A (Long) Chat With Peter L. Bernstein

Reposted from Jason Zweig and CNN Money, October 15, 2004
By Jason Zweig

What if all investors could have their own personal Yoda — a voice of wisdom to calm our fears, quiet our greed and guide us through the wilds of the financial world? If I could design mine, he would be a creative thinker with an open mind, a wealth of experience, and encyclopedic knowledge of psychology and market history. Unfortunately, people with any of these attributes are about as common on Wall Street as a Wookiee with a crew cut — and people with all of them are rarer than a Valentine’s Day card from Darth Vader.

Thank goodness, then, for Peter L. Bernstein. In Wall Street’s herd of narrow and twitchy minds, he is patient wisdom personified. Over the vast sweep of his long career, he has probably learned more about more aspects of investing than anyone else alive. Even a summary of his career puts most “experts” to shame: classmate of John F. Kennedy at Harvard, intelligence officer during World War II, researcher at the Federal Reserve Bank, economics professor, money manager, pioneer in investment analysis, historian, expert on risk and author. Like Yoda, Bernstein is ageless. At 85, two of his favorite words are “wow” and “fun,” and he still pumps out his institutional newsletter, Economics and Portfolio Strategy, twice a month. Besides Against the Gods, a brilliant history of financial risk, Bernstein has published four other books after he turned 75. (The latest, a history of the Erie Canal, comes out in January.)

Bernstein has first-hand knowledge of both booms and busts: His grandfather’s leather factory became a growth business in the 1920s when the exploding popularity of the automobile created huge demand for sponges and chamois-skin polishing cloths. Then, in 1929, Bernstein’s father sold the business “for a price he never dreamed he would get” — and put all the proceeds into the stock market, which promptly crashed, nearly wiping the family out. Bernstein understands conservative investing, too: When his father started a brokerage, his partner was Frederick Macaulay, who invented the modern discipline of bond management. Above all, Bernstein grasps the human elements of investing: His own money-management firm, which he sold in 1967, specialized in what he calls “handholding” for wealthy clients.

I’ve known Bernstein since 1996 and have never ceased to marvel at his energy, his knowledge and the relentless way he questions his own beliefs. (Last year he stirred up a hornet’s nest by suggesting that market timing might not be a bad idea.) With his new book on the way, this seemed like an excellent time to sit down with Bernstein. Every investor can learn not only from his words but also from his flashing leaps of intuition.

Q: What are investors’ most common mistakes?

A: Extrapolation. Leaving fund managers in a down year to go with whoever’s hot. The refusal to believe that shock lies in wait. Believe me, individual investors are not the only ones who mire themselves in this mistake. It is endemic throughout the investing community.

Q: Do you think the investing public has gotten smarter?

A: I think my answer would be no. The day-trader phenomenon would not have developed out of a population that was thoughtful about how the stock market works. And I don’t think that many individual investors have learned that the more you press, the more problems you’re going to get into. They have not learned that, and maybe they never will.

A lot of investors feel it isn’t hard, they just don’t know how. Because the more you think this is easy, the more you persuade yourself that you can take the heat. And then, the sooner the oven gets hot, the more shocked you are and the worse you get burned. After 50 years in the investment business I still haven’t got it all clear. And that’s okay, because I understand that I haven’t got it figured out. In a hundred years, I won’t have it all figured out.

Q: How can investors avoid being shocked, or at least reduce the risk of overreacting to a surprise?

A: Understanding that we do not know the future is such a simple statement, but it’s so important. Investors do better where risk management is a conscious part of the process. Maximizing return is a strategy that makes sense only in very specific circumstances. In general, survival is the only road to riches. Let me say that again: Survival is the only road to riches. You should try to maximize return only if losses would not threaten your survival and if you have a compelling future need for the extra gains you might earn.

The riskiest moment is when you’re right. That’s when you’re in the most trouble, because you tend to overstay the good decisions. Once you’ve been right for long enough, you don’t even consider reducing your winning positions. They feel so good, you can’t even face that. As incredible as it sounds, that makes you comfortable with not being diversified. So, in many ways, it’s better not to be so right. That’s what diversification is for. It’s an explicit recognition of ignorance.

