Episode #490: Bill Bernstein on Financial History, Star Managers & The 4 Pillars of Investing
Guest: William (Bill) Bernstein is a financial theorist, a neurologist, and a financial adviser to high net worth individuals. Known for his website on asset allocation and portfolio theory, Efficient Frontier, Bill is also a co-principal in the money management firm Efficient Frontier Advisors. He recently released an updated edition of The Four Pillars of Investing.
Date Recorded: 7/12/2023 | Run-Time: 50:14
Summary: In today’s episode, Dr. Bernstein shares two key updates since the first edition. Then we walk through some his best quotes and tie them to both timeless topics and current events like the AI craze and the media’s love for star managers.
Click here to listen to Dr. Bernstein’s last appearance on the podcast.
Comments or suggestions? Interested in sponsoring an episode? Email us Feedback@TheMebFaberShow.com
Links from the Episode:
- 39 – Intro
- 1:20 – Welcoming our guest, William Bernstein; Episode #60: William Bernstein, Episode #346: William Bernstein
- 2:44 – Overview and flow of Bill’s book; The Four Pillars of Investing
- 3:06 – Which of the four pillars is the most important one?
- 3:42 – The single most important determinant of one’s long term success is one’s behavior in the worst 2% of time; Memoirs of Extraordinary Popular Delusions
- 8:02 – The danger of charlatans
- 10:42 – The stockbroker serves their clients the same way Bonnie and Clyde service banks
- 14:54 – The only black swans are the history you haven’t read
- 18:13 – One of the quickest ways to the poor house is to make finding the next Microsoft your primary investing goal
- 19:34 – Why people are still seduced by glamor stocks
- 23:08 – Whether or not he has a play account for individual stock trading
- 26:16 – The biggest risk of all is failing to diversify properly
- 38:13 – The best ways to diversify a 60/40 portfolio
- 42:18 – Things Bill’s thinking about as he looks to the future
- 47:39 – Books Bill’s reading that he’s enjoyed over the past few years; The Secret of Our Success, The WEIRDest People in the World, Expert Political Judgement: How Good Is It?, Demosclerosis
Transcript:
Welcome Message:
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Disclaimer:
Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb:
What’s up everybody? We got the doctor back in the house today, our three time returning guests, Dr. William Bernstein, a neurologist turn investment advisor. He’s an author of several books and just came out with an updated edition of one of my favorites, The Four Pillars of Investing, which came out over 20 years ago. Today’s episode, Dr. Bernstein chairs two key updates since the first edition, we walk through some of his best quotes and tie them both to timeless topics and current events like the AI craze and the media’s love for star managers. If you enjoy this episode, check out the link in the show notes to listen to Dr. Bernstein’s First two appearances on the podcast. And while you’re at it, please leave us a review. Please enjoy this episode with Dr. William Bernstein. Dr. Bernstein, welcome back to the show.
Dr. Bernstein:
My pleasure. Good to be back.
Meb:
Where do we find you today?
Dr. Bernstein:
In Portland, Oregon. The Rose City on a nice sunny day, as you can see in the background there.
Meb:
I love it. You are a third time guest now. Listeners will put the fryer appearances in the show notes. But, you got a new book out. Well, I can’t say new book, but it’s a 20 year update. Is that right?
Dr. Bernstein:
Correct.
Meb:
One of my favorite books, and it’s rare for me to reread books called, The Four Pillars of Investing. And I read the sucker cover to cover again. So kudos, and it had a little different feel to it. And by the way, we’re going to do something different in the podcast today. But before we start, remind the listeners what is the flow of the book.
Dr. Bernstein:
I’ve always felt that you have to master for subjects to be a competent investor. And the first is the theory of investing, how risk and return are connected, basic portfolio theory, that sort of thing. It’s the math. The second thing is the history. All the math in the world doesn’t do you any good if you’re not aware of the history of investing, what tops look like, what bottoms look like, not necessarily to be able to time them, but just so you can keep your discipline. The third thing is your own psychology. The biggest enemy you have, as Benjamin Graham famously said, is the face staring back at you in the mirror. And then finally, there’s the business of investing. It’s dealing with the investment industry, which is a shark circling in the water, just waiting to take bites out of your wealth. And you have to be able to master those four things. Those are the four pillars.
Meb:
If you had to, if someone forced, said, “Dr. Bernstein, you have to rank.” You don’t have to go 1, 2, 3, 4. You can if you want. But, which one is most important you think of these four pillars?
Dr. Bernstein:
The psychology, and particularly the social psychology, because that’s the thing that brings most people to grief. It’s making bad decisions, it’s making bad mistakes. If you can avoid making awful mistakes, then you’re probably going to do all right. And, most of avoiding bad mistakes is avoiding psychological mistakes.
Meb:
Yeah. So, what we’re going to do a little different today, listeners, is first of all, I want you to read the book. So we’re not going to totally dredge up all the secrets of the book, because I want you to read it. But what we’re going to do that I thought would be fun is we picked out a bunch of quotes of yours. You’re very quotable, very quotable. And then, we’ll use those as jumping off points to kind of just talk about wherever we may lead. And you hinted to the first quote, the single most important determinant of one’s long-term success is one’s behavior in the worst 2% of time. Tell us more about that.
