The Four Pillars of Investing ft. William Bernstein (EP.124)

0:28We all need to make smart decisions with our money. writer. Bill has authored several finance and history books, but he recently published a revised version of The Four Pillars of Investing, a book that personally was very influential to my own education. I think you will really enjoy our conversation, which goes over the four pillars of investing, some common traits of market bubbles, the history of risk, and some potentially attractive segments of the market. As always, you can find detailed show notes and links to all resources at thelongterminvestor.com. And now here is my conversation with William Bernstein.

1:10Bill Bernstein, welcome to The Long-Term Investor. Glad to be here. Your books have been very influential to me throughout my career. And I don't even think I think I realized when I was first reading your materials that you'd started your career as a neurologist. I'm kind of curious, what made you transition into finance in the first place? Well, as you might imagine, it's a shaggy dog story. I began to realize 45 years ago that I lived in a country that doesn't have a functioning social welfare system, and I was going to have to provide for my own retirement. So I did what I thought that anyone with scientific training would do, which is to read the peer review literature and the basic texts, collect data, build models.

1:55And that's what I did. And after I had accomplished that about 30 years or so ago, I realized that I had done something that was of use to small investors because 30 years ago, those models just weren't available to small investors. So the internet had just arrived in my rural locale. And I put some articles and finally one of my first books up online. And that got me a career as a writer. And I realized after a while that I enjoyed writing history because history is such an important part of investing. So I sort of got myself a third career after that, writing about historical topics as well.

2:35Well, I did reference how prolific of a writer you are in the introduction. And I've noticed maybe not so much in your history books, but in your investment books, as well as when I've watched past interviews of you, you've talked about how physicians are not necessarily the best investors. I'd love for you to share a little of why you think that is, because honestly, I think that it applies to almost anyone. Yeah, well, that's a good point. I mean, your introductory email to me, you basically said, you know, I really don't think that physicians are any worse than anybody else. And you're probably right.

3:08But what really disappoints me about my colleagues and sticks in my craw, I suppose, a little bit about them is they don't treat investing seriously. These are people who, after all, would not treat so much as a stuffy nose in a patient without reading the peer-reviewed literature and looking at randomized studies. And yet when they invest their life's savings, they put almost no effort into it. And it's kind of like a neurosurgeon going and instead training in the usual manner, reading articles about neurosurgery in USA Today. That's not a wise way to do things. You need to consult better sources.

3:44So that's why I single out my ex-colleagues for special criticism. Well, as the child of a physician and a nurse practitioner, those sort of examples always resonate with me. And I do feel like because medicine is evidence based, as should be investing, it's really a nice natural connection. But what I know from experience is regardless of your profession, I don't think that people take investing seriously enough. As you mentioned, reading USA Today or whatever publication, and assuming that there as some piece of knowledge without really understanding the core tenets of investing. And your second edition of the book, The Four Pillars of Investing, I think covers a lot of those important issues.

4:28I was hoping you could just touch on briefly what those four pillars are. Well, the first is investment theory, which is the connection between risk and return. If you want perfect safety, you're going to have to satisfy yourself with low returns. If, on the other hand, you want higher returns, then you are going to sustain risk, which is a polite way of saying bone crushing losses from time to time. So that's the first thing. And of course, the portfolio theory also gets involved as well, how to put together portfolios of hopefully uncorrelated or less correlated assets. So that's the theory.

5:06The next is the history. And the history is so very important because you have to know how the movie ends while it's playing out in real time. And if you study history, then you've read the script and you know how the story ends. And you know, for example, that the highest returns are earned by fishing in the most troubled waters. It's when things look the worst that you make your best purchases. And when there's lots of sunshine and you're optimistic and everybody else is optimistic, those are the times when the worst returns are obtained going forward. Then the third pillar is the psychology of investing, and that's realizing that we evolved over millennia to survive in an environment which emphasized short-term risk.

