cap kind of. And then the Russell 1000 is the large cap. Now, every June when they reconstituted every active management hedge fund, a high frequency trader knew exactly which stocks would leave and which stocks would enter, and they would front run the indexes and they would buy the stocks that were entering before the index.

[00:12:38] Larry Swedroe: They’re driving those prices. And they would short the stocks that would leave the index because they knew the index funds would have to be selling those securities. And guess what? The Russell 2000 dramatically underperformed similar indices. There’s something called the CRISP six 10, which is the  Center for Research into security prices.

[00:13:02] Larry Swedroe: The universe of Chicago by something like 2% a year. The S&P 600 is a better design and stuff, and it’s actually been changed over the years to incorporate the academic. So actually Vanguard used to run their small cap index fund based on Russell 2000 and GU Saer. After observing how poorly the fund did because they could get exploited, got them to change it, and they went to, I forgot, which was, I think it was either the CRISP or MCI 1750, and they changed it.

[00:13:38] Larry Swedroe: One of those others. So the active managers are always going to choose the index that is easiest to be not the one that best represents exactly what they’re doing. Now we can identify that by running what is called regression analysis against these academic definitions that have been [00:14:00] now in the literature, and then you can run and see what their exposure was to these factors.

[00:14:06] Larry Swedroe: And then if there’s excess return, either positive or negative, you could say whether the fund was generating value or destroying value. So it is really important to look at what exactly is the benchmark, and you could be virtually certain they’re choosing inappropriate ones, the ones that are easiest for them to beat.

[00:14:28] Rebecca Hotsko: Yeah. And I’m glad you brought up that index because you write about that a lot in your book. The problems with the Russell 2000. And so I guess for investors thinking about buying ETFs or if you have ETFs that track that you, would you suggest that they might wanna reconsider and switch that for a different one?

[00:14:46] Larry Swedroe: I would not reconsider. There are other indices. The S&P 600 is a better index. The MSCI 1750 is better constructed. Less ability to front run then as well. 

[00:15:01] Rebecca Hotsko: Yeah, that’s super good to know. And I want to get into your recommended ETFs a little bit later in the discussion, but I want to ask a little bit more about the shrinking alpha, because one of the reasons you talk about that it’s been shrinking over time is because of increased competition.

[00:15:16] Rebecca Hotsko: And so can you talk a little bit more about this? What do you mean by competition is getting harder? You talk about something called the paradox of skill, which I thought was super fascinating in the book. 

[00:15:27] Larry Swedroe: Yeah, so here’s what’s important for investors to understand. I was really part of the first generation, so I’m gonna date myself here.

[00:15:36] Larry Swedroe: That took courses in finance, in a finance program because there really was no financial theory up until. Really the late 19 mid to late sixties when William Sharp and a few others were given credit for creating the first capital asset pricing model, like what’s called the Cap M. And now [00:16:00] we had a way to define for the first time how risk and reward were related insecurities prior to their early seventies.

[00:16:09] Larry Swedroe: If you took a finance class that was probably in an accounting program or an economics program, So I went through both undergraduate and graduate school, really the first programs that taught financial theory because there wasn’t really much before that. So who is, who are the people who were doing security analysis on Wall Street?

[00:16:30] Larry Swedroe: They were often, maybe an English major, went to work at Merrill Lynch and got trained and they learned and they would pick stocks based upon their research. Today, virtually everyone who is running money is a world class mathematician, nuclear physicist. Has degrees MBAs, if not PhDs, and advanced degrees in finance as well as math.

[00:16:57] Larry Swedroe: So the competition is so  much tougher. Literally, the heads of research for example, Avanti, I mean, he’s a rocket scientist. So they’re much more skilled, better trained. They also have access to much better databases, which weren’t around 50 years ago, and much faster computers that can look through data and help them do that.

[00:17:23] Larry Swedroe: So today, the managers are far more skilled, right? So you have to think about the level of competition, how that is. And a good way to explain it is I think about tennis. Roger Federer, many people think, is certainly one of the greatest tennis players of all time. He literally never lost a match in the first round of a Grand Slam tournament.

[00:17:52] Larry Swedroe: Now he was still playing against one of the top 128 players in the world, and he never lost the match. That’s tough competition. Right? And he still never lost in the second round. Maybe he lost once in the third round a couple of times. By the time he got to the semi-finals, he still won maybe two thirds of his matches and maybe in the finals 60% of his.