Dr. Bernstein:
Well, that’s a mistake that I think is one of the more common investing planning mistakes is people will collect a lot of historical data, they’ll spreadsheet it, and they optimize the portfolio over the whole port period, over the whole 80, or 100, or 45 year period that they’re studying, and all of which are probably long enough to give you reasonable results. And, what they don’t understand is that what matters is not how the portfolio performs in the 98% of the time, that’s normal. It’s how the portfolio performs and you perform during the worst 2% of the market, because the single most important thing about the mathematics of investing is the magic of compounding. And, Charlie Munger’s first rule of compounding, his prime directive of compounding is to never interrupt it. And that compounding is most likely to get interrupted. You’re most likely to screw things up during the worst 2% of the time.
And so, what that means is that you should have a portfolio that is a good deal, more conservative than you think it otherwise should have. And it’s going to be suboptimal. It’s going to be suboptimal, because you’re going to be carrying more cash, less stocks, but a suboptimal portfolio that you can execute and you can benefit from the magic of compounding is superior to an optimal portfolio that’s stock heavy, that you can’t execute when the excrement hits the ventilating system.
Meb:
If we had to stress out that 2% of market events, it’s not just necessarily the bad times, right? The March, 2009 or December, 2008, but also the 1% of time where you’re getting seduced into the insanity. Obviously, the last few years have reverted, but if we were here in, what was it, February, 2020, talking about, I don’t know, Dogecoin, or meme stocks, or everything that was just going bananas, people getting seduced into the exciting, crazy, exponential investments, which one do you think, if we had a wand we could wave and see which destroys more portfolios? Is it the panicking and the bad times? Or is it getting seduced into the nonsense and the euphoric times?
Dr. Bernstein:
Well, that’s an excellent point. I mean, I really didn’t address the comparison between those two directly in the book. And maybe I should have. But you’re absolutely right. I mean, it’s during the best 2% of the time that you also want to be wary. Probably, the best single investment I ever made was the $8 I paid for my copy of a used volume of Mackay’s famous book, memoirs of Extraordinary Popular Delusions and the Madness of Crowds. I read that 30 years ago, before the madness of the late 1990s, about five years before. And I thought to myself, “Gosh, this is an interesting book. This is fun. But I’m never going to live through anything like this. I mean, this is totally off the wall. It’s like a bad B movie about the end of the Roman Empire.” And then, lo and behold, before my very eyes, the madness played out. And, I had read the script, I had seen the movie, and I knew how it ended. So, that probably was just as beneficial to me as being able to maintain discipline during the 2008, the March, 2020, that period.
Meb:
You and I were talking a little bit before the podcast started, and one of the things that certainly has transpired, as you mentioned, was the craziness of 2020. I mean, I graduated college during the internet bubble, so experienced it very much as a participant. And, I thought I’d never see that again in the U.S. Figured I may see it somewhere else in a different area or maybe in a sector industry, but never broad-based. And, I had a conversation, we put it on Twitter, we asked as the poll, but I was also chatting with Professor Shiller where I was like, “Do you think we take out the all-time valuation record of ’99?” And for a while, it looked like we might get there. I mean, we got up to I think 40 on the Shiller cape and the high was 44 something. You mentioned in the intro that some of these delusions and getting seduced into crazy investments, you mentioned some in the book, but you also said you left some out. Talk to us a little bit about what you could add as an appendix if you could.
Dr. Bernstein:
Well, the one thing that I did write about indirectly in the book is the danger of eloquence and how charlatans are able to deploy that. And so, the classic example of that was Jack Welch who came across at his height as the second coming of Thomas Edison. But, what in fact, he was just a bean counter who was massaging his earnings. But he was a darling. And, what were some other darlings? Well, Elizabeth Holmes was a darling, and Sam Bankman Freed was a darling. Their faces were all over the financial press. So, I mean, Kathy Woods’ face is still all over the financial press, even though she has savaged her average dollar weighted investor.
And so, that eloquent, that charisma is a real danger sign. And, Sam Bankman Fried was just about to blow up as I was finishing the final drafts of the book. And, I wished I had mentioned his name because he’s just a classic example of someone who’s extremely charismatic, and has an extremely impressive narrative, and that thing is always a danger sign. The other face of that is the people I listen to the most tend to be awful public speakers. And I’m not going to mention names. But I think there’s an inverse correlation between how charismatic someone is and how smart they sound, and how good a forecaster they are and how good a money manager they are.
