Tag Archives: value stocks

Investing: What the heck is a Larry Portfolio?

PortfolioGuest post by Contributing Editor, Matthew Amster-Burton, Mint.com.

Recently, I wrote a three-part series on how to start investing.

Today, I want to look at an advanced topic. Generally, I avoid advanced topics in investing, for two reasons:

  1. Most people don’t even have a grasp of beginner-level investing yet.
  2. The vast majority of “advanced” investing techniques can’t beat a simple, diversified portfolio over time.

Today, I want to look at a possible exception. It’s called the Larry Portfolio, developed by a guy named (you guessed it) Larry Swedroe and presented in his short and readable new book, Reducing the Risk of Black Swans, cowritten with Kevin Grogan.

Like momentum investing, which I explored last week, the Larry Portfolio is a way to attempt to capture more return from your portfolio without taking more risk—the holy grail of investing. Spoiler alert: it’s a promising idea that may or may not be appropriate—or possible—to implement in your own investments.

This is fairly technical stuff, although I’ll leave the math out of it. If you’re interested in investing as a hobby, read on. If you just want a simple portfolio that will beat your stock-picking friends, that’s fine. Go back to my original series.

One kind of risk

Smart investors like to take smart risks.

Investing in just one company is a dumb risk. That company might go bankrupt in any number of unexpected ways. Investing in lots of companies (aka diversification) is a smart risk: you’re no longer exposed to the risk of one company flaming out.

You’re still exposed to the risk of the market as a whole, and that’s the risk that investors can expect to get paid for over time.

Investors call this total-market risk beta. Beta measures the volatility of the stock market as a whole. Generally speaking, to get more return, you have to take more risk: Treasury bonds have low beta and low expected returns; stocks have high beta and higher expected returns. A total stock market portfolio has a beta of 1. (Let’s talk about low-beta stocks another time, please!)

So you might imagine that the best possible portfolio would look something like this:

  • Low-risk bonds (Government bonds from stable governments, high-quality corporate bonds, CDs)
  • A total world stock market fund

Mix them in whatever proportion suits your risk tolerance. One popular formula is 60/40: 60% stocks, 40% bonds.

Many kinds of risk

Then, in the early 1990s, two professors at the University of Chicago, Kenneth French and Eugene Fama, took another look at the data. They found that beta couldn’t explain all of a portfolio’s returns.

Two other factors seemed to be important, too. A portfolio taking these factors into account could, some of the time, beat a total-market portfolio without being riskier. These factors are:

Size. Small company stocks tend to have higher returns than large company stocks.

Value. “Value” stocks, essentially stocks with low prices, tend to have higher returns than growth stocks. How do you decide which stocks are value stocks? Use a measure like price-to-earnings ratio.

Value stocks are essentially stocks in mediocre, boring companies. This seems like an odd way to make money, but it’s a highly persistent effect. (Value is believed to be a stronger effect than size.)

You can now easily buy mutual funds concentrating on small or value stocks, and many investors choose to “tilt” their portfolios toward these factors, hoping for bigger returns without bigger volatility.

It’s a reasonable hope, because beta, size, and value have low historical correlation. When you have multiple stocks in your portfolio that are exposed to different risks, we call that diversification. The same can be said for having multiple factors in your portfolio.

The Larry Portfolio

Now, what if the stock portion of the portfolio was made up of entirely small value stocks?

That would give plenty of exposure to beta (because small value stocks are still stocks, and correlate with the wider stock market), and also maximum exposure to the small and value premiums. It’s also reasonably well-diversified, because there are thousands of stocks that fit the profile.

This sounds like a risky stock portfolio, and it is: high risk, high expected return.

Larry Swedroe’s insight was: what if we mix a little of this very risky (but intelligently risky) stock portfolio with a lot of very safe bonds? Say, 30% small value stocks and 70% bonds?

The result is the Larry Portfolio, a portfolio with similar expected return to to 60/40 portfolio I described, but lower risk, because the portfolio is mostly bonds—the kind of bonds that did just fine during the Great Depression and the recent financial crisis.

Swedroe warns in the book that there are no guarantees in investing. “[A]ll crystal balls are cloudy—there are no guarantees,” he writes. The research behind the Larry Portfolio may be sound, but “we cannot guarantee that it will produce the same returns as a more market-like portfolio with a higher equity allocation.”

Is it for you?

I took a look at my portfolio. It looks almost exactly like the portfolio Swedroe describes in the first part of the book, a diversified 60/40 portfolio with plenty of exposure to beta but no exposure to the size or value premiums.

So I asked him the obvious question: should I have a Larry Portfolio?

“There is no one right portfolio,” Swedroe told me via email. “The biggest risk of the LP strategy is the risk called Tracking Error Regret.”

Tracking Error Regret is a nasty thing. Here’s what it means.