[00:18:18] Larry Swedroe: So now he’s playing against the number two or three player, likely in the world, he would still win, but his margin of winning was smaller, right? What that tells you is when the competition is easy and this big dispersion of, you know, skillset, skill sets, it’s easier to win the skill differences can.

[00:18:42] Larry Swedroe: When the skill differences narrow, much more of it might be luck. How did he feel that day? Did a ball hit the tape and drop in or just miss or whatever? And that’s what’s happened in the equity markets for a second reason. Not only are these  managers much more skilled, but the pool of victims needed to outperform has been shrinking dramatically.

[00:19:07] Larry Swedroe: You have to remember, if one manager outperforms because they bought say Tesla, and they overweight it relative to the market, say Tesla is 1% of the market and they have 5% of their portfolio, so they’ve overweight Tesla and Tesla outperforms, then somebody by definition. Underweight right. Well, you need victims then that you’re exploiting.

[00:19:33] Larry Swedroe: Who are the victims? There are two groups of investors we wanna consider. One is retail and the other is an institution. The evidence is overwhelming that retail investors, on average, of course, the stocks they buy go on to underperform the market after they buy them and the stocks they sell go on to outperform after they sell them.

[00:19:59] Larry Swedroe: You’re buying stocks,  the odds are they’re gonna underperform after you buy ’em. And if you sell, the odds are they’ll outperform after you sell. Now somebody’s gotta be on the other side of that trade, right? So it’s the reverse for institutions. They are more sophisticated. The problem is that you still have costs to overcome and both sides to lose.

[00:20:24] Larry Swedroe: The retail investors happen to lose even before expenses of trading, taxes, et cetera. The institutions win, but before expenses, but an average, not enough to overcome their total expenses. All right, so that’s key. Now, the problem for the market, why they’re shrinking alpha is coming outta World War ii, 90% of all stocks were held by individuals in their brokerage account.

[00:20:58] Larry Swedroe: So there were plenty of suckers  at the poker table to exploit. Today, almost 90% of the trading is done by the big institutional investors, hedge funds, high frequency traders, Goldman Sachs, et cetera, who are the victims. What it means is when Renaissance technology is trading against Goldman Sachs, Who’s the sucker at the poker table?

[00:21:22] Larry Swedroe: It’s hard to know. The odds are probably 90% that they’re, when they’re trading with somebody with the same skill level. Very hard to win that game when you’re both spending money and only one of you can outperform even before expenses. So you have these two problems here. The last point I’ll make is.

[00:21:43] Larry Swedroe: Investors make the big mistake of thinking about competition in the way we think about a tennis match or a chess match. If I’m playing tennis against, you know, somebody, if I have a little bit more skill than them, I’m gonna win a significant number of the matches. If I have a lot more skill, I’ll win every one of them.

[00:22:05] Larry Swedroe: Right? Like we said, Roger Federer never lost the first round match and he’s still playing against the top 28. But when he is playing against those top few, he only wins by a small margin. Right? But when we’re competing in the stock market, we’re not competing one-on-one. We’re competing against the collective wisdom of the entire market and all these big institutions who, in their collective wisdom, are setting prices.

[00:22:33] Larry Swedroe: It’s much harder to win a game when you’re competing against the collective wisdom of the market. 

[00:22:40] Rebecca Hotsko: And then I guess just on that point, because you talked about, and you spoke about this a lot in our last episode, how the winning strategy, in your view, is passive along with factor investing. But on the flip side, then we know that more funds are moving into passive versus active.

[00:22:56] Rebecca Hotsko: But what role do active managers play in markets? Because what would happen in the very extreme scenario where everyone went passive, 

[00:23:06] Larry Swedroe: Yeah. So let’s just go back to your paradox of skill. Just to wrap it up. I just wanna make sure everyone understands. So the paradox of skill is the more skillful the competition, the harder it is actually to outperform, and that sort of seems to make common sense, right?

[00:23:24] Larry Swedroe: All right. So active managers play a very important role in the market. So we definitely don’t want all of them to disappear. Their actionS&Pr, what’s called price discovery, help to make the markets efficient. And by that we mean moving prices to what is really the best estimate of the right price.

[00:23:47] Larry Swedroe: That’s important because if you have, you know, mispricing like financial bubbles, which happen from time to time, Then too much capital gets allocated to those industries  and gets wasted in terms of the economy. We get wasted investment, right? So we want markets to be efficient and clearly they play an important role.