And I view diversification not only as a survival strategy but as an aggressive strategy, because the next windfall might come from a surprising place. I want to make sure I’m exposed to it. Somebody once said that if you’re comfortable with everything you own, you’re not diversified. I think you should have a small allocation to gold, to foreign currency, to TIPS [Treasury Inflation-Protected Securities]. If you’re worried about the strength of the U.S. dollar, then gold would be a good thing to own. It’s a very bad thing to own when things are good.

Can you manage yourself in a bubble, and can you manage yourself on the other side? It’s very easy to say yes when you haven’t been there. But it’s very hot in that oven. And can you save your ego, as well as your wealth? I think I might have just said something important. Your wealth is like your children — the primary link between your present and the future. You should try to think about it in the same way. You want your children to have freedom but you also want them to be good people who can take care of themselves. You don’t want to blow it, because you don’t get a second chance. When you invest, it’s not your wealth today, but it’s your future that you’re really managing.

Q: Your first job was working in the research department of the Fed in 1941. What did you learn there?

A: Two things. One, being a good boss or teacher is a tremendous thing, a great thing. My boss at the Fed, John Williams, was much more conservative than I was; he disagreed with me and I was just a kid out of college. But he really turned me loose on a big idea: the future of central banking. The second thing is that what you think is true one day is not necessarily true the next. All the Fed really did [at that time] was make sure that the rate on 90-day Treasury bills didn’t get above 3/8%. A few years later the Fed dropped that “peg” and cut the price it would pay for T-bills. The bond market was never the same again.

Q: How did your father become business partners with Frederick Macaulay?

A: My grandfather was a leather tanner. It was assumed that my father would take over the family business, but somehow he got into Harvard and was on his way to becoming a nice gentleman. He decided to manufacture shoes and gloves. Then my grandfather died early in the 1920s, and so my father did come back to the family business and become the boss. They had long been importing sponges and chamois cloths (made from goatskin or sheepskin). And this was at the exact historical moment when everyone was buying automobiles. And sponges and chamois were what you used to keep your automobile looking brand-new! So, through sheer luck, they suddenly had a real growth company on their hands.

Then, in 1929, a competitor offered to buy my father out. The price was so much more than he ever would have expected that he agreed. Then he took the proceeds from selling out the business and turned right around and put it all in the stock market. Right at the top, the absolute top!

He was wiped out, like almost every other speculator. So then our family had some hard times as my parents strung together odd jobs and tried any number of different things to make ends meet. But one day, a family friend said to him, “You’re always giving people advice. Why don’t you just go into business giving financial advice?” So he started Bernstein-Macaulay in 1934. Somehow or other, my father knew David Dodd [the professor at Columbia Business School and co-author, with Benjamin Graham, of Security Analysis]. He said to David, “I want somebody to come into business with me who has a name and who knows something. And if it’s not a Jewish name, that would help.” [Laughs.] Dodd introduced him to Wesley Mitchell [of the National Bureau of Economic Research]. Mitchell said, “Frederick Macaulay is the name.” Macaulay was this big, bawdy, cigar-smoking, cursing human being. He must have weighed 300 pounds. And he was brilliant.

Q: As an aviation intelligence officer in Europe during World War II, you saw civilians ravaged by war. How worried should we be that terrorism might become a part of daily life in the U.S.?

A: I arrived in London during the V-bombs [launched by Nazi Germany in 1944]. You heard the engines of the V-1s falling, all day and all night, followed by the explosions. As long as you heard the engine, you knew you were all right, because the engine was still going. But when you heard the engine go like this — coff! coff! coff! — and then you heard only silence, it really was scary, because you knew it was about to come down and you couldn’t know where. I still remember, it was June 24th, and on the street, there was an American soldier, a big strapping guy, standing on a street corner, screaming, hysterical, screaming “I can’t stand it anymore!” One evening I went to a concert at Royal Albert Hall, and behind the conductor’s head was a red lightbulb. If it went on, that meant “imminent danger” — a bomb was coming.… To stay in your seat meant that you could be blown to bits. The red light went on three or four times during the concert. But everybody knew that if anybody moved, we could all be killed in a stampede for the door. Nobody moved. The British showed that if you didn’t go on [with life as usual], you couldn’t go on. It was wonderful. This is how people survive. People are resilient.