Inevitably, the Larry Portfolio will sometimes underperform a 60/40 portfolio. If the stock market is soaring, it might underperform it for years at a time. A Larry Portfolio holder might look around and say, “Dang, everyone is making a ton of money but me. This portfolio sucks.”

Then you jump off the Larry train and back into a 60/40 portfolio—probably right before a market crash that decimates your stock portfolio. (That’s the Black Swan in the book title.) “Oh no—Larry was right!” you conclude, and buy back in, but it’s too late: now you’re selling cheap stocks to buy expensive bonds.

There really isn’t any cure for Tracking Error Regret. You can write an investment policy statement (IPS) to remind yourself that you’re a long-term investor and shouldn’t be watching the market too closely, because it’ll only raise your blood pressure.

The worst way to address the problem is to assume that you’re too smart or tough to experience it.

Can we build it? Maybe we can

Finally, there’s one other reason the Larry Portfolio might not be for you: it requires using mutual funds that might not be available in your retirement plan.

If most of your money is in a 401(k) plan, and that plan doesn’t have a US small value fund and an international small value fund, you can’t really build a Larry Portfolio. You might be able to build a watered-down version, but it won’t have the same risk-return characteristics as the real thing.

I haven’t decided yet whether the Larry Portfolio is for me. If you’ve read this far, however, you’ll probably enjoy Swedroe’s book. And if you already use a Larry Portfolio or are considering one, please let me know in the comments.


The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Mint.com is not affiliated with Folio Investing or The Portfolioist.

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Am I Effectively Diversified?

This is the sixth installment in our series on how individual investors can assess their financial health.

Diversified FolioDiversification is a perennial topic among investors, and if it seems controversial at times, that may be due to the fact that people don’t always share the same understanding of what it means. But diversification isn’t about investing in a certain number of securities or funds. And it’s not about investing in every possible security under the sun.


Diversification and Risk

Simply put, diversification is the process of combining investments that don’t move in lockstep with each other. For example, Treasury bonds tend to do well when stocks are falling, and vice versa.  Combining stocks and bonds thus helps to limit risk.  Bonds also reduce the risk of a portfolio because they tend to be less risky on a standalone basis than stocks.

This brings us to an important point: the aggregate risk/return properties of a portfolio depend not only on the risk and return of the assets themselves, but also on the relationships between them.  Determining the right balance among these three factors (asset risk, asset return, and diversification benefit) is the challenge of diversification.

A Diversification Self-Assessment

The starting point in the determining whether your portfolio is properly diversified is to come up with a risk level that matches your needs.  I discussed risk estimation in last week’s blog.  Assuming you have a target risk level for your portfolio, you can then attempt to determine how to combine assets so as to achieve the maximum expected return for this risk.

The word “expected” is crucial here.  It is easy to look back and to see, for example, that simply holding 100% of your assets in U.S. stocks would have been a winning strategy over the past five years or so.  The trailing five year return of the S&P 500 is 15.7% per year and there has not been a 10% drop in over 1,000 days.  Over this period, holding assets in almost any other asset class has only reduced portfolio return and risk reduction does not look like a critical issue when volatility is this low.  The problem, of course, is that you invest on the basis of expected future returns and you have to account for the fact that there is enormous uncertainty as to what U.S. stocks will do going forward. Diversification is important because we have limited insight into the future.

Many investors think that they are diversified because they own a number of different funds.  Owning multiple funds that tend to move together may result in no diversification benefit at all, however.  A recent analysis of more than 1,000,000 individual investors found that their portfolios were substantially under-diversified.  The level of under-diversification, the authors estimated, could result in a reduction of lifetime wealth accumulation of almost one fifth (19%).

Additional Diversifiers

Aside from a broad U.S. stock index (S&P 500, e.g., IVV or VFINX) and a broad bond index (e.g., AGG or VBMFX), what other asset classes are worth considering?

  • Because the S&P 500 is oriented to very large companies, consider adding an allocation to small cap stocks, such as with a Russell 2000 index (e.g. IWM or NAESX).
  • There is also considerable research that suggests that value stocks—those stocks with relatively low price-to-earnings or price-to-book values—have historically added to performance as well. A large cap value fund (e.g. VTV, IWD, VIVAX) or small cap value fund (e.g. VBR, RZV) may be a useful addition to a portfolio.
  • In addition to domestic stocks, consider some allocation to international stocks (e.g. EFA or VGTSX) and emerging markets (e.g. EEM or VEIEX).
  • Real Estate Investment Trusts (REITs) invest in commercial and residential real estate, giving investors share in the rents on these properties. There are a number of REIT index funds (e.g. ICF, RWR, and VGSIX).
  • Utility stock index funds (e.g. XLU) can be a useful diversifier because they have properties of stocks (shareholders own a piece of the company) and bonds (utilities tend to pay a stable amount of income), but have fairly low correlation to both.
  • Preferred shares (as represented by a fund such as PFF) also have some properties of stocks and some of bonds.
  • Another potential diversifier is gold (GLD).