[00:24:10] Larry Swedroe: The question is, how many of them do we need? Do we need the tens of thousands of hedge funds and active mutual funds and active ETFs to keep the market efficient? I would argue you need maybe 1% of them, and I base that on this in the 1950s. Rebecca, how many mutual funds do you think there were in the United States?

[00:24:35] Larry Swedroe: Just take a guess. Today the numbers are like in the 10,000 plus mutual funds and 10,000 hedge. 

[00:24:43] Rebecca Hotsko: I don’t know. My gut is saying there would be less. 

[00:24:46] Larry Swedroe: It was under a hundred and while the market was not as efficient as it is today, because the competition is much tougher, the pool of victims is, you know, much smaller.

[00:24:58] Larry Swedroe: And we didn’t have academics converting alpha into beta in the fifties. And still in that era with less than a hundred funds, most of the mutual funds were still under. So today we have much more competition. The sources of alpha are disappearing because academics convert them into simple beta, the pool of victims and shrinking, and the supply of dollars.

[00:25:25] Larry Swedroe: That’s the fourth factor in the incredible shrinking alpha. Has grown dramatically chasing a smaller pool of alpha, because 30 years ago there were only about 300 billion. For example, in hedge funds today it’s like four or 5 trillion, so a lot more dollars. Chasing these in a smaller sauce of alpha and fewer of them.

[00:25:49] Larry Swedroe: That’s why it’s getting harder and harder, but we want to keep ’em around, but we don’t need tens of thousands of them. My guess is given the sophistication and the high  speed computers, if you had a hundred active managers, markets would be highly efficient. 

[00:26:06] Rebecca Hotsko: All right. And I guess the other thing that I wanted to kind of talk to you about is another thing that a lot of investors struggle with is whether to go concentrated or more diversified.

[00:26:18] Rebecca Hotsko: And so some people might meet in the middle somewhere, but I really like your perspective on this and all the research that you put out behind this topic. And so I was hoping you could share your recommendation on this for our listeners. 

[00:26:32] Larry Swedroe: Yeah, well the question for investors is what’s your objective? Is it to get rich?

[00:26:39] Larry Swedroe: Or, which also means you have to take a lot more risk to do that or to give the best chance of achieving your financial goals. You want to get rich, you can take your IRA to the lottery tickets and go buy one or the racetrack or Las Vegas casinos or buy one stock  and maybe you get lucky and you bought Tesla or Google.

[00:27:03] Larry Swedroe: On the other hand, I can name you some of the greatest companies in the world that were, you know, the high flyers of their day and they’re all bankrupt and gone. Like Polaroid and Kodak and Enron, and we can name many others that will once be the Teslas and Goggles of their day. What most people don’t understand, but economists know and that’s why they call diversification.

[00:27:29] Larry Swedroe: The only free lunch in investing is they think, let’s say we assume that the stock market just for easier, has an expected return of 10. So if you ask somebody what the odds are if you buy one individual stock, you’re gonna get 10%. They probably think of a potential distribution of, say there are 4,000 stocks, that it would look like a bell curve.

[00:27:57] Larry Swedroe: Where the mean and the median are  the same. So half the stocks would do better than 10, and half the stocks would do worse than 10. Unfortunately, it doesn’t look anything like that, and it can’t look like that really, because you have to think about that. Stock market returns can’t be normally distributed, and the reason is this, what’s the most you can lose when you buy one individual stock.

[00:28:27] Rebecca Hotsko: You could lose just 100% of your investment, right? Unless, I guess it’s a margin account, right? 

[00:28:32] Larry Swedroe: Well, you can still only lose a hundred percent, right? You may have to then put , you know, to meet the margin call, right? So that’s a risk there. So your losses could, in theory, be unlimited there, but what’s the most you could gain as a percentage.

[00:28:47] Larry Swedroe: Yeah. It’s infinite. So when you think about that, then if you own the one Google and you get a 10000% return just to pick a number, right. And the market got 10. Then whole bunches of other stocks must have done much worse than 10 to allow that to happen, right? And so what the data shows very clearly is that the mean stock is very different from the median.

[00:29:18] Larry Swedroe: So most of the stocks get less than 10%. Think it’s like 60% roughly might think of it that way, and a large majority, the most common actually return is minus a hundred percent. A lot of stocks eventually go to zero, and only 4% of all the stocks account for 100% of the excess return above treasury. So if you think about that, what are the odds you are gonna own?