Meb:
It’s something that I think you and I both have come to appreciate over the years, this concept of narrative and storytelling. I’m a data person all day long. I could sit there and read tables, and charts, and visually that’s how I learn. And, as we’ve seen many times, people respond to storytelling. One of the most popular books of this past decade has been Morgan Housel’s book, which doesn’t have a single charter table in it. And so, for me, that doesn’t really speak to me as much as reading ones that are really deep in the data. But that narrative and storytelling can be used for good, or it could be used for bad. And, SPF very classically revealed in text messages and DMs that he understood how the game was played, when he talked about donating to charity, or doing these things, or putting on this very public image, he was doing it to manipulate, rather than being that’s actually who he was. And, you can see how that plays out in our world as well of investors and, as you mentioned, the Wall Street brokers and et cetera.
You had a good quote on that, let me see if I can find it. “The stockbroker services it’s clients in the same way, Bonnie and Clyde service banks. A broker’s only hope of making a good living is the milk your account dry with commissions and spreads.” It feels like that world should have gone away. How come the internet disinfected in general just information hasn’t made that entire industry disappear?
Dr. Bernstein:
Well, people prefer narrative cotton candy to data-driven spinach. It’s that simple. The way I like to put it in a more general sense is that if you are a seller of opinions or of concepts, you want to deploy narratives. And, on the other hand, you’re a consumer of opinions and of concepts, which as an investor is what you’re really doing. You want to ignore narratives and you want to consume only data. And that’s the real cleavage here is that professionals consume data and amateurs consume narratives. If you find yourself entranced by a narrative, that’s an alarm bell.
Meb:
Yeah. Jason Zweig has a good quote where he says, “I put two children through Harvard trading options. Unfortunately, they were my broker’s children.” It’s funny, because I was on Instagram and saw an ad for an investment offering. It said in bright letters, something like, “30% IRR.” And I said, “Huh, that’s funny.” You’re not really supposed to say that. And so, I liked it or bookmarked it so I could review it later. And then, the way the algorithms work, if you like something, you get served more of those. And so now, every day I get served countless investing opportunities. Now, 90 plus percent of them are private equity real estate, or private real estate funds, and I have a running Twitter list, so it’s now up to 20 of these funds, and some promise 50% IRR, and claim they have a billion in assets under management, and they have testimonials all over the place, and you pull up the FAQs, you have to dig forever to get to the fees. And there was one that had nine different fees. It was a broker fee, a finder’s fee, on, and on, and on.
And so, if I was an enterprising young person, listeners, I would go through my list, spend a few hours on each, and, I don’t know, of those 20, you probably have maybe five great whistle-blowing candidates on misleading illegal marketing, et cetera. But my goodness, this cycle that still happens, it astonishes me. I don’t know. Maybe I shouldn’t be surprised being in business this long.
Dr. Bernstein:
Social media is algorithmically optimized to serve you the most compelling narratives it possibly can. That’s what it’s designed to do. And the further away you stay from social media, the better off your pocketbook will be.
Meb:
Yeah. We may be bouncing around a little bit, but let’s keep doing some quotes. This is an interesting one. “The only black swans are the history you haven’t read.” What do you mean by that?
Dr. Bernstein:
Well, what I mean is that the more history you read, the less you will be surprised. When someone calls something a black swan, what that almost invariably tells me is they haven’t read enough history. For example, 2022, what happened in the bond market was unprecedented. Well, no it wasn’t. There have been bond market crashes just as bad as that. And they have coincided with stock market crashes, which is what made it a little unusual. But go back to ’70s, you had a 10-year-long, maybe a 15-year-long period, where both stocks and bonds lost an enormous amount of money, and your bonds did not save your bacon. And, if you had read that, you wouldn’t have considered what happened in 2020 to be the black swan that everyone called it. That’s the best example I can think of. But it’s true throughout all of not just financial history, but geopolitical history. There is almost nothing new under the sun.
Meb:
Yeah. And we tell investors, I mean, most people think… You’ll see on CNBC or whatnot, if the market goes down three or 5%, they’ll just be like, “Oh my god, black swan or crash.” Like, “No, what do you mean? This has happened many times in history.” And, you have to study history to know how crazy it already is. It’s like, watching Game of Thrones, when George Martin was talking about it, he’s like, “No, I based most of this off actual events.” I mean, it’s like, “The dragons, obviously not.” But, the crazy red wedding, and all the murders, and killing, and things that have gone on.
So, study the market to come up with what… I mean, the past is already crazy enough. But you have to at least still consider the fact that the future by definition can only get weirder, right? Your largest drawdown, it can only get bigger, it can’t get smaller. And so, I think having it as a base case, I mean, last year was a great example. I think, watching people getting lulled into bonds are always the panacea for stock pain was a lesson that people had forgotten wasn’t always true.
Dr. Bernstein:
Yeah. And just because you believe in market efficiency doesn’t absolve you from the duty to expected returns. For example, you go back and you look at the bond market in the middle of 2021, and I don’t have the exact number inside my head, but the three-year bill was yielding about 13 basis points or 16 basis points, and the five-year note was yielding all of 29 basis points. So you got about 13 basis points by taking five years of duration risk. That was just nuts. And yet, there were people who thought that it was a good idea to buy long bonds in 2020, 2021.