Q: You’ve had a front-row seat at many of the critical events of the 20th century — including military and economic transformations that changed history.  If you had five minutes in the Oval Office, what advice would you offer on setting priorities and structuring policy?

A: On economic policy, I would propose a bipartisan Congressional committee to deal with the budget deficit — nothing sudden is necessary but a plan for the future is necessary, with the pain of higher taxes imposed gradually rather than all at once.  I would also appoint an energy-conservation czar, surely as a cheerleader but probably also with authority over the EPA to impose government regulations to conserve energy consumption.  And we have to do something about our educational system when kids can barely add and subtract without their hand-held joyboxes.

Q: A good case can be made for either optimism or pessimism about the economic and social future.  Optimism: Communism has fallen, democracy has spread, technology is continuing to light the way.  Pessimism: Terrorism has become epidemic, the rich-poor gap is opening into a gulf, rogue nukes and global warming might end it all.  How would you go about putting odds on the optimistic vs. the pessimistic scenario?

A: The great Michigan economist Paul MacCracken, at the blackest moment of 1974, told me never to believe in apocalyptic scenarios.  But on balance, the advantages of the optimistic developments are waning while the power of the pessimistic developments is growing.  We cannot reverse the balance without sacrifices and fear and pain that can last many years.  The structures we grew up with are crumbling before our eyes, and nothing new is there to take their place.  By structures I mean the global environment as well as global political and economic relationships.

The most hopeful thing I do see is the emergence of Asia as a young economic power.  Although they will be competitors to the U.S., the [emerging Asian countries] lend a dynamic character to the world economy that the old powers can no longer generate. Like the U.S. in the 19th century, they are the dynamo that can drive things forward.  Higher living standards in those countries is also a strong positive for the world.  But they have no interest in the environment, and corruption is endemic, so they are no angels.

Q: What are the important lessons about risk from your book Against the Gods?

A: Two things. First, in 1703 the mathematician Gottfried von Leibniz told the scientist Jacob Bernoulli that nature does work in patterns, but “only for the most part.” The other part — the unpredictable part — tends to be where things matter the most. That’s where the action often is.

Second, Pascal’s Wager. You begin with something that’s obvious. But because it’s hard to accept, you have to keep reminding yourself: We don’t know what’s going to happen with anything, ever, over any period. And so it’s inevitable that a certain percentage of our decisions will be wrong. There’s just no way we can always make the right decision. That doesn’t mean you’re an idiot. But it does mean you must focus on how serious the consequences could be if you turn out to be wrong: Suppose this doesn’t do what I expected it to do, not just because it goes bad but even if it just doesn’t go up enough. What’s gonna be the impact on me? If it goes wrong, how wrong could it go and how much will it matter?

Pascal’s Wager doesn’t mean that you have to be convinced beyond doubt that you are right. But you have to think about the consequences of what you’re doing and establish that you can survive them if you’re wrong. Consequences are more important than probabilities.

This isn’t just a paradigm for always coming out with conservative decisions. It’s really how you should make decisions, period.

Q: Is Pascal’s Wager only a guide for minimizing losses, or can it help you maximize gains?

A: In the late 1950s a grubby-looking guy asked us to take him on as a client. He had a huge portfolio, at least $200,000 on margin in just three stocks — AT&T, [aerospace company] Thiokol and U.S. Steel. He’d been a reporter for the Brooklyn Eagle and lost his job when the paper folded. He’d had $15,000 in the bank plus his wife’s salary as a schoolteacher. So he’d decided to shoot the moon. If he lost it all, they’d just go broke one year sooner. But if it paid off big, it would change their entire life. So, for him, the consequences of being right dominated the probabilities.

Q: What happened to him?