[00:29:48] Larry Swedroe: Buy and hold on. So you get that great return to that 4% of the stocks. Well, the research shows the active managers are highly unlikely to do it. What are the odds you are? And so the more stocks you own, the closer you move the mean to the median there. So they both are the same. If you own the entire market, you get the market return.

[00:30:13] Larry Swedroe: The fewer stocks, the odds favor, you’ll actually underperform. It’s just simple math. So what you wanna do is identify the risks or factors or traits or characteristics that you want exposure to. So if you want to be like Warren Buffet and all the funds I invest in are run by fund families like Bridgeway Dimensional and Avanti, they buy all of the stocks that fit their defined universe.

[00:30:43] Larry Swedroe: And these are what I own, are small value, profitable quality companies, but they buy all of ’em. They’re not trying to identify which ones. So my, you know, expected return is the same exactly as anyone who buys one stock, but my dispersion of potential outcomes is much narrower. Then the one person who buys one stock.

[00:31:08] Larry Swedroe: They could go bankrupt or they could make, you know, 10 times the market return. 

[00:31:15] Rebecca Hotsko: I just have one follow up on kind of when you were talking about some stocks or even, I don’t know if you said a large portion go to zero, but I’m wondering if there’s any color on kind of what subset of stocks those are. I would assume it would be maybe smaller microcap companies, but do you have any more color on that?

[00:31:34] Larry Swedroe: Yeah, there is a group of stocks that I call lottery stocks. They have a distribution that is nowhere near a normal distribution. Their distribution of returns looks like a lottery ticket. So, for example, there are people who buy stocks and bankruptcy, right? You’ve even seen the Reddit crowd jump on and try to spread the word, Hey, when I think Herz  or one of them was going bankrupt, you know, they loaded up on this stock.

[00:32:03] Larry Swedroe: Well, the academic research shows. That you had a hundred stocks that were in bankruptcy, and they’re still indices and owned by them, but none of the funds I own include them because they’re academic research based. So they screen these stocks out, but as long as they’re in an index fund will buy ’em.

[00:32:24] Larry Swedroe: You had a hundred of them. One of them, on average, will return even one penny too. But investors like them because they say, well, if I buy a thousand dollars, I can only lose a thousand. But if it comes out of bankruptcy and does well, I can make a hundred times my investment. Right? Problem is you could still lose a hundred percent.

[00:32:45] Larry Swedroe: And the odds greatly favor that you will do that. There’s a whole group of stocks that are very similar to the stocks that Kathy Woods of her arc fund buying these innovative, disruptive technology companies. Companies, the research shows that have rapid growth of assets, high investment then, but low profitability have got awful returns over the long term.

[00:33:14] Larry Swedroe: They’ve underperformed treasury bills, but people love to buy them because they’re hoping they can hit the next Microsoft, the next Google, the next Tesla. But the odds of doing so are so poor you shouldn’t. 

[00:33:29] Rebecca Hotsko: That was really helpful and this gets into an even broader topic I wanted to talk to you about, which is why good or even great businesses are not always great investments.

[00:33:41] Larry Swedroe: Yeah, this is a really interesting one. So let’s talk about a problem Rebecca, that investors have and they don’t understand the difference between information and value relevant information. Okay. And there’s a big difference. And the example I use to explain this, it relates to sports betting, which has become a huge business in and of itself in the United States.

[00:34:10] Larry Swedroe: So here I show an example of choosing, there’s a basketball game in college basketball between a team called Duke. Is a perennial great team. They’re usually in the NCAA tournament. They’ve won many national championships and they’re playing the Appalachian State team. If they played them a hundred times, they would likely win a hundred times, and so, If you wanna bet on Duke, you can’t just bet somebody and say, I wanna bet on Duke.

[00:34:44] Larry Swedroe: I call you up, Rebecca, and I say, let’s put a hundred dollars. I’ll take Duke and you’ll take Appalachian State. Even if you knew nothing about sports, being a bright woman, you might go and look on the internet and find that Duke is favored by 10 points. What that means is if Duke wins by less than 10, you would win the bet.

[00:35:09] Larry Swedroe: So in other words, if Duke won the game, say 69 to 60, you get 10 more points as Appalachian State added to your 60 in terms of our bet. And now your score is 70 and Duke is 69. I lost it. Okay, so what the point here is this, everybody knows that Duke is a better team. They’ve got better athletes, they’ve got better coaching, better facilities, you know, et cetera.