Meb:
Yeah. I was pulling it up the other day, and I was looking at zeros. They’re down, I think, 50% still, or roughly somewhere right around there, long bonds got to be not too far away for a boring old fixed income investment. Man, that’s exciting is trading the queues, I think, or whatever the new one of the day is zero-day options. It’s the new way to nuke your money. Speaking of poor house, you have another quote. “One of the quickest ways to the poor house is to make finding the next Microsoft your primary investing goal.” I thought that would be a good lead in. We could talk a little bit about… It’s a little bit post-book, but Nvidia.
Dr. Bernstein:
Most people think that the goal of investing is to optimize your returns. It’s to maximize your chances of getting rich. And unfortunately, optimizing your chances of getting rich also optimizes your chances of getting poor. To use a somewhat comical cartoonish example, if you wanted to get fabulously rich inside of the next week, the only way you’re going to do it if you’re starting with $100 is to buy a lottery ticket.
On the other hand, if you want to get poor, the worst thing you could possibly do is to have buying a lottery ticket as your investment strategy, or lottery ticket investment strategy. And it’s the same thing with investing, most people think that the best way to have good returns is to look for the next in video, or the next Amazon, or the next Tesla, and that is the fastest way to the poor house, because for every Tesla, there are 100 companies that look like Tesla that are going to go to zero. So you’re optimizing your chances of buying poor, and maybe 1 person out of 10 will do well, but the other 9 people are going to be eating cat food in their retirement.
Meb:
I was thinking about this. I see some headlines coming across on Rivian trucks, which I would love to buy a Rivian truck. They’re very expensive. But I saw that the 80,000 they sell for costs 150,000 to make. I was smiling. I was like, “The math of this doesn’t necessarily work out for some of these glamorous stocks.”
Dr. Bernstein:
Well, like Lucille Bull, they’ll make it up in volume.
Meb:
Right. I do a lot of angel investing. And I think, that’s a wonderfully interesting and exciting area to where I fulfill my itch for these lottery ticket concept. I do it very small, I make a lot of bets. But for me, it’s a lot of fun. You get to see the world changing on all these companies and optimistic. But, you see even late stage private, where we’ve had this blur of public versus private over the past 20 years. SpaceX being a 100 billion plus company. But, you’re seeing all these private brokerages that’ll broker shares in SpaceX.
And, one thing to charge a brokerage fee on that investment, I’m okay with that. But there’s a lot of people that are doing 2 and 20 offerings just to get shares of SpaceX. I mean, that feels so gross. I don’t know what about it that it’s a 100 plus billion dollar company. I get if you’re a $10 million startup, you’re leading the round, you did the due diligence. It’s a lot of work. But just being the middleman on that and charging 20% carry on $150 billion company to me seems like it’s the worst. We said the other day, we said so many of these fintechs and offerings of the modern venture capital Silicon Valley is just vanguard, but with way higher fees. It’s a prettier version of Vanguard. And so, this is a brokerage, but charging 20% carry, which to me, anyway, just seems nuts. I don’t know. But people are still seduced by the glamorous stocks. Why is that? Is it just it’s in our nature to want to hit the grand slam instead of bunt singles?
Dr. Bernstein:
Well, I think it’s simpler than that. I think it’s what Kahneman and Tversky wrote about, which is, heuristics, which is that when you’re faced with something that is computationally extremely difficult and has an enormous amount of certainty attached to it, you default back into narrative mode, which is, great company, equals great stock. And, we both know that in fact, the opposite is true. That great companies tend to have a very low cost of capital, and the flip side of that is that they’re going to have a very low expected return, because the prices bid into the stratosphere. And on the other hand, a really terrible company is going to have a very high cost of capital, so it’s expected return has to be higher to justify the risk that you’re undertaking.
The classic study that was done on that was done I believe by David Draymond, in which he took glamorous companies. He looked at companies with very high PEs and he found out that when they got a disappointing earnings announcement, they got taken out and shot, which we all know happens. Now, the flip side of that is when they came up with positive earnings surprises, their prices didn’t increase that much. Now, when you look at value companies, you look at doggy companies, the companies that no one can stare in the face. What he found was that they had a negative surprise, they really didn’t do that badly. They didn’t fall that much. And when they had a positive surprise, they went through the roof. So that’s where I think most of the value effect comes from, and that’s where most of the danger of chasing tech stocks, glamorous tech companies comes from.
Meb:
Yeah. We talk a lot about it, but looking back to the examples of late-90s to today, and you see some of the companies separating business versus stock, it’s like classic example of Cisco versus Microsoft, where the stock just got so far ahead of the business. The business was perfectly fine and actually did great for another 10, 15, 20 years, but the stock really underperformed, just because it got so expensive. And, it’s hard to, as you said, make it up on volume, but make it up on earnings to really keep up with that massive valuation.
Dr. Bernstein:
Yeah. I mean, for every Amazon there were 10 Ciscos and for every 10 Ciscos there were 100 pet.coms.
Meb:
Yeah, I owned most of them. CMGI, I had that. I had capital off carry forwards for 15 years. Does Dr. Bernstein have a play account? Do you allow yourself to have some investments you’ll trade around a little bit or are you too strict for that?