A: He came to us because he could not bring himself to unwind the tremendous gains in his portfolio. His wife, meanwhile, had been very calm and supportive on the way up. But now that they had made it big, she was terrified of losing it. So we diversified the portfolio for them. By the way, when I managed money we had clients who saved, and clients who used capital. And I always seemed to find that the ones who spent it were nicer and more enjoyable than the ones who squirreled it away.

Individuals can know more than the professionals give them credit for. I remember a man came to us once, and he said, “Don’t buy me any bonds.” I said, “Why not?” He said, “I am bonds.” He had a government job of some kind and really felt — rightly — that his income was so secure, because it was backed by the federal government, that he needed to take some more risk in his financial portfolio.

Q: Give me an example of when you put Pascal’s Wager into practice.

A: In 1981, I was retained to advise a major foundation on its investment portfolio. At this point I no longer remember exactly what their existing portfolio held. But I was convinced that the bond market was an unbelievable bargain, actually the equivalent to the stock market in 1932. Long-term U.S. Treasury bonds were yielding 15%. One of the members of the investment committee was the president of a major bank, and he was so apoplectic at my recommendation he got red in the face. His memory bank was full only of losses — the hundreds of millions, maybe billions, his bank had lost on bonds for years on end. But I held my ground, and I explained to them that if they were wrong to buy [bonds], they would still get 15%, and if inflation stayed high or went higher they still weren’t likely to be wiped out. But if they were right, then this would be like buying stocks in 1932. I wasn’t familiar with Pascal’s Wager then, so I didn’t think of this specifically because of that framework. But it was Pascal’s Wager to a T.

Q: What investing and personal advice do you offer your great-grandchildren?

A: As they are four and two (and about three months in the womb), they are not likely to take much of my advice, nor should I be giving them the kind of advice you have in mind.  But I would teach them Pascal’s Law: the consequences of decisions and choices should dominate the probabilities of outcomes.  And I would also teach them about Leibniz’s warning that models work, but only for the most part.  I would remind them of what the man who trained me in investing taught me: Risk-taking is an inevitable ingredient in investing, and in life, but never take a risk you do not have to take.  I guess I would also tell them not to worry if they lose the little gifts Barbara and I give them, because Daddy is there to bail them out.  So they should be willing to take big risks with those little gifts.  If they win, they will be off Daddy’s back.  If they lose, well, they are on his back anyway.

Q: You’re 85 now. Have you grown more conservative as an investor over the years?

A: Not really. In years past I had heavy bond exposure because I felt my life was highly equity-oriented, correlated to the fortunes of the stock market. I wanted to be able to survive at least a four-year bear market. [Pause.] I think I’ve probably survived a lot longer than most people involved in this business.

If you’re picking stocks for other people there’s this idea that you should eat your own cooking. But I happen to think there’s enough of your livelihood at stake already in doing the cooking. You don’t have to eat it too. You should be able to sleep well and be relaxed and not panic every time the stock market goes down.

Q: You’ve often written that something important happened in September 1958. What was it?

A: [For the first time in history,] stocks began to yield less than bonds, and it was not something tentative. The lines crossed without any period of hesitation and just kept on going. It was just, zzzoop! All my older associates told me that it was an anomaly and it could not last. To understand why that happened and what that meant — and to recognize that what was accepted wisdom for a couple hundred years could turn out to be wrong — was very important. It really showed me that you don’t know. That anything can happen. There really is such a thing as a “paradigm shift,” when people’s view of the future can change very dramatically and very suddenly. That means that there’s never a time when you can be sure that today’s market is going to be a replay of a familiar past.

Markets are shaped by what I call “memory banks.” Experience shapes memory; memory shapes our view of the future. In 1958, younger people were coming in who had a different memory bank, who did not carry all that extra baggage of depression and world war and tariffs. The bond market went down and the stock market didn’t go down, because people with a different memory bank didn’t know that wasn’t “supposed” to occur. That’s also what happened [in 1999] when tech stocks were enormously exciting; most of the new participants in the market had no memory of what a bear market is like, and so their sense of risk was muted.

How strong is the memory of the inflationary nightmares of the 1970s?  Anybody under 50 did not really experience it, in the sense that they were [then] too young to be decision-makers.  I believe sustaining that memory is more important to the future than all the vivid memories of the bubble and its aftermath.