Diversification Example

To help illustrate the potential value of diversification, I used a portfolio simulation tool (Quantext Portfolio Planner, which I designed) to estimate how much additional return one might expect from adding a number of the asset classes listed above to a portfolio that originally consists of just an S&P 500 fund and a bond fund.


Risk and return for a 2-asset portfolio as compared with a more diversified portfolio (source: author’s calculations)

The estimated return of a portfolio that is 70% allocated to the S&P 500 and 30% allocated to an aggregate bond index fund is 6.4% per year with volatility of 13%.  (Volatility is a standard measure of risk.)  Compare that to the more diversified portfolio I designed, which has the same expected volatility, but an expected return of 7.3% per year, as estimated by the portfolio simulation tool.  The diversified portfolio is not designed or intended to be an optimal portfolio, but rather simply to show how a moderate allocation to a number of other asset classes can increase expected return without increasing portfolio risk.[1]

The process of analyzing diversified portfolios can get quite involved and there are many ideas about how best to do so.  But the range of analysis suggests that a well-diversified portfolio could add 1%-2% per year to portfolio return.


I have observed that the longer a bull market in U.S. stocks goes on, the more financial writers will opine that diversifying across asset classes is pointless.  We are in just that situation now, as witnessed by a recent article on SeekingAlpha titled Retirees, All You Need is the S&P 500 and Cash.

On the other hand, there is a large body of research that demonstrates that, over longer periods, diversification is valuable in managing risk and enhancing returns.  That said, a simple allocation to stocks and bonds has the virtue of simplicity and can be attained with very low cost.  Diversifying beyond these two assets can meaningfully increase return or reduce risk, but an increase in average return of 1%-2% per year is not going to take the sting out of a 20%+ market decline.  What’s more, a diversified portfolio is quite likely to substantially under-perform the best-performing asset class in any given time period.

But over long periods of time, the gain of 1%-2% from diversification is likely to increase your wealth accumulation over 30 years by 20%-30%.  This is consistent with the analysis of 1,000,000 individual investors cited above, from which the authors concluded that under-diversified portfolios were likely to reduce lifetime wealth accumulation by 19%.

For investors seeking to diversify beyond a low cost stock-bond mix, there are a number of simple portfolios that include a range of the asset classes discussed here and that have fairly long track records.  These are worth exploring as a template for further diversifying your own portfolio.

[1] For details on how the model estimates risk and return for different asset classes and for portfolios, see the whitepaper I wrote on the subject.


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Explaining the Value Premium

Guest post by Contributing Editor, Robert P. Seawright, Chief Investment and Information Officer for Madison Avenue Securities.

Value has persistently outperformed over the long-term.  Why is that?

In the most general terms, growth stocks are those with growing positive attributes – like price, sales, earnings, profits, and return on equity.  Value stocks, on the other hand, are stocks that are underpriced when compared to some measure of their relative value – like price to earnings, price to book, and dividend yield. Thus growth stocks trade at higher prices relative to various fundamental measures of their value because (at least in theory) the market is pricing in the potential for future earnings growth. Over relatively long periods of time, each of these investing classes can and do outperform the other.  For example, growth investing dominated the 1990s while value investing has outperformed since. But value wins over the long haul. Continue reading

Accounting Professor Joseph Piotroski’s Investing Ideas Beat Wall Street Gurus

Among the very most successful stock investing strategies of the year has been one focused on companies selling cheap but with strong book values. The strategy isn’t the brain child of Wall Street legends. It’s one developed by someone you may well have never heard of, a reserved Stanford accounting professor named Joseph Piotroski. In a paper published in 2000 by the Journal of Accounting Research Piotroski outlined the filters used to achieve 23 percent annual returns between 1976 and 1996. Piotroski’s ideas were compelling enough to attract the attention of John Reese, founder and CEO of Validea and Validea Capital Management, (pictured). Reese has spent the last 15 years studying history’s best investors and then building investment strategies based on that research. Among his “gurus”: Warren Buffett, Peter Lynch, and Ben Graham. So far this year, Piotroski’s method has topped those three, and the rest of Reese’s portfolios.

In this guest post, updating an earlier piece on his blog The Guru Investor,  Reese explains the Piotroski strategy and offers some stocks that fit the bill today. Continue reading

Portfolio Investing 101: Bill Bernstein

In his new book, The Investor’s Manifesto, William J. Bernstein makes a strong case not just for the idea of portfolio investing, but the fact of it. Any one of us, with a modest amount of effort, can build a good portfolio, Bernstein argues.  Then he proves it.

Bernstein is not your typical individual investor. A PhD and formerly practicing neurologist, he has a wild passion for investing, and an appetite for dot matrix diagrams that can be a bit intimidating.  A bestselling author of four previous books on investing and economic history, in this tome the good doctor set out to write something accessible to the masses. He’s achieved his goal. Continue reading