5:52And unfortunately, in a modern post-industrial society where your financial horizon is as long as a half century and maybe even longer than that, those instincts that we evolved as part of our survival package serve us very poorly. We turn to be risk aversion, myopic. So your biggest enemy is the face staring back at you in the mirror. And that's why mastering the psychology is so very important. And then finally, there's the business of investing. You're swimming with sharks, and you have to know how to avoid them. And that is the final step or the final pillar of the four pillars of investing.

6:29Now, this might be difficult to really single out, but do you feel like if you can only learn one of the pillars, that there's one that's more important than the others, recognizing that they're all important? The history. The history is so very important. I'm not saying you should try and time the market it and recognize market highs and lows. But you have to at least be able to maintain your discipline. Einstein is supposed to have said that the most powerful force in the universe is compound interest. He, of course, really never said that. But the point is that compound interest is so very powerful.

7:01And you have to obey Charlie Munger's prime directive of compounding, which is to never interrupt it. And if you know the history, you're much less likely to panic and interrupt it. That's the single most important pillar, I think. I tend to agree with you. If you know that something bad is coming, I feel like every conversation I have with clients, regardless of what the topic of discussion would be, I always try to remind them about the frequency and magnitude of losses within the market, because it's a completely normal piece. If you weren't expecting it, your animal instincts will kick in and you'll do exactly the wrong thing.

7:40understanding how normal losses are just seems like an incredibly important piece of the puzzle. The other thing, and you talk about this in the book, are just some of the things that never really change about human nature, the bubbles, the manias. I know that from listening to you speak when your book came out, that when you submitted the first draft of this manuscript, the FTX and crypto bubble had not quite burst yet. I'm wondering if you could talk a little about bubbles from a high-level view and some of the common threads that you see across all of them? Well, financial economists have real problems with bubbles.

8:17You talk to the highest level financial economist, and they'll tell you that the very word drives them crazy. And the reason why bubbles drive financial economists crazy is because they can't model them. You can't mathematically model them. I mean, even Sir Isaac Newton knew that 300 years ago when he is supposed to have said that he could calculate the motions of the heavenly bodies, but not of the madness of people. But you can approach it from a sociological point of view. It's kind of like famous Supreme Court justice said about pornography. He can't define it, but he knows it when he sees it.

8:50So what does a bubble look like? A bubble has four essential characteristics. Number one is that the object of the speculation of the bubble becomes an everyday topic. So I can remember going back 25 years ago in the late 90s, going to people's houses, just getting into a cab, and people were talking about stocks all the time. They were talking about getting rich with dot-com stocks. Everybody was talking about it. I had relatives who, for the first time in their life, joined a stock club. That's a bad sign. The second sign is related to that. It's when people quit otherwise lucrative professions to day trade.

9:33And I had a wonderful example of this. One of my medical colleagues back 30 years ago worked at a clinic that had gotten one of the town's first high-speed internet connections. And you couldn't get online at that clinic because he was tying it up all the time day trading. All right. So that's the second characteristic. The third characteristic, and this is one that's very subtle and you wouldn't think is related until you connect it, which is that skepticism is met by outright hostility. So again, back in the 90s, when you told people that you thought that tech stocks were a bubble and dot coms were a bubble, people just didn't politely disagree with you.

10:10They got angry at you. All right. And you see the same thing with crypto today. You express skepticism about crypto and people will get angry at you. And they basically say the same words that I heard 30 years ago, which is you just don't get it. And they might easily add to that, you old fogey. So that's the third characteristic. And then finally, the fourth characteristic is when people make outlandish predictions. And a famous software entrepreneur once said that he would commit an act on national television that involved a great deal of spinal flexibility if the price of Bitcoin didn't reach a half million dollars.

10:46That's the kind of prediction that you see in a market bubble. So those four characteristics, I think fairly reliably enable you to identify a bubble. Now, it doesn't tell you when a bubble is going to burst. Just because you identify a bubble doesn't mean that's the time to sell. Bubbles can last a long time. Well, and the allure that causes so many people to chase whatever that bubble is sort of blinds you to the mistakes that you'll make. And to me, a lot of investment success comes down to simply just minimizing mistakes. Obviously, getting into a bubble would be one, but what are some of the biggest mistakes that you feel like people make as investors?