Dr. Bernstein:
No. For two reasons, number one is, I learned my lesson early on just like you did. And, number two, I also am a co-principal in an IRA firm, and I just don’t want to be dealing with trading individual stocks. Actually, truth be told, I do own one individual stock and that was a residual position that I had in Telmex 25 years ago. And Telmex, if you-
Meb:
I owned that back in ’99 too.
Dr. Bernstein:
… And Telmex spun off all these different companies, and one of them was Telfonos, some crazy share class that got de-listed and I was never able to sell it. So it’s sitting there as a ghost position in my brokerage account for the past 15 years. So, I do own one stock that will probably be worth nothing to my estate.
Meb:
There’s so many investor comments and narrative frameworks they get in their head that get stuck in the mud about. And I tweeted one yesterday, because it was on mine. I was talking to an investor. And, they made the comment about one of our strategies had a great run. They’re like, “I’m going to wait for it to pull back before I buy some.” And I said, “There’s the converse of that too, which is, ‘I’m going to wait until it recovers.'” So something that done very poorly waiting for it to go up, “And then, I’m going to magically get in as it starts its ascent.” And I said, “My experience is that in both of those cases, they want to delay the decision and they’ll never actually make an investment.” Do you think that’s accurate? Or do you ever hear people say, “I’m just going to wait for it to pull back”? Or, “I’m going to wait for this to come back before I sell it”?
Dr. Bernstein:
Yeah, all the time. I mean, that’s the marker for someone who doesn’t understand or is not asking the question, “Who’s on the other side of my trade?” It’s not some uninformed dentist from Peoria. The person on the other side of that trade is very likely the CFO of the company who knows more about that company than anybody else in the face of the planet, and you’re going to make money trading with them? Good luck.
Meb:
Yeah, one of my Instagram ads was for an algorithmic 30% a month, which to me sounds pretty good. Pretty soon you’ll catch up with Elon in no time. You got another quote. And, we could probably spend a bit of time here, but you said, “The biggest risk of all is failing to diversify properly.” 2022 was obviously really tough for traditional market cap weight U.S. stocks and bonds, but what does it mean to you when you say diversify properly? What does the properly word mean?
Dr. Bernstein:
Well, it means owning more than a small list of securities. You can own the total U.S. stock market, and you’ll probably do just fine. You can probably own the S&P500 and you’ll do just fine. Those are both properly diversified portfolios. They have a very large number of names in them. A portfolio that is not properly diversified is one that owns 5 or 10 names, because even at 10 names, the odds that one of them is going to do well in the long run is not very great. Something like 4% of the total U.S. market cap is responsible for the entire equity risk premium, the excess return of stocks over bonds.
So that means you’ve got a 1 in 25 chance of earning the equity risk premium when you own one stock. And, even a list of 10 or 15 of those stocks, you’re very possibly not going to be owning even one of those stocks. So that’s a portfolio that is not properly diversified. You’re not properly diversified probably if you invest only in Chinese stocks, or you invest only in Indian stocks, or Polish stocks, because you could have some sort of a national level extinction event in terms of the markets that is going to wipe you out, so you’d want to avoid that.
Meb:
Anything with extinction event in its name seems like an important topic. And, you also mentioned, you said it’s the behavior of the portfolio as a whole, not the asset in it that matters most. And I feel like this is a topic that is hard for people. We see advisors that’ll talk to us and say, “Well, I’m going to make this 1% adjustment over here.” Or, “I’m going to add gold, but I’m going to add 1% gold.” And I say, “Don’t even bother. It’s not going to do anything.” But people have a hard time thinking of the whole, they want to look at the individual slices in the great examples, sitting down with your financial advisor every quarter or whatever for the past 10 years probably and say, “Anything other than U.S. stocks. Why do we own bonds? Why do we own real estate? Why do we own commodities? Why do we own foreign stocks?” Are there any narratives to get people to look at the whole as opposed to all the zigzag parts?
Dr. Bernstein:
Yeah. Well, that is mathematically true, and I hammered that home in the first edition of the book and I still largely believe it. What I’d like to tell people is, “Look, you’ve owned Pacific Rim stocks for the past 15 years. And they’ve done terribly. You’d have been better off with them not in your portfolio. It feels awful just looking at that ETF or that mutual fund in your portfolio.” But, the fact of the matter is, is that, even the best diversified, most wisely designed portfolio going to have a dog in it, if you have 10 different asset classes, one or two of them are just going to be awful performers and you wished they weren’t there. That’s the nature of investing.
Now, the way I’ve modified my thinking though is I’ve come to realize that the head game, dealing with the Shakespeare investing, as opposed to the math of investing, has to do with how you psychologically deal with the worst 2% of the time. And I’ve changed my thinking about that a bit to realize that nothing beats being able to see yourself through the worst of times than a nice pad of good safe assets, and I’m talking about anything with the U.S. government guarantee, preferably of short duration as we found out in 2022.
