The key to designing portfolios isn’t maximizing profits in average markets but surviving terrible markets, says financial author William J. Bernstein.
“If you design your portfolio to survive the worst 2% of the time, that means it’s going to be more conservative than you think it should be,” he tells Barron’s. But after 50 years of compounding, “you’ll be glad you did.”
Bernstein became an icon to do-it-yourself investors with the 2002 publication of The Four Pillars of Investing: Lessons for Building a Winning Portfolio. The book explained how to use low-cost index funds to construct and maintain durable investment portfolios.
Bernstein has spent the last year researching and writing a new version of the book, which comes out this month.
He says he is placing more emphasis in the new book on having bullet-proof portfolios that survive terrible markets than he did in the first edition. He used to recommend that ordinary investors own corporate bonds through mutual funds because they yield higher than Treasuries. He doesn’t anymore. That’s because in terrible markets, corporate bond prices fall along with equity prices as investors worry about credit losses. Treasuries, by contrast, tend to rise when stocks fall.
“You want the riskless part of your portfolio to be absolutely riskless,” Bernstein says. “Corporate bonds really don’t belong in your portfolio.”
Bernstein wants to avoid losses in his safe capital, so he won’t have to sell losing investments to buy stocks during market crashes. “It’s never easy to buy stocks at the bottom, and it’s especially hard if you have to take a haircut to do it.”
The time when Treasuries do tumble is when interest rates soar, as they did last year, producing epic bond losses. Bernstein has preached for years that investors could protect themselves from this outcome by keeping their money in short-dated Treasury Bills rather than longer-dated Treasury Bonds.
He goes on: “There is a reason that Warren Buffett has 20% of
Berkshire Hathaway
in either cash or cash equivalents.”
Bernstein, a neurologist, practiced medicine for 25 years before becoming a fulltime financial and historical author and money manager in 2005.
He is well versed in the mathematics of investing, and his newest book has detailed mathematical explanations for those who want them. Still, Bernstein says those who view investing as purely a math exercise are in for a deep shock. Market psychology is equally important and helps explain why markets can behave in ways that mathematical models can’t predict.
“History tells you that the markets can be a cruel mistress,” he says.
Ordinary investors tend to overestimate their risk tolerance, Bernstein says. “They say, ‘I can tolerate a 60/40 mix of stocks and bonds. I can tolerate my portfolio going down by 30%.’ But when it actually happens, it’s a different thing.”
The aim of investing for most people should be avoiding poverty, not getting rich, Bernstein says. He starts out his book talking about Long Term Capital Management, which was started by acclaimed market experts including two Nobel Prize-winning economists in the 1990s. The firm aimed to profit from a complex derivatives-based trading strategy that was leveraged 25 to 1 with borrowed funds. “It quadrupled investors’ money over a four-year period before it imploded,” Bernstein writes.
He contrasts that celebrated flameout with Sylvia Bloom, a legal secretary who spent 67 years working at a New York law firm and left behind an estate of $9 million. She did it merely by investing in common stocks and allowing her money to compound for a long period of time.
“The more slowly you drive, the more likely your assets are to arrive safely at your destination,” Bernstein wrote. “This is what Bloom did with her money; LTCM’s principals, to their and their investors’ detriment, put the pedal to the metal.”
Ordinary investors can take lessons from Long Term Capital’s collapse, Bernstein told Barron’s. “The name of the game with investing is not to get rich, but to avoid getting poor. If you want to get rich, you want to buy the next
Apple
or the next
Nvidia,
and that’s not a good way. Because 99% of the time the company that looks like the next Nvidia or the next Apple is going to sink like a stone.”
Bernstein has written extensively on financial history, and in his newest book he discusses all the various bubbles and scams over the years and what they tell us about market psychology. Bernstein cautions investors to beware of flashy people who are peddling various get-rich schemes.
“If you are persuasive and eloquent,” Bernstein says, “the temptation to monetize it in the world of finance is irresistible.”
He adds: “The people I respect the most are almost universally bad speakers.”
Write to Neal Templin at [email protected]
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