Q: Ten years ago you pooh-poohed dividends. Now you insist they are vitally important. You once described a portfolio of 60% stocks and 40% bonds as “the center of gravity of asset allocation for long-term investors.” Then in 2003 you urged big investors to abandon fixed asset allocations in favor of strategies like market timing. Why all the flip-flopping?

A: I make no excuses or apologies for changing my mind. The world around me changes, for one thing, but also I am continuously learning. I have never finished my education and probably never will…. I’m always telling myself, “I must sit down and explain why I said this, and why I was wrong.”

Q: Is market timing [short-term trading back and forth among asset classes] really a good idea?

A: For institutional investors, the policy portfolio [a rigid allocation like 60% stocks, 40% bonds] had become a way of passing the buck and avoiding decisions. The problem was that institutions had settled on a [mostly stock] asset allocation because in the long run, they concluded, that’s the only place to be. And I think the long run ain’t what it used to be. Stocks don’t have to do well in the future because they did well in the past. In fact, the opposite may be more likely.

As you know, I have my doubts about the certainty so many investors feel about the long-run attractions of investing in stocks.  We do not know what is going to happen over the long run, never have, never will, and when [in 1999] the institutional funds were relaxed about [holding] equities, it was a moment when equities were far away from anything resembling real value.  Ben Graham said to invest with a margin of error, so you don’t get killed when you are wrong.  They invested with a margin so small or nonexistent that meant they had to be right or they would get killed — and they were.

Individuals can’t ignore the asset-allocation question. You want to have some structure as to where you want to be. And rebalancing is a wonderful form of market timing for individuals, almost judgment-free.

Q: Against the Gods is a great book. Is it your own favorite among the many books you’ve written?

A: I was actually reading parts of Capital Ideas the other day and was surprised by how much I liked it. It’s an intellectual history of modern finance, but I had forgotten how much of that story I was there to witness, as well.

Q: You’ve made waves by advocating market-timing, or an active long-short market strategy.  Do you think it’s possible or desirable for a large number of institutional investors not to be net owners of securities?  What empirical evidence is there to suggest that market timing can consistently add value for many large clients? How can — or should — the average small investor implement the strategic changes you have been advocating?

A: If you don’t think you have (or can find) the expertise to execute it, then you probably shouldn’t do it. It is certainly possible for a large number of investors not to be net long. Whether it is desirable is a value-loaded matter.  The market should be more efficiently priced if short selling increases.  The asymmetrical nature of short selling — infinite upside risk and inherent leverage — is the nub of the problem and could cause huge and maybe even catastrophic disruption.  But the question reminds me of people who said indexing would never amount to anything, because if everybody did it active management would be the way to go.  I doubt if the volume of short selling would ever reach a point where the market as a whole is no longer net long, or even close to it.

Q: Why has the low saving rate in this country not caused the problems most experts predicted? How worried should we be that no one saves anything anymore? Or are we not correctly measuring our savings?

Savings figures are very difficult to interpret. Nevertheless, I am deeply concerned over this problem, because spending beyond income means borrowing, and all of economic history proves that too much borrowing is the core of economic disasters and chaos. The corporate sector at this point is in excellent shape, which is one good thing, and some of the excitement about households is overdone because moving from a rented apartment to a house means more debt service but also less rent. But the [Federal debt], which promises no solution of any kind, and the heavy dependence on foreign investment in our government securities, scares me plenty. It is like giving foreigners a huge demand deposit on the U.S., and we have nothing to redeem it with if they want to withdraw it.

That there is no serious effort to deal with this problem is perhaps the most disturbing matter of all. Politics has reached a point where inflicting pain on the electorate is a no-no, which means fundamental economic adjustments are impossible except with Big Bang crises. Perhaps after the election a bipartisan group can try do tackle this, but I am doubtful.

Q: You have voiced worries over the “twin towers” of the national debt and the federal deficit. Warren Buffett is so concerned that he is (at last report) short the US dollar. But most economic observers — and nearly all investors — seem unruffled by the debt and deficit.  Who’s right, and why?