And I like to call T-Bills elixir of equanimity, and they may be the lowest performer, the worst performing asset class in the long-term. But, in the short run, they may have the highest return of your portfolio, because they enabled you to get through the worst 2% of the time. The shorthand for that is, there is a reason why 20% of Berkshire is in T-bills and cash equivalents, and that’s it. It enables Warren Buffett and Charlie Munger to sleep at night, because that 20% of T-bills and cash equivalents means that they and many more generations subsequently of little Mungers and Buffett’s are going to do just fine. They don’t have to worry. And that’s how the rich get richer, and the poor get poorer. The rich person is someone who has 10 or 15% or 20% in T bills, and that 15 or 20% of T bills is enough to pay their living expenses for a long time. They are going to be buying stocks from the person who is 90/10, who sees their life flash before their eyes at age 50 when their portfolio goes down 40%.
Meb:
Yeah. I mean, it seems like, for almost all of the risk optimizations that most of the automated service provide, it’s like buying a cotton T-shirt, where you know it fits great, but you go home and you put it in the dryer and it’s automatically going to shrink, so you buy it one size bigger. I feel like portfolios almost always, you find the portfolio, say, “All right, this is what I want.” And then you take it down a notch on the wrist, because whether you get 8 or 9% is probably not going to determine the success of your life, but if you get 8 or 0, where you say, “No, I can’t handle this. This is way too volatile. Are you kidding me?” But, a little more airing on the side of steady Eddie. And it seems like, people rarely struggle with the opposite, which is like, “Wow, man, I should be taking way more risk.” When looking back on it. Even though they maybe should in some cases.
Dr. Bernstein:
Yeah. What I tell people to do is look at the risky side of their portfolio and ask myself, “How am I going to do over the next five years if 80% of it gets zapped over the next five years.” Which can happen. It almost happened in 2008 and 2009 for some asset classes. And if the answer is, “I’ve got a good, solid, secure job and I’m just going to be putting more money away.” Then, that’s fine. But, if you’re 65 years old and you have no more human capital left, then maybe you want to think about that eventuality good and hard.
Meb:
Yeah. So, when people come to you with portfolios here 2022 and 2023, or you’re chatting with people, what tends to be the biggest non-diversified mistake they’re making? Are they just loaded up on U.S. only? Do they have way too many positions in complexity? Is it too much in high fee tax inefficiency? What tends to be the major things that make you cringe that you see or chat with people about in this cycle?
Dr. Bernstein:
The biggest mistake I see people making is listening to a stockbroker and having a non-diversified portfolio of 10 or 15 different stock names, or on the opposite side of the end of the spectrum, 50 or 100 different mutual funds, many of which have high fees on which the broker is taking a 1 or a 2% annual commission. That’s mistake number one. When people don’t have a broker, the biggest mistake I see happening is in people of my age range, who need a set amount of money to retire on. And, they have at 80 or 90% in stocks. That to me is a mistake waiting to happen.
Meb:
Yeah. Well, but they sit down in a meeting and say, “Well, what are you talking about, Bill? Stocks have been the place to be for the past 10 years. I can handle these declines. They only go down 20%. And then, right back to all-time highs. You keep telling me…” Maybe don’t, but maybe do, “You keep telling me that I need to own a little bit in foreign and maybe some real assets stuff, but S&P has been a better performer. You sure you’re not just getting senile and I shouldn’t just be putting it all in S&P?” Do you ever hear that, or do your people ever complain? It must be a little problematic, because people that talk to you, I assume, come pre-proved, but pre-sold, right? They read your books, they get it, but do you still hear those comments?
Dr. Bernstein:
No. You hit the nail on the head. It’s not my audience. I’ve selected my audience so I don’t have to deal with that nonsense hardly at all.
Meb:
We think a lot about, are there any behavioral sort of gates and hoops? Obviously, having a financial advisor is one. But, even talking to financial advisors and watching them make some of the same mistakes or challenges. We had a conversation where an investment advisor emailed me the other day and they said, “Meb, I’ve been watching your strategy or fund for a while.” And, everyone loves to compare it to something else. “And so, there’s this other fund. And, I see yours has done better, but this other one’s cheaper. So I’m going to watch them for the next year or two, and then we’ll see which one to go with.” And I wrote back and I said, “Just a fun thought exercise, are you more likely to buy it if it outperforms or underperforms?” And he’s like, “What are you talking about? Why would I buy it if it underperforms?”
Dr. Bernstein:
Yeah, yeah, that makes no sense at all. I mean, when you’re talking about, and you’re talking about both active management and passive management, 95% of it is noise, so another year’s worth of noise is going to give you more information. I don’t think so. And that’s one of the joys of passive management, is with active management, when you see something doing poorly, you really don’t know whether you’ve got a lemon of a manager, or it’s just the asset class. Whereas, when you’re a passive investor, you know it’s the asset class. The asset class has gotten cheaper, and you know that an asset class that’s done very poorly over the past 10 years is just as likely to do really well over the next 10.