[00:35:40] Larry Swedroe: So then you ask people who determine the point spread and they think it’s Las Vegas bedding houses, but it’s not true. They just set what’s called that initial point. And let’s say Rebecca, that they set, you know, the Las Vegas 

house woke up one morning and took a stupid pill, right? So they set the spread at zero.

[00:36:06] Larry Swedroe: What would you do? Without even knowing too much about sports, you might pick up the phone, call your bookie and bet as much as you could on Duke, right? because it’s almost certain. So now the bookie wakes up and the bookie’s got a bet that Duke will lose, right? They’re on the other side. They don’t like that.

[00:36:28] Larry Swedroe: Bookies don’t wanna make bets. They want to take bets. So what does that mean? They’ve gotta find someone. Now on the other side, So they, the stupid pill is starting to wear off. They raise the spread to five now, and I come along and I bet on Duke, and now they got an even bigger buck on that. So they now raise the spread until maybe it’s 20 points and then someone says, I know Appalachian’s not gonna win, but I don’t think Duke will win by 20.

[00:36:57] Larry Swedroe: And they pushed the spread. So by the end, just before the game starts, it’s the collective action of thousands and thousands of individual betters, often betting with their hearts and not their minds, because there may be a graduate of Duke or a graduate of Appalachian State who are actually setting the point spread.

[00:37:19] Larry Swedroe: Now, how many people do you know, Rebecca, that have gotten rich betting on sports? I don’t know any personally. Now I don’t know anyone either, right? Doesn’t mean they don’t exist, but most people, the ones who get rich are the bookies, right? So here we have a bunch of amateurs like you and me, setting the point spread.

[00:37:42] Larry Swedroe: What does this have to do with investing? Okay, so let’s say you have a glamor growth stock and a, let’s call it Google and a distress value company. Let’s just say it’s Ford Motor. Now, let’s say they both have earnings of a dollar a share, but the PE of Google is say 30, and the PE of Ford motor is seven.

[00:38:08] Larry Swedroe: So the price of Ford is seven and the stock price of Google is 30. This would be a rational market, right? You pay a higher price to get a much greater earning. What if the price of Google was seven, in which case there would be no point spread, right? It would be like Duke playing Appalachian State and having no point spread.

[00:38:32] Larry Swedroe: That world can’t exist because smart people would bid up the price of Google until it got to 30, and now the risk adjusted odds of betting on either team or investing in either company would be the. Just like it is the same here. The point spread here equalizes the risk of Duke against Appalachian State.

[00:38:58] Larry Swedroe: There was actually a Rebecca, a study done on sports betting and the National Basketball Association. Over a number of seasons, they found that the actual difference in the average era in the point spread, so let’s say the Boston Celtics were playing the Lakers and the point spread was favoring the Celtics by three.

[00:39:21] Larry Swedroe: Now they may win by 13. That would be an error of 10. They may actually lose by five. That would be an error of minus eight. The average error was less than one quarter of one point, which tells us that the market in sports betting is highly efficient, meaning the average error is very small, and the same thing is true as stock prices.

[00:39:48] Larry Swedroe: Here you have much more sophisticated investors setting prices through their actions, and this is why it’s so difficult. So, Google. If you [00:40:00] hear, say, Jim Kramer, come on CNBC and tell you, here’s this great company. It’s got, you know, great management, great products, their earnings are gonna explode, et cetera.

[00:40:12] Larry Swedroe: All he’s told you is something that everybody already knows. You just heard it on CNBC and he’s told you nothing more than the equivalent of. Has better athletes. They’ve got two seven footers. An Appalachian state’s tallest player is six seven. They’ve got better coaching, et cetera. That knowing Google is a better company and has better prospects is information.

[00:40:38] Larry Swedroe: It’s not valuable information because that information, if it’s known, is known by everyone and the market prices for risk, not growth. That’s what people don’t understand. So let’s address your question. Finally, tie this all together for you by looking at, say, Rebecca, you had 10 million to. And you could buy one of two identical properties, brand new constructed buildings with the same technology.

[00:41:13] Larry Swedroe: One in Manhattan on Park Avenue, and it’s going for 10 million. The other is in downtown Detroit and it’s going for 10 million. Which building would you buy? I would go to New York. Yeah, because the rents are gonna be much higher than they would be in Detroit. Right. You know, you could command maybe today a hundred bucks a square foot there and maybe 10 bucks there.

[00:41:40] Larry Swedroe: Which building is Google and which building is Ford Motor. 