11:21I think the biggest mistake that people make, as I've already mentioned, is not treating it as a serious subject, a subject worthy of serious study. The second mistake they make is they're overconfident. And they're overconfident about many things. They're overconfident about their ability to pick securities. They think that the person on the other side of the trade is some dentist from Peoria that God placed on this earth for them to make money off of when, in fact, the person on the other side of the trade is probably somebody like Warren Buffett or Goldman Sachs. That's the first mistake they make.

11:53They make the mistake of thinking they can time the market. They make the mistake of thinking that they can pick successful money managers. But those aren't the most dangerous overconfidences. The most dangerous overconfidence is overestimating your ability to bear risk. Times like this, when the markets are fairly ebullient, everybody's a long-term investor. It reminds me of that famous financial economist Michael Tyson's famous statement that everybody's got a plan until they get punched in the mouth. You mentioned bearing risk. In the book, you talk about two types of risk, shallow risk and deep risk.

12:28Do you mind explaining that? Well, shallow risk is the risk that everyone thinks of, which is volatility, typically measured as standard deviation of returns. And that's short-term risk. That's losing 50 % of your money between, let's say, 2000 and 2002 or from 2007 until 2009. But typically, those kinds of declines are reversed and you wind up eventually making a lot of money in the long term. That's shallow risk. And that's the kind of risk that everybody pays attention to. But that's not the worst kind of risk. The worst kind of risk is, I define at least as deep risk. And I define that as losing more than half of your purchasing power for a period of at least a generation.

13:14So what are some examples of deep risk? Well, deep risk is buying Japanese stocks in late 1989 and still being underwater by a significant amount in real returns 35 or 33 years later. So that's deep risk. Let me, there's another kind of deep risk that people really didn't think about until very recently, which is not the deep risk of stocks, the deep risk of bonds. If you bought a long bond, the long treasury in 1940, and you reinvested the interest in it, you still wound up with a real loss, an inflation-adjusted loss 40 years later of almost two-thirds of your money. All right? That's deep risk.

13:55And that risk, of course, came home in 2022. There's another example you gave of deep risk in the book, which was Japan, and that they had been in a bear market for, what is it now, 30-plus years? Are we approaching 40 years at this point? No, it's late 1989. I was coming up on 34 years. A third of a century works for me. When I started my career, I graduated in 2007, just ahead of the financial crisis. And for most of the first few years of my career, I'd be speaking with clients and they would say, why do we have so much US? We should have more international and especially emerging markets, by the way, that was the hot place to be.

14:35Whereas the past several years have been, why do we have so much international? We should have more U.S. To me, it seems like international diversification is one of these ways to protect yourself against deep risk. And yet they've underperformed. Diversification is sometimes hard to live with. What do you make of this? Well, you've just described recency bias, red in tooth and claw. I mean, back 15, 20 years ago, it's why didn't you invest more in international? Obviously, that's a big part of the world economy. 20 years ago, foreign stocks were 60 % of total world market cap. So why aren't we invested more abroad?

15:14Well, now that that has reversed in US stocks and trounced foreign stocks, it's why are we investing in these crappy foreign stocks that have done so poorly? And of course, past is almost always the opposite of prologue in the financial markets. When I see an asset class that has underperformed everything else for the past 30 years, that's when my interest starts to perk up. We would love to be able to perfectly forecast the future, but the best that we can do is make some educated guesses. And you've been very consistent about publishing some calculations on expected returns. You did it in your first edition of The Four Pillars of Investing.

15:50You have done it in other investing-related books. And of course, you did it in this latest edition where you arrive at what I would consider to be a relatively low real return, that is, return net of inflation. I personally, as chief investment officer of a large independent advisory firm, I get a lot of fund providers calling me and pointing to the same thing, saying we might expect lower real returns in the future. And they would tell me that the answer to that is using alternatives. Two questions for you. One, could you just at a high level, talk a little bit about how you come up with your expected return calculation?

