Investing is inherently risky and, every now and again, an event occurs which takes investors by surprise.Take 9/11, for example, or the financial crisis of 2007-08.
The scholar and statistician Nassim Nicholas Taleb has referred to such events as black swans.
So how do investors minimise the risks these events pose? Well, a new book claims to have come up with a solution.
It’s called Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility. It’s written by Larry Swedroe and Kevin Grogan from Buckingham Asset Management.
We went to Buckingham’s headquarters in St Louis, Missouri, to meet the authors.
So, we asked Kevin Grogan, how CAN you reduce risk without substantially reducing expected returns?
Kevin Grogan: The way we attack that problem is by taking the stock side of the portfolio or the equity side of the portfolio, overweight small cap stocks and overweight value stocks, but then we reduce the amount that is allocated to equity overall.
So let’s say you are, have a portfolio that’s 60% stocks and 40% fixed income, but that 60% that’s invested in stocks is invested in the total stock market so you own all the stocks in the world.
Another approach might be, let’s invest 40% into stocks but then overweight those stocks to value and and small cap stocks. Then have the other 60% invested in fixed income and with that approach you’re maintaing that same expected return because you’re lowering the amount that’s invested in stocks which have higher expected returns than bonds but then you’re supercharging that equity allocation by tilting towards small cap and value.
A helpful way of looking at expected returns is like this.
Say the average expected return is 7%. Well, there’ll be some years when returns are disappointing and fall to the left of this graph. In the good years, returns will fall on the right. These sections here are called tails.
So effectively what Swedroe and Grogan have done is to design a portfolio that reduces the length of each tail. In other words, it minimises the risk of sharp falls in the value of your portfolio in exchange for slightly lower expected returns.
Larry Swedroe: That allows you over the long term to get about the same returns but cutting the downside risk dramatically which is particularly important for people who are one in the wealth preservation stage and also retirees, because drawdowns in their early years of your retirement means that it could be difficult for your portfolio ever to recover because you’re withdrawing the portfolio so when the market recovers you don’t get the full recovery because you’ve spent that money to meet your living expenses. So it’s key to be able to reduce that left tail risk and this portfolio strategy of what we would call a low beta, meaning low exposure overall to stock risk but then a high tilt, meaning lots of exposure of the equities you do own to the riskier small value stocks, allows you to achieve this objective.
Of course, there’s no such thing as a perfect portfolio.
If you’re a young investor, for example, or if you’re relatively relaxed about risk, you might well consider the low-beta-high-tilt approach much too cautious - but it it will appeal to many risk-averse investors who are disciplined enough to stick with it for the long term.
A reminder: the book is called Reducing the Risk of Black Swans, and it’s by Larry Swedroe and Kevin Grogan.
If you’ve read it, we’d love to hear what you think of it; and if there are any books you’d like us to feature in future videos, we’re open to suggestions: just get in touch.