Meb:
Yeah. We say a lot, the discretionary managers in trying to ascertain why they’re doing great or poorly, that is the most unenviable and hardest job in the world in my mind. Being an allocator and deciding we’re going to allocate to discretionary managers, and then be like, “Well, is it because they’re going through a divorce, or is it because they now have made a ton of money and just drive Lamborghinis on the weekend all the time and don’t focus on stocks anymore? Is it because they made huge bets instead of…” You see a lot of the value guys turn into macro guys, and all of a sudden they’re prognosticating on all sorts of other stuff. That seems like an impossible job. So many institutions do it though. They continue to. I love poking a few of these very large ones and say, “Look, you guys are better off just firing everyone and buying a basket of ETFs.” But, they don’t listen to me.
Dr. Bernstein:
Well, yeah, I mean, as we both know, there’s this enormous industry out there, which is the endowment and pension consulting industry. And, what are the odds that the scales are going to fall from their eyes and they’re going to see the light and say, “Oh my God, my entire career has been wasted. I think I’ll go into teaching kindergarten or something that’s societally useful.” That is not very likely to happen. These people are going to continue to try to sell their craft to the endowments and the pension funds. And the pension funds and the endowments will continue to employ them, because they want to be able to blame somebody else when their policy goes south.
Meb:
As you stray away from U.S. stocks and bonds, what are the areas you think that add the levers most? Has it changed at all in the last 20 years? Is it the real assets lever? Is it foreign? Is it some sort of tips or precious metals? What’s the stuff that you think makes usually the most impact to a traditional U.S. 60/40?
Dr. Bernstein:
Well, you have to look at expected returns. And, when you look beyond the broad U.S. stock market, excuse me, for expected returns, well, there’s tips. Tips weren’t very attractive two years ago. Now, they’re quite attractive. You can get close to… Well, at least as of yesterday, a 2% real yield, all the way, excuse me, from short stuff up to around five or six years. I don’t think you can get 2% anymore as of today, I may be wrong. But even at the long end, you can get a percent and a half, 1.6, 1.7% on a real basis that is guaranteed by the U.S. government. That seems to need to be very attractive. Small value stocks around the world are cheap. They’re selling single digit PEs abroad, both in emerging markets as well as in developed markets.
U.S. small value stocks are selling it, not quite single digit PEs, but close. I think that commodities futures are a mugs game, because it can tango, because of the shape of the term structure, because you’re buying long at a higher price and you’re selling as they roll towards maturity at a lower price. So you’re getting clobbered by several percent per year. If you’re going to play the commodities game in the long-term, buy commodities producing stocks, because they have a positive real expected return, and in an inflationary environment, they’ll do pretty well.
Value stocks in general, if you’re afraid of inflation, value is a reasonable long-term bet on inflation. And then finally, even just the broad stock market is not a bad bet on inflation. Inflation will do bad things for the stock market in the short-term, but in the long-term, the common stock of companies are a claim on real assets, and they produce real products whose prices go up with inflation. And so, when you look at the very worst cases of inflation around the world, the Weimar inflation of the 1920s, Israeli stocks in the ’70s and ’80s, and a lot of South American markets as well, they did very, very well on an inflation adjusted basis. If you held German stocks between 1920, in the end of 1923, when the value of the Reichsmark fell by a factor of 1 trillion, that’s trillion with a T. The real return was actually positive, over that period of time.
Meb:
Yeah. You are watching what’s going on in Turkey right now, I think is a probably similar example of very high inflation. I mean, even the UK has high inflation. U.S., we’re back down to 3% or wherever we are today. So, hopefully, it’s been settled that we are not going back up. But, certainly in places like Turkey had a great stock market return last year, I think, relative to massive inflation. But, I don’t know if they’re the best example, where they go from here. I don’t know.
Dr. Bernstein:
I would hope that you’re right. But the problem is when you look at the history of inflation around the world, even in the U.S., it takes a long time for it to come down. It is very unusual to see the sorts of inflation that we had, and then have it all vaporized in the space of a year or two. It happens. That’s rare. The far more common case is for inflation like this to last for at least 5 or 10 years.
Meb:
Yeah, that would be my expectation. This was the consensus that it would come down the summer to this 3%, maybe even 2% range, but then rest of the year, and going forward, we’ll see where it goes from here. My belief, if I had to flip a coin, but useless, would be, the heads higher, but who knows. Bill, we’re running out of quotes. What else is on your mind as this book goes to print, as readers take this first spin, anything else you’re thinking about as we look forward into the future summertime in Oregon that you’re scratching your head about, you’re excited about? What else?
Dr. Bernstein:
I am reasonably optimistic, as optimistic as I’ve actually been in 15 or 20 years about securities returns in about people’s ability to spend. What we told people until relatively recently was if you’re a typical 65-year-old retiree, a 2% burn rate is bulletproof, 3% is probably safe, 4%, you’re probably taking some risk, and at 5% burn rate, you’re taking a real risk. And I think that given the increase in real bond rates and the general decrease in valuations almost everywhere in the world except in the U.S. and especially with U.S. large cap stocks, I think that expected returns have increased to the point that you can increase those burn rates by about a percent. And that may not sound like very much, but going from 2% to 3% gives you 50% more spending power each and every year. So, I’m reasonably optimistic about future security returns, both for people who are going to be putting money away, and people who are going to be spending as well, assuming they didn’t get too badly clobbered in 2022.
