Consuelo Mack -- Peter Bernstein Transcript

Consuelo Mack WealthTrack - July 17, 2009
CONSUELO MACK: The investment world lost one of its seminal thinkers this summer, but economist, historian and author Peter Bernstein shared his timeless wisdom in several exclusive television interviews with us. Peter Bernstein is next on Consuelo Mack WealthTrack. Hello and welcome to this Great Investors edition of WealthTrack. I'm Consuelo Mack. This week we're visiting with an investment great who recently left us. Peter Bernstein died in June at the age of 90, publishing the last of his biweekly "Economics and Portfolio Strategy" newsletters just five days before his death, a publication read by global investors who own or manage assets worth several trillion dollars. Peter was a rare combination of old fashioned gentleman and razor sharp intellect. He was an economist, historian and strategist, a teacher, editor and former investment advisor. He was a recognized expert on risk and author of ten books, most of them written in the last 20 years of his life including Against the Gods: The Remarkable Story of Risk, one of our bookshelf favorites, as well as a fascinating history of the building of the Erie Canal titled Wedding of the Waters: The Erie Canal and the Making of a Great Nation, which he described in an interview as a story of globalization and technological progress that gives it current resonance. We were blessed to have Peter for WealthTrack television exclusives in 2005 and 2007, where he shared some of his timeless wisdom. To start the conversation, I asked Peter about one of his favorite theories about understanding risk. It's called Pascal's wager.PETER BERNSTEIN: Pascal was a French mathematician in the 17th century. A compulsive gambler. And he was at the gambling tables one night and a nobleman came up and asked him something about what are the chances something would happen. As a result of which he invented probability, the idea that we can calculate probabilities began with Pascal 1654. Very religious man, and a nut. The other half of his life, he was, he led a life of sin and then he would fluctuate back and forth. Finally retired to a monastery and he asked himself a question. He said, God is or God is not. Is there a God or is there not a God? And he said you can't reason this, because there's no way you can figure it that way. So how do I deal with this question, it's an important question.CONSUELO MACK: Very.PETER BERNSTEIN: Then he said, well, I can deal with it, I can decide how I lead my life. That has something to do with whether if I believe in God and lead a virtuous life, and then I die and there is no God, well, I may have given up some goodies, but had a pretty good life. If I lead a bad life of sin and lust, and then I die and there is a God, I'm in big trouble. And the moral of this story is that there are many cases where we make choices and decisions where the consequences matter more than the probabilities. I may be able to run fast enough to cross the street before I get hit, but if I'm wrong, I'm mush on the roadway. So once I learned about this, I use it now in all kinds of decision making where it really matters. That very often you have to forget the probabilities because the consequences are so serious.CONSUELO MACK: Talk about its importance in investing, that some consequences matters more than the probability.PETER BERNSTEIN: Let me talk about it from a positive side. It doesn't necessarily mean that you always make the cautious decision, maybe the other one. Many years ago, I haven't managed money for a long time, but when I was managing it, a woman came to us who had been very badly injured and she was in an airplane crash, and badly injured, and had a settlement from the airline, I think it was $100,000, something like that. All she had in the world, and how do you take care of this? She was young in her 20s. So we decided we would put half that money in bonds, but the other half we were going to shoot the moon. Because she didn't have very much anyway and if we lost it, she was in trouble anyhow. But if we could make a killing on that, it would make a tremendous difference. So this was a case where if we were wrong, we felt the damage would be minor and that being right was what could really pay off. In the late 1970s, when bonds were yielding 15, 16% and inflation was raging, I remember I was consulting with a foundation and a very well-known bank president was on the investment committee. I said you should take a big decision on these bonds, this is a fantastic opportunity. And he said but inflation is running at 14, 15%, I said that's already in the price. If we buy them and we're wrong, we can't lose much because we've got these tremendous coupons coming in, whereas if we're right we really pay off. So, it's, as I say, it's not always a line of thinking that makes you make the safe decision. Sometimes