Black Swans And The Larry Portfolio


In the late first century, a Latin poet named Juvenal described something thought to be unlikely as “a rare bird in the lands and very much like a black swan”.  At the time, black swans were thought to not exist at all and the idea was preposterous.  The clever turn of phrase was both memorable and descriptive, and by the 16th century “black swan” was a common expression in London to describe the idea of impossibility.  Of course there was a looming problem with this saying, and in 1697 Dutch explorers discovered that black swans really do exist in western Australia.  What once was used to describe something impossible quickly changed meaning to connote ideas thought to be impossible that are later discovered to be real.

A man named Nassim Taleb recently made the term famous in a series of books describing disruptive unforeseen events that greatly change the world around us.  In financial markets, the concept is often used to describe watershed moments like the stock crashes in 1929 and 2008 that nobody saw coming.  Rare but painful, black swans are things that most investors wish to avoid.

So when Larry Swedroe and Kevin Grogan wrote the book Reducing the Risk of Black Swans, they weren’t preaching about the color of waterfowl but of the types of rare-but-real dangers that investors are subjected to every day without realizing it.  An extremely insightful view into portfolio construction, the short but interesting book discusses ways in which portfolios can be built to thoughtfully reduce the likelihood of undesirably harsh negative returns.  It’s basically a succinct summary of modern portfolio theory and definitely worth a read.

As a follow-up to my recent decision to remove the Swedroe Min Fat Tails portfolio from the site due to a lack of good TIPS data, I decided to do just that and found the book at my local library to learn more about similar portfolio options.  As it turns out, the MFT portfolio was actually a bit of an older iteration of Swedroe’s ideas, and “Reducing the Risk Of Black Swans” offers a newer version built from assets we can model*.  To eliminate any confusion with the competing versions, I’ll go by the name they use in the book — the Larry Portfolio.


(*) Be sure to read the portfolio page for additional information on the funds chosen.

If you read different sources, the exact percentages may vary a bit.  Swedroe generally chooses to focus more on the academic concept of matching the return of a target portfolio but with less volatility, and depending on the portfolio in question and the data you have access to the percentages may change.  For practical comparison purposes I’ve chosen nice round numbers of 15% SCV, 15% I-SML, and 70% ITT that are about the average I’ve seen in a few places.  One can adjust the percentages to taste based on your personal needs.

Fans of the Min Fat Tails version will immediately see the similarity.  The basic idea is that by investing only in the highest return stock options and offsetting the additional risk by reducing overall stock exposure, one can achieve similar returns to more traditional portfolios but with less volatility.  To illustrate the concept, Swedroe uses a nice chart in the book that we also have an analog for here on Portfolio Charts — the Annual Returns chart that shows the distribution of annual real returns for a portfolio.

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The term “Fat Tails” refers to the far left and right extremes of this chart — the wider the distribution, the fatter the tail.  One could also think of the far left market disasters as the negative financial black swans that nobody thinks will happen to them but that absolutely do exist.  When they happen investors tend to freak out and sell low, and the unlucky ones depending on that money to pay the bills are often irreparably harmed in the process.

Since these very poor years are most likely to shake the confidence of even the most experienced investor, the alternative is to identify a portfolio that had similar average returns but a narrower distribution of results.  That’s where the Larry Portfolio steps in. The insight that not only are some portfolios are more consistent than others but also that by using modern portfolio theory the added consistency does not necessarily require lower average returns is quite profound.  Meeting your financial needs with much less exposure to uncertainty is a terrific goal for every investor.

In the book they make the case for the Larry Portfolio using available data since 1989.  I personally think that simply looking at average returns and standard deviations over one investing period is insufficient to truly understand portfolio behavior in a meaningful way to real-world investors.  That said, my specialty is studying compound real returns over multiple timeframes and I’m always excited when I can bring new information to the table.  For example, here is every investing period for the Larry Portfolio since 1970:


Now I admit that I also don’t have great data for International Small prior to 1982 and the results are only estimated (thus the different-looking squares).  However let me make two points.  First, the Larry Portfolio with 15% SCV and 15% I-SML is already right on the edge of what I’d consider verified data even for that older period — just reduce I-SML by only 1% and you pass my automated data tests.  And second, just because you’re a bit short on international data doesn’t mean that the decade we know was terrible for US stocks and treasuries didn’t happen.  That’s why I go to great lengths to at least give some estimation for how a portfolio may have performed all the way back starting in 1970.  It’s all about perspective.

Look at what is omitted by only starting in 1989 — you miss not only the left fat tails in the 70’s but also the right fat tails in the 80’s.  Basically, the returns look a lot more consistent than what a real investor would have experienced if you only look back a little farther.  On the other hand, to see a portfolio with some truly volatile assets never have a 2-year compound loss since 1981 is pretty remarkable when you think about it.  I think it speaks well for the concept, and I can see how many investors may find that appealing.

Take the time to really study the Larry Portfolio and read about how it works, and I suspect you’ll walk away with a new appreciation of the potential of modern portfolio theory.  I should point out that the Larry Portfolio method for minimizing downside risk is not the only option, and many of the other portfolios on the site follow similar concepts.  Stare at this for a few minutes, and you’ll start to appreciate how well different portfolios address the issue of black swans and fat tail risk.

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Or even better, check out the Drawdown charts for a more direct illustration of what the worst investing periods really felt like over time.

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Fortunately, black swans are dangerous to investors only to the extent that you believe they do not exist.  One can never eliminate all risk, but by studying history and applying intelligent asset allocation principles one can certainly mitigate many of the worst outcomes.  The Larry Portfolio is a nice example — check it out.