16:25And second, what do you say to people who suggest alternatives are the answer to those lower expected returns going forward? The answer to the first question is the Gordon equation, which is as close to the law of gravity as you can get in finance, which is that your long-term expected return is the sum of dividend growth and the dividend yield. So you start, for example, in 1926 with the origin of the Ibbotson database or the CRSP database. And you started out with a dividend yield of 5%. And real dividend growth probably at that point was about 1%. So you would guess that the long-term expected return of stocks would be an inflation-adjusted real 6%.

17:10Well, it turned out to be closer to 7.5%. Why was it a percent and a half higher? It was a percent and a half higher because the dividend yield fell by a factor of four. So the price increased by a factor of four. And you annualize that over 96 or 97 years, and you come up with that gap, that percent and a half gap roughly. And so the Gordon equation will be off to the extent that that multiple has changed. So the reason why the estimates that I and other people made 20, 30 years ago were a little low was just for that reason. Over the past 20 or 30 years, multiples have increased. And that's part psychology, right?

17:49I mean, we can't predict what crowds will be feeling over those periods of time. Isn't that right? Yeah, it's not just crowds. It's also that there are any number of reasons why the expected returns of stocks have fallen and why prices have risen. And that's, you know, I could probably spend hours talking about that. But it's basically the savings glut is when you have more and more money chasing a relatively fixed pile of stocks, then prices are going to rise and future expected returns are going to fall. Now, the second part of your question has to do with alternatives. And I have a little metaphor for that, which is David Swenson's buffet table.

18:29David Swenson, for those who aren't familiar with him, was the chief investment officer of the Yale Endowment. And he did brilliantly by investing in alternatives. He basically invented what other people call the Yale model, which is a conventional allocation of stocks and bonds, which is overlaid on top of a large amount of private equity, private real estate hedge funds. And he shot out the lights doing that. And so everybody else said, ah, this is the way to go. And what they didn't realize is that David Swenson had discovered a buffet table and he got to it first and he took all the prime ribs and the lobster tail.

19:07Okay. The people now who are telling you to invest in alternatives as a solution to low expected returns, we're going to wind up with the tuna noodle crass roll. That's all that's left after David Swenson took the good stuff. I love that. Staying with the expected returns conversation a little bit more, do you feel that some stocks, if we're going to kind of shift back towards traditional assets of stocks and bonds. Do you feel like some stocks have higher expected returns than others? Well, that's the$64 trillion question. You and I are both amenable to factor investing. Look, it's still looking at stocks that have cheaper metrics.

19:44And historically, they have beaten growth stocks over the very long term. But that's not been true over the past 20 years. Over the past 20 years, growth stocks, in fact, have done better than value stocks. So the question is, why is that? And there are two possible explanations. One is that everybody now knows about it and something that everyone knows about has been arbitraged away and isn't worth anything anymore. To take off on Bernard Baruch's famous statement that something that everybody knows isn't worth knowing. And that's the first explanation. If that were the case, you would expect the valuations, the relative valuations of value stocks to have risen.

20:24The other explanation is that people have fallen in love and are overpaying for growth stocks. And if that's the case, then you expect to see the opposite, which is that the valuations of value stocks would be falling relative to growth stocks. And in fact, when you look at the empirical data, that seems to be what's happening. They're out of fashion. They're now cheaper than they used to be. And their expected returns going forward are going to be higher. Now, I think, like everything else in finance, that's at best a 55-45 bet. I wouldn't bet the farm on it. I wouldn't put all of my money into value stocks.

20:59But I think that a tilt towards value stocks is a bet that is perhaps worth making. If it pays off, you'll be happy. If it doesn't pay off, there will be no shortage of people who will tell you that I told you so. Well, I like the way that you phrased that. And when I think about differences in expected returns, if I think of even if I'm just looking at the United States and there are, let's say, 5 ,000 stocks, I wouldn't expect every stock to have the same return. And I think that's important for people to realize that different stocks should have differences in expected returns. The question is, which ones are higher?