justifies taking the risk.CONSUELO MACK: In a low return environment, which is what you think that we are in and we'll be in for the foreseeable future, where do you get the best kind of returns? Or how do you invest so that you do get returns, because that's the whole point of investing?PETER BERNSTEIN: As you know, I believe passionately in diversification so you have a little bit of everything. The United States is kind of very well worked over as an investment opportunity. So I think one goes abroad. Somebody once said to me you're not diversified if you're comfortable with everything that you own. And we're always comfortable with what we know. We live in New York, we buy Con Edison. If we live in California, we buy the California utility. But going outside the U.S. is very important. And it's a big part of the world now, it's not a peripheral thing, it's a major part of the world.CONSUELO MACK: We've been fed this mantra that stocks provide long-term growth, that's where we should be. You disagree with that, about U.S. stocks at this point. But how do we diversify and what should we be investing in? Do some asset allocation for us.PETER BERNSTEIN: I guess today I would have no more than half my assets in the U.S. if I were starting fresh.CONSUELO MACK: In U.S. stocks?PETER BERNSTEIN: Well, U.S. stocks, maybe even U.S. stocks and bonds. One can do this quite easily. There are exchange traded funds, all kinds, almost anything you want. And exchange traded funds that will offer a whole big piece. For instance, you can buy all the stocks in the world outside the U.S. in one iShares, I forgot exactly, the MSCI--CONSUELO MACK: The Morgan Stanley-- right.PETER BERNSTEIN: Yes. World stocks. And similarly, you can buy bonds outside the United States, and there's one for gold. So I do not think the individual would say, I wonder what French stock I should buy or what German stock- I wouldn't dare do that myself. So it should be done in funds. And these are the best ways to do it. It's worth looking at.CONSUELO MACK: One of your major themes has been, in investing, that dividends matter.PETER BERNSTEIN: Yes.CONSUELO MACK: So dividends have mattered historically. I think the stock returns from reinvested dividends is 50% or something like that.PETER BERNSTEIN: That's right.CONSUELO MACK: But in this day and age with stock payouts low and dividend yields low, do they matter as much and will they matter as much in the future?PETER BERNSTEIN: Yes. I think they matter first because it is cash in your pocket. And at a time when who knows what earnings are, there's been so much hanky panky all the way, now they're going to start expensing options so that it gets a little more complicated. This at least you know what it is. You can make more of a judgment about a stock, the growth rate of dividends. But dividends at this point I think have two positive features that deserve attention. One is the tax rate is the same as on capital gains, 15%, not a big number. Means 85% is yours. And the other is that because the payouts are so low and because the tax thing and so forth now there is pressure for companies to increase their payouts. The dividend will increase faster than earnings. So if you're in something where you think the earnings growth is there and the dividend, it is important, it's an important consideration. Even Microsoft is paying dividends.CONSUELO MACK: Yes, they are, they paid a big one as a matter of fact. You wrote a book about the history of risk.PETER BERNSTEIN: Yes.CONSUELO MACK: When you and I have talked, you were actually, it strikes me that you're an optimist.PETER BERNSTEIN: Yeah, I really am.CONSUELO MACK: And why given the risks that all of us toss and turn about every night, why are you essentially an optimist?PETER BERNSTEIN: I'm an optimist about the U.S., but I'm an optimist because problems do get solved. Maybe not one day you wake up and everything is back in order. But it takes an awful lot to crush a system as vital in many ways as flexible as the U.S. economy. So there's a lot of resilience, there's a lot of youth in this country, a lot of new people coming in who want to be part of it. Sure, I'm an optimist.CONSUELO MACK: For individual investors for successful long-term investing, what should our philosophy be? What should our mantra be, what should our approach be to really take advantage of the vitality that you see in the capital market?PETER BERNSTEIN: The vitality you get in the equity markets. No question about it. You must be there. All the scare stories about what might happen and so forth, you should still have some money in the equity markets, this is essential. I think big things outside the U.S. also. I am, since I don't like stock picking and I'm not very good at it, a big believer in funds, rather than trying to do it yourself. And this occurred to me the other day. The mutual fund industry has been criticized