Peter's Uncertainty Principle
Peter Bernstein may know more about investing than anyone alive. And the most important thing he knows is this: He has no idea what the future will bring
(MONEY Magazine) – 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 since he turned 75. (The latest, a history of the Erie Canal, comes out in January.)
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. (For a fuller transcript of our conversation, go to money.com/bernstein.)
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. After 50 years 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. 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].
Q. As an 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. 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. 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. 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. 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 [see the box above]. 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. 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 expect it to do. 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.
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.
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. 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.
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.
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.
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. 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. 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 ones who are the most smart aren't going to make it. 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.
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?