21:35And yes, when you pay a lot for the same fundamentals, you would expect less return. Or similarly, there's an example you give in the book, I believe, where you say if executives from Caterpillar and Amazon walk into the room and they're trying to raise capital, if you feel like Amazon's the better company, you're taking on less risk. You're not going to demand as high of a return from Amazon as you are Caterpillar. Now, to be clear, I'm using these two without any real nuanced view of their fundamentals. But I think that over time, the empirical evidence of these factors are very strong. At the same time, most returns at the end of the day are just going to be driven by your asset allocation rather than your investment selection.

22:18So when you say, hey, a tilt towards value, at the end of the day, you're still suggesting, I think, that asset allocation is going to be the real driver here. Is that right? That's correct. You actually asked me in your email, how do we know that? And the answer is very simple, which is that when you do regressions, factor regressions on portfolio returns, the alphas are very small. OK, that is the part due to security selection is very small. It's usually on the average. It's negative because people have expenses, but they're relatively close to zero, whereas the betas are very large. All right.

22:52So that tells you that the betas are what measure your asset allocation. So the betas, that is the asset allocation, is so very much more important than the alphas you're getting out of security selection. Now, we've had the opportunity to touch on two of the pillars, theory and history. And we even have touched a little bit on psychology. But one of the things I wanted to ask you is when you published the first edition of the book 20 years ago, I would say behavioral finance was far from mainstream at that point. what are some of the biggest differences that you see between the editions not just what you put into the book but in the world we live in and the means in which we can sometimes address some of our behavioral quirks i wrote the new edition for two reasons because i came to realize that two things had changed not necessarily in the markets but about my thinking about them and the first is encapsulated by a quote from a history historian by the name of Robert Kaplan, who I heard an interview with.

23:50And he said that half of everything is geography and the other half is Shakespeare. And I realized that that's precisely analogous to investing, which is that half of investing is math and the other half is the Shakespeare. All right. And if you only pay attention to the math and if you think that your ability to manage money correlates very highly with your ability to solve differential equations and understand complex math, you are going to have your head handed to you. And we had a wonderful example of that with long-term capital management, most brilliant mathematical financial economists in the world, Nobel Prize level people, built a bottle that wasn't constant with the Shakespeare, and eventually they went bankrupt and had to be rescued.

24:34So that's a short, long way of saying that I've realized that the math needs to be de-emphasized and the history and the psychology need to be over-emphasized, need increased emphasis. So that's the first thing that I realized. And the second thing I realized is just the importance of obeying Charlie Munger's dictum, which is not interrupting your compounding. You are most likely to interrupt compounding during the worst one or two percent of times. All right. So the most important thing, the most important thing that you have to keep in mind when designing your portfolio is that worst two percent of the world in mind, when you're not only likely to perhaps want to buy stocks at the fire sale, but you may even lose your job and your rental income and the world seems to be crumbling beneath your feet.

25:24And so you need to design your portfolio to be a bit more conservative and perhaps a good deal more conservative than you might otherwise think that your models tell you. There is a reason why Warren Buffett has 20 % of Berkshire in treasury bills and cash equivalents. That's exactly the reason why. I could not agree more with so much of that. I mean, at the end of the day, we don't live in a spreadsheet. So to make every single financial decision as if you do, now that doesn't sound rational. So I think it's a wonderful part of the book. The last pillar that I haven't had the chance to touch on is the business of investing.

26:03What do you think has changed the most in the last 20 years since writing the first edition about the business of investing? Well, we can start almost a half century ago with May Day and lowering of fees and investment expenses. And that's a process which has accelerated dramatically over the past 20 years. Over the past 10 years ago, I think it was 2013 that Robinhood, bless their souls, eliminated commissions on the trading of ETFs. And then in 2019, everybody else was forced to cave on that. Fidelity, Schwab, Vanguard were forced to adopt no commission trading. And if you know what you're doing, that's a wonderful world to be in.