[00:41:44] Rebecca Hotsko: So I think Google would be the better one. So New York and then Ford would be Detroit in this? 

[00:41:51] Larry Swedroe: Exactly. Which one is Duke and which one is Appalachian? 

[00:41:56] Rebecca Hotsko: That one, I can’t remember. Duke would be the better one. Yeah, 

[00:41:59] Larry Swedroe: right,  exactly. So this world can’t exist anymore than Duke would have a zero point spread against Appalachian.

[00:42:07] Larry Swedroe: It can’t exist anymore than Google and Ford Motor with both traders at the same PE ratio. So let’s look at a more realistic example. So now you know you’re an investor and you say to your financial advisor, you know this building in Manhattan, I love it, but I’ve gotta pay their market prices 30 million.

[00:42:31] Larry Swedroe: But I’m gonna get, I estimate a hundred bucks. A square foot and their rents will grow. And so my expected, but not guaranteed return. Nobody knows what’s gonna happen about the future of return to work, et cetera, but our best estimate is of the future, rents will give us an expected return of 10% if I have to pay 30.

[00:42:56] Larry Swedroe: Now the Detroit property, it’s only gonna cost you 5 million, but the rents are much lower. So you could end up with the same expected return even though you’re getting low rents, but you paid one six the price. Now, which building should you prefer here, given that they have the same expected return?

[00:43:19] Larry Swedroe: Before you answer it though, think about which one is safer. And if you have the same expected return, but you have a less risky option, which should you prefer? So what, which building would you buy knowing that these are expected returns, but not guaranteed. 

[00:43:38] Rebecca Hotsko: I guess a rational person would probably want the less risky one because then you have a, and that’s the Manhattan property?

[00:43:46] Rebecca Hotsko: Yeah. 

[00:43:46] Larry Swedroe: Yeah. And that’s the Manhattan property. So this world can’t exist either because we don’t just look at expected returns. We care about risk relative to that. So now the price  of Manhattan property gets built up to 50 million, and the price of Detroit gets down to 3 million. Now we have a rational world where some people who want less risk, maybe a widow, she says, I’m happy getting that 6% return.

[00:44:18] Larry Swedroe: I’ll buy a share. I can’t buy a 50 million building, but I’ll buy one. A real estate investment trust that owns those types of buildings. So now I get hundreds of them and they look like that, and my expected return is 6%. I’m happy. And then you have another, maybe a younger investor who got a stable job, can afford to take some risk with some portion of his portfolio.

[00:44:46] Larry Swedroe: That invests in much riskier property. But they have higher expected returns. There’s no right answer here, and this is Google versus Ford Motor. Ford Motor, you said is B. It’s got to have  a much higher expected return to entice you to invest. Google should have a lower expected return because it’s a safer investment, and that’s the problem.

[00:45:12] Larry Swedroe: Investors, they mistake this difference. Riskier companies have to have higher expected returns if the world is rational, and therefore, great companies should have lower expected returns. That doesn’t mean they’re bad investments, that just means they’re less risky. 

[00:45:32] Rebecca Hotsko: Okay. Thank you for tying that all together.

[00:45:34] Rebecca Hotsko: That really hit it home. I, it did, for me at least, and I hope it did for everyone listening, because I think a big reason or an argument for favoring great businesses as Warren Buffett calls them, where he holds them forever, is that his logic is, I wanna own great businesses because I believe they will continue to compound at this high rate.

[00:45:54] Rebecca Hotsko: They have this moat and that they’re able to, I guess, achieve this super normal return. But then I. Maybe your argument and what you just explained makes sense where these great businesses then by definition, should have a lower expected return because they’re safer and that’s information. And then is there anything else to that argument you would like to add that you didn’t cover in that previous example?

[00:46:18] Larry Swedroe: Yeah, the only thing I would add is when, because since you mentioned Buffet, buffet buys great companies at low prices. So he doesn’t just buy cheap companies, he buys cheap companies that are profitable and don’t have a lot of financial leverage, so they’re a little less risky, right? He could buy riskier companies and maybe even get higher expected returns for that, but that’s not his pre.

[00:46:44] Larry Swedroe: The one thing I would add on top of that is this. One of the things we know is that one of the strongest forces in the universe is reversion to mean abnormal earnings. So what do we mean by normal earnings? Obviously, over the long term corporate earnings should grow about the rate of growth of the economy.

