Reducing the Risk of Black Swans is a rigorous brain teaser that imparts financial wisdom by explaining scholarly research and evaluating alternative investment strategies.
The tutelage is conducted by Larry Swedroe and Kevin Grogan, director of research and director of investment strategy, respectively, for Buckingham Strategic Wealth and The BAM Alliance.
Their book’s subhead is Using the Science of Investing to Capture Returns With Less Volatility. The authors tell us in their introduction that they will avoid “the empty rhetoric or the distracting noise often heard in the active investment world. Science and hard data make our case. There is no need for elaborate prose or hyperbolic statements.’’
At 179 pages, including six appendices, Reducing the Risk of Black Swans is “short in length,’’ (but) “its content is heavy,’’ Swedroe and Grogan write.
The authors start with chapters on the basics, including estimating future returns to stocks and bonds; a brief history of modern financial theory; building a more efficient portfolio; and the virtues of a well-diversified portfolio.
On stock returns, Swedroe and Grogan warn against ignoring the fact that “current stock valuations play a very important role in determining future returns.’’ Yes, they say, the “real return to stocks from 1926 through 2016 has been 6.9 percent,’’ (with inflation factored in) but “most financial economists are now forecasting real returns well below that level.’’ Although there is no agreement on the best metric for estimating future returns, they say that the Shiller CAPE 10 is considered as good or better than others.
In discussing the birth of modern finance and its early proponent, the authors say that the most important aspect of Nobelist Harry Markowitz’s seminal 1952 paper “Portfolio Selection’’ is its finding that “it is not a security’s own risk and expected return that is important to an investor, but rather the contribution the security makes to the risk and expected return of the investor’s entire portfolio.’’
Research the authors present by various academics and economists bolsters the conclusion, which leads to their analysis of the Fama-French Three Factor model (using the factors of market beta, size and value), which introduces a critical element of their discussion: correlation.
They write that because “even many of the professional advisors we have met’’ have an incorrect understanding of the term correlation, the authors devote a chapter to explaining positive and negative correlation, in terms of assets’ returns.
And that leads Swedroe and Grogan to launch into the risk and rewards of diversification and a consequence of risk: negative tracking error.
“Only investors willing and able to accept the risk of tracking error regret should consider diversifying across other risk factors.’’