William Bernstein, the author of several books on investing including “The Investor’s Manifesto,” was also trained as a neurologist. So, when IndexUniverse.com Managing Editor Olivier Ludwig caught up with him recently, Bernstein made clear that he knows all too well how the human brain can affect investor behavior. What’s the takeaway? Asset allocation will always be important, even though the “Great Recession” has some important lessons to teach us all.
Have the dramatic market events of the past few years changed any of your thinking on asset allocation?
I don’t think much has changed, but what’s happened has reinforced some lessons and forced us to think about some new things. The basic verities are still there: Costs still matter; passive still beats active in the long run because it has to by mathematical certainty; adhering to an asset-allocation policy still matters and the emotional discipline needed to adhere to that policy is even more important. The markets, at base, are a mechanism that distributes wealth to people who have a plan and can execute it from those who don’t or can’t. That part hasn’t changed.
So how do we rethink things based on our experiences in this radical episode?
From the point of view of personal finance, I think the thing that stunned everybody was just how fragile the largest financial institutions are. Where that becomes important to the individual is that most people should be annuitizing when they retire. If you’ve won the game, why keep playing it? If you pay an insurance company a fixed sum of money and then have an income stream that is perfectly safe that’ll see you through to the end of your retirement, then you’re crazy to put that money at risk in any substantial amount in the stock market.
That’s not to say that people shouldn’t be investing in stocks and bonds pre-retirement, and that’s not to say that if you’re Warren Buffett, and you can live on a small percentage of your corpus and want to leave a large amount of assets to your relatives and your heirs and your charities, that you can’t invest in a conventional portfolio and make that grow.
The second thing that this market taught us that was unique and singular was how illiquid fixed instruments that we generally thought of as safe were—municipal bonds and particularly corporate bonds. In the crisis there was only one thing that worked, and that was Treasuries. I finally understood in late 2008 why Warren Buffett puts all his reserves in Treasuries. When Buffett buys, liquidity is often in very short supply, and Treasuries are the only things that work.
The third thing is that in the wake of this crisis, risk-free yields are zero. How does one respond to that? Say you believe there’s going to be big-time inflation and you hunker down, buy short-term instruments to immunize yourself against this, and wait for rates to flame upward so you can roll your fixed-income instruments into the much higher interest rates that are going to result from inflation. If you’re wrong and there is no inflation, what have you lost? You’ve lost a couple of points on the yield curve by not going out. But what if you don’t think there’s going to be inflation and you reach for yield out the curve and you’re wrong? You will have your head handed to you. To me it’s a classic Pascal’s wager. So you take both these concepts to heart, grin, hold your nose, and accept these awful short-term rates.
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