[00:47:08] Larry Swedroe: So if the economy is growing at 6%, 3% real and 3% inflation to pick numbers, corporations can’t grow their earnings more than 6% a year unless they eventually become the whole economy. Right. So abnormal earnings growth is more than 6% or negative. Abnormal would be less. Now, what most people don’t understand is abnormal earnings growth reverts to the mean at an incredibly fast rate on average.

[00:47:39] Larry Swedroe: So companies like Google and Tesla are extremely rare, where they’re able to grow their earnings at abnormally high rates for longer periods of time, and even then they eventually run into a wall. And here’s the numbers. So let’s say you are growing earnings at  26%, and six is the. That’s a, your abnormal earnings are 20% on average, abnormal earnings revert to the mean at 40% a year.

[00:48:12] Larry Swedroe: So 40% of 20 would be eight, so instead of 26, next year, you’re gonna grow more likely to be 18. And then now that gap is 12. 40% out is five the next year here, now down to 13, and it’s quickly. So unless you are paying a, well, let me say it this way. If you’re paying a price that anticipates Kathy Woods, you look at these incredibly high PEs that they are trading at, that is literally impossible to continue.

[00:48:43] Larry Swedroe: The stock she was buying was without question vastly over paying for and bubbles eventually burst. When you see high peas like that, it literally certainly possible for one or two companies to do that for a long time, because. While they’re small, they can grow large enough and eventually become large enough.

[00:49:03] Larry Swedroe: You can’t do it anymore, but when you own a hundred stocks, it’s literally impossible for all of them to justify that high a pe and that we saw what happened, for example, on the NASDAQ in March of 2000 was trading like over a hundred times earnings. And the NASDAQ, those stocks collapsed like 80. You know, things that can’t continue, eventually end, that’s pretty simple to remember.

[00:49:29] Larry Swedroe: So what you wanna make sure you’re careful of is do not extrapolate abnormal earning growth far into the future. It’s highly unlikely disruptive technologies get disrupted themselves. And you can see it. Just for example, you know what happened, even say to a Google and their search engine, all of a sudden chat, GBT comes along, says, oh my God, this could change the whole world.

[00:49:55] Larry Swedroe: And you know, their ability to generate revenue from search. Literally disappears overnight. That’s not a prediction. I’m not saying that, I’m just pointing out that some of the greatest companies in the world, like Polar Leroy and Eastman Kodak and many others, digital equipment were the, you know, stars of their day and people were paying 50 times or more earnings for them because they expected them to continue that abnormal earnings growth for a long time.

[00:50:25] Larry Swedroe: And of course, that didn’t happen. 

[00:50:28] Rebecca Hotsko: It is so interesting to look at the largest market cap companies a couple decades ago. None of them are the same today, and so we think that these tech companies are here forever and that they’re, I guess, indestructible. But at the end of the day, it just took one AI innovation for them to, for the markets to be scared and for that to maybe disrupt them.

[00:50:50] Rebecca Hotsko: Yeah, it’s, I really like that point. You hit home. I feel like I never have enough time when I’m chatting with you, because I have a couple more things. Well, one more thing I wanna get through at  least, and that’s on dividend stock investing because, This is such a cool topic too, because often dividend companies are thought of as great investments, and they’re sometimes preferred by investors, and some reasons could be that they like the immediate cash flow.

[00:51:15] Rebecca Hotsko: Instead of a future unknown appreciation, they have this perceived stability of the stock, given that it’s usually more mature, lower beta, and then some investors might think, Dividend stocks actually outperform non-dividend paying stocks. So I wanted to explore these reasons with you because I know you’ve done a lot of interesting research on this work, and so I was hoping you could shed some light if there’s any merit to any of these claims.

[00:51:40] Larry Swedroe: Well, it’s sort of the answer isn’t black or white in this case, but the academic evidence and theory is very clear, so I’ll try to put it this way. Dividends are irrelevant. They’re not good and they’re not bad, except from a tax  perspective, if you’re a taxable investor, dividends are bad because you pay income tax on the cash flow, and if you don’t need that cash flow, then you’re better off deferring the tax and getting it in the form of long-term capital gains.

[00:52:16] Larry Swedroe: Eventually when you sell, you allow yours to. Dividends company. People like dividends for psychological reasons. That’s a discovery. But they make the mistake like they’re thinking a dividend is a return on their investments. So I’ll give you an example. Stocks have returned roughly 10% over the long term, and let’s just assume for simplicity purposes, half of that came from dividend.