Meb:
People, anytime they give me a hard time about foreign stocks, I send them Vanguard’s forecast where they have foreign equities is the number one expected return asset class. I said, “Don’t talk to me. Go talk to Vanguard. Their expectations are much higher than mine.” I think a lot of that has to do with potential very low valuations coupled with much higher dividend yields than we have in the U.S. All right. So you’re an optimist. Now that you’ve inked this one, you’re always writing. So, what are you turning your attention to next? Are you like, “No, I’m going on sabbatical rest of the year. All the ink in my pens are dry”? Is there any new ideas? Are you going to turn your attention to anything else? What’s on the brain for writing?
Dr. Bernstein:
Well, I spend most of my time these days writing history books. And, the one historical concept, and it’s an economic concept that fascinates me, is radius of trust. When you look at nations around the world, you just have to ask yourself the question, “Why are some countries rich? And why are some countries poor?” I think it correlates the highest with its societal trust. And there’s something that sociologists like to ask people, which is what’s called the trust question, which is very simply, “Do you think that people as a general rule can be trusted?” And, if you look at those places in the world where the highest percentage of people answer yes to that question, they’re the richest places in the world. And if you look at the places where people answer no to that question, they’re the poorest places in the world.
And so, the question is, how do societies develop trust? Why do some develop it and why don’t other societies develop it? Which is basically you’re asking, “Why are some places rich and some countries poor?” And it’s a fascinating question, because it’s not a single deterministic thing. It turns out, that a richer a country gets actually the less trusting that it can become because you develop established elites that co-op the system and that destroys trust. We see that happening in the U.S., where people on both the right and left will tell you, “Yeah, the system is rigged against me.” And when people believe that, that’s not a good thing for the future. And it turns out that’s a characteristic of really wealthy societies. The wealthier societies get, the more that something called the wealth pump, which is a term that Peter Turchin uses, which just refers to growing inequality. And the more that inequality grows, less trusting people become. So, in a sense, wealthy trusting societies sow the seeds of their own destruction, which I’m afraid is happening in the U.S. And that’s what I’m thinking of writing about.
Meb:
That’s fascinating. I’d love to read that. We spend a lot of time thinking about company formation and trying to incentivize people to become investors, but also, encourage entrepreneurship around the world. And part of something I’ve noticed over the past decade is you’ve seen this Y combinator template, where these startups, where it used to be everything had to be bespoke. It’s like buying a house now. For the most part, fairly templated, or you have rules and regulations, but trying to make it simple. Maybe that’s a bad example. Because I had a hard time getting a mortgage. Because every mortgage place was convinced that I’m a hedge fund manager. And I’m like, “Do you even know what a hedge fund is? Because we do the opposite of that.” Anyway.
But they templated the startup entrepreneur mindset, and we’re starting to see that percolate all over the world. It’s going to be fun to watch in Latin America, and Africa, and Asia to see as these companies start to become successful, and then start to build a base of other entrepreneurs how that will impact those countries. It’ll be fun to watch. I hate asking this question, so I apologize ahead of time. Because I can never answer it. But you are much more well-read and articulate than I am. But as you think about history and are reading, what are some of the good books that you’ve been reading on history or topics that have interested you? You’ve obviously written a few, we’ll put links in the show notes, but what are some of the books that you thought have been particularly wonderful over the past few years?
Dr. Bernstein:
There’s a list of five or six of them. Let’s see if I can pull them out of my memory banks. Two by Joseph Henrick, who to my mind is one of the most brilliant observers around. He’s the head of theoretical biology at Harvard. And he wrote two books. One is The Secret of Our Success, which is about how human beings thrived as a species. And then, the other is a book called The WEIRDest People in the World, WEIRD being an acronym for Western Educated, Industrialized Rich, and Democratic, and just how strange we are in Western society, and how we got to be that way.
And then of course, there’s Phil Tetlock’s book, Expert Political Judgment, which is an analysis of forecasting and just how difficult it is, and tells you who you should listen to, who you shouldn’t listen to, and how you should try and forecast the future. And then, finally, a book by Jonathan Rosche, by the name of Demosclerosis, which is a popularization of Olson’s book on the subject that I was just talking about, which is how wealthy societies get captured by rent seeking elites and sow the seeds of their own destruction. It’s basically how societies rise and fall. And those would be, I suspect, the big four. If you gave me another 10 minutes, I could probably come up with a couple more that are just as important.
Meb:
Dr. Bernstein, it has been a pleasure as always. Listeners, go check out his new book, The Four Pillars of Investing. It’s wonderful. I promise you it’ll be some wonderful summer reading. Dr. Bernstein, thanks so much for joining us today.
Dr. Bernstein:
My pleasure.
Meb:
Podcast listeners we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at the mebfabershow.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening friends, and good investing.