A: People seldom worry until the stuff hits the fan, a moment that may be inevitable but whose timing is impossible to predict. America has always somehow come through, but the world today is not the world in which we always scored ultimate success. Buffett is right, even if he’s early.

Q: In the face of $50 oil and relatively loose money, why has inflation not heated up faster?  Do you think the Fed can create a smooth recovery without setting off high inflation?  How, if at all, should investors be hedging against the risk of a sudden rise in the cost of living?

A: Oil is a smaller part of our economy than it used to be.  I do not know whether the Fed can pull it off, but I think they are doing the right thing.  We need some inflation — there is nothing like the prospect of higher prices to energize a sluggish economy.  Many people have inflation hedges in their homes, in huge cash deposits and short-term securities that can be rolled over into higher interest rates.  They do not have to get fancy under those conditions.  But there is a tendency — as I’ve suggested in answering all your questions — for people to expect the status quo either to last indefinitely or to provide advance signals for shifting strategies.  The world does not work like that.  Surprise and shock are endemic to the system, and people should always arrange their affairs to that they will survive such events.  They will end up richer that way than [by] focusing all the time on getting rich.

Q: Tell us why dividends are important.

A: In 1995 I said, “Dividends don’t matter.” I’ve been eating those words ever since. I assumed that reinvestments [the cash that companies put back into the business instead of paying out as dividends] would earn the same rate of return. I was wrong. Managements are more careful when they’re not floating in cash.

Q: Hugh Liedtke, the former CEO of Pennzoil, used to joke that he believed in the “bladder theory”: Companies pay dividends so that management can’t p–s all the money away.

A: It’s hard to improve on that. In the 1960s, in “A Modest Proposal,” I suggested that companies should be required to pay out 100% of their net income as cash dividends. If companies needed money to reinvest in their operations, then they would have to get investors to buy new offerings of stock. Investors would do that only if they were happy both with the dividends they’d received and the future prospects of the company. Markets as a whole know more than any individual or group of individuals. So the best way to allocate capital is to let the market do it, rather than the management of each company. The reinvestment of profits has to be submitted to the test of the marketplace if you want it to be done right.

Q: Over the course of your career, what are the most important things you’d say you had to unlearn?

A: That I knew what the future held, I guess. That you can figure this thing out. I mean, I’ve become increasingly humble about it over time — and comfortable with that, I might add. You have to understand that being wrong is part of the process. And I try to shut up, you know, at cocktail parties. You have to keep learning that you don’t know, because you find models that work, ways to make money, and then they blow sky-high. There’s always somebody around who looks very smart. I’ve learned that the people who are the most smart aren’t going to make it. What’s great about this business is that you keep learning. In fact, I don’t know anybody who left investing to become an engineer, but I know a lot of engineers who left engineering to become investors. It’s just so infinitely challenging. You just have to be prepared to be wrong and to understand that your ego had better not depend on being proven right. Being wrong is part of the process. It’s really why the market fluctuates.

Q: What’s the best book you’ve read lately?

A: Washington’s Crossing by David Hackett Fischer. It has nothing directly to do with investing, but it has lots to say about the process of decision-making, dealing with losses, deciding when to take (and when not to take) risks, responding to surprises, and working with others under highly stressful conditions.

Q: Your new book is Wedding of the Waters: The Erie Canal and the Making of a Great Nation. Who cares about the Erie Canal? Isn’t that just so 1825?

A: Barbara and I are good friends with [economist John Kenneth Galbraith and his wife]. They have a house near here. We were there one day, and if you go into the middle of town there’s a Civil War memorial, with about five names on it. And we commented on why there were so few names, and Ken said, “Well, you know, Vermont used to have much more farmland.… But then the Erie Canal opened up in 1825 and just emptied out the state; everybody left.” And that got us thinking. The canal opened the West to the Atlantic Ocean and opened the Atlantic to the West. It’s a story of globalization and technological progress, and that gives it current resonance.

Q: This is your ninth book. You needed more work?

A: That’s right. [Laughs.] I don’t know. How else do you find out how much work you can handle?

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