[00:52:44] Larry Swedroe: And half from capital appreciation. Now you gotta remember, 70% of all the stocks don’t pay any dividends. Okay? Now, what people forget is they don’t understand that the companies who paid no [00:53:00] dividends, they got the same 10% return that the stocks that pay dividends. So companies pay dividends, they just change the form of the earnings.

[00:53:10] Larry Swedroe: And when you, if you own a stock, let’s say trading at a hundred, And you own one share and you get a dividend of $10. Now the price is 90 and you have $10 in cash. You have a hundred bucks investment. And I own a company that is trading at a hundred and doesn’t pay a dividend. So the stock price doesn’t move.

[00:53:32] Larry Swedroe: We both have a hundred dollars. But you had a taxable dividend and I didn’t. So why would I prefer the dividend? I shouldn’t. I’d much prefer the company to buy back the stock drive, which would push the stock price up. And if I need the cash, I will then sell the stock to generate the cash so I could sell $10 worth of the stock to create the same cash flow if I need it.

[00:53:58] Larry Swedroe: And that’s why academic theory is very clear. Stock dividends should be completely irrelevant because you can create your own self. And it doesn’t matter there. So the mistake that people make is buying stocks for the dividends. Now, having said that, companies that pay dividends tend to have certain characteristics or traits, as you said, tend to be mature, and may be more profitable.

[00:54:25] Larry Swedroe: So the tendency is not always the case, some of them go bankrupt and suspend their dividends. But generally, companies that have increasing dividends, right, are stocks that have provided higher returns, but they don’t provide any higher returns than stocks that have the same characteristics, but don’t pay any dividends.

[00:54:48] Larry Swedroe: So you look at the characteristics we talk about whether the PE ratio, for example, is a measure of value. Their profitability is their quality company in  terms of their financial leverage, those types of characteristics. And the research shows if you take two groups of stocks that have the same traits, but one group pays dividends and the other does not, you get the same.

[00:55:14] Larry Swedroe: For taxes, but for taxable investors, you’re better off. The other thing is since 70% or so of the stocks don’t pay dividends, you clearly have a less diversified portfolio, and that means you have a greater dispersion potential outcomes, which means you have a more risky portfolio with the same expected return.

[00:55:38] Larry Swedroe: So that’s a reason why you shouldn’t own just dividend paying stocks. You should own stocks with the characteristics you desire, and don’t care whether they pay dividends per se or not. So that gives you a broader diversified portfolio. There’s tons of academic research on this. I’ve written about it.

[00:55:58] Larry Swedroe: Many of my books have  independencies explaining the psychological reasons why people prefer dividends. And the research showing that there’s no logical financial reason to own them, but you do wanna consider what factors or traits or characteristics you would prefer. 

[00:56:19] Rebecca Hotsko: That was extremely helpful and insightful.

[00:56:21] Rebecca Hotsko: As always, Larry, thank you so much for coming back on again. The time always flies when I have you on. So before I let you go, can you remind the listeners where they can go to learn more about you and all of your books and work that you put out 

[00:56:36] Larry Swedroe: Well, I write regularly for three websites now: Wealth Management, Advisor Perspectives, and Alpha Architect. Usually, once a week, I post all my articles so everyone can follow me on Twitter or LinkedIn. I’m also the Head of Financial and Economic Research at Buckingham Wealth Partners. You can check out our website, and of course, you can go to [00:57:00] Amazon and search my name to see the 18 books I’ve written. I encourage investors to get educated, which is my most important advice. By that, I mean learning about the academic literature, which is the most prudent way to invest. Tuning into CNBC or Bloomberg News to hear what we call noise is likely to lead you to poor outcomes.

[00:57:24] Rebecca Hotsko: Awesome. I will make sure to link those in the show notes so the listeners know where to find you.

[00:57:29] Larry Swedroe: My pleasure. Great being back. Happy to come back again Rebecca. 

[00:57:33] Rebecca Hotsko: All right. I hope you enjoyed today’s episode. Make sure to follow the show on your favorite podcast app so that you [00:50:00] never miss a new episode. And if you’ve been enjoying the podcast, I would really appreciate it if you left a rating or review. This really helps support us and is the best way to help new people discover the show. And if you haven’t already, make sure to sign up for our free newsletter, We Study Markets which goes out daily and will help you understand what’s going on in the markets in just a few minutes. So with that all said, I will see you again next time. 

[00:58:18] Outro: Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday, we teach you about Bitcoin, and every Saturday, we study billionaires and the financial markets.To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.