because their returns aren't good enough and so on. How much worse, the people who were in mutual funds may be disappointed with what happened, but if they had managed that money themselves, I know they would have done worse. So this may not be divine and perfect, but it's better than doing it yourself. Worth the cost.CONSUELO MACK: My next interview with Peter Bernstein took place in 2007. In 1992, you wrote a book that's now a classic called Capital Ideas: The Improbable Origins of Modern Wall Street. And it was about a small group of pioneering academics who really created the theories or discovered the theories of modern finance. First of all, what did they discover? Give us a little history lesson.PETER BERNSTEIN: It's interesting. These guys were not only academics; far as I remember, most of them had never owned a share of stock in their lives and they're just thinking. The big idea that came through was risk; that risk matters, you can't think about return without thinking about risk. And nobody had really articulated that before. Even the greats like Benjamin Graham talk about it in a sense, but this is the center piece for decision making. Since you don't know what's going to happen, you have to think about risk as well as return, that's the big idea. So they took it from that and to methods to try to maximize or improve as far as possible the tradeoff between risk and return. In theory anyway, risk and securities should have higher-- you don't buy them unless they have higher returns-- the less riskies, you don't expect as much from a Treasury bill as a common stock, and then how to make that tradeoff as optimally as possible. The overwhelming importance of diversification, which is kind of a free lunch, diversification doesn't reduce your return, but it does reduce your risk. So this is a big step toward making the tradeoff.CONSUELO MACK: Let's bring it down to the individual investor level, as far as all the questions that you asked, about how do I diversify, how do I among different asset classes, you know, what kind of risk do I want? How do we apply that as individual investors?PETER BERNSTEIN: I think the beginning is very important. If the Yale endowment fund, which has been beaten by all other universities for a long time by a lot, begins there, then I think I should begin there too. It's not that complicated to think through that. First of all, my primary consideration is how much risk do I want to take?CONSUELO MACK: Right.PETER BERNSTEIN: It's conventional to say to people, how much do you think you could afford to lose, or if you lost 25% how would you feel? These questions are very hard to answer- "oh, it wouldn't bother me" but it goes down 10%, you're in a panic. So really think that question through. And then say with that, are the assets that I own more risky or less risky than I want to hold? In many instances I think people are frightened and take too little risk. Or they're badly diversified. They think I'm not going to take any risk, put all my money in the bond market. That's stupid, because you've got a huge risk there. If there's inflation, you're in bad shape. So really thinking through the asset allocation question in a systematic way: where what can I afford to lose, how diversified am I, what kind of return do I really think I can get? Somebody tell me, it's probably less than you think. Anyway that number is a long-term number. Can I live with volatility? Volatility is a friend of the long-term investor because volatile assets tend to be priced cheaper than Treasury bills which are not volatile at all.CONSUELO MACK: So stocks, which tend to be more volatile than bonds, or at least they used to be.PETER BERNSTEIN: That's right. So if you can stand the heat in the oven, you should be taking more risk. And then there is this enormous question, what's called the efficient market hypothesis. There are a lot of smart people in the market, and they are handling huge sums of money and they are mostly the people that are making the prices. And do you really think that you can know more than they do? You can't. You put your money in a mutual fund, an actively managed mutual fund, study it very carefully and be sure that they have an established track record. In this kind of case, judging performance, a long track, this is something that Mark Hobart stresses a lot, a five, ten year track record counts much more than two or three years. Don't pick the recent winner, but get somebody who has lived through thick and thin. And then maybe you will outperform the market. But don't make all your bet on outperforming, own index funds too. Again, this all comes out of the theory of what we've learned because we've learned how to observe markets and people who manage securities. Very often the difference between beating the market and not beating the market is simply the cost of doing it.CONSUELO MACK: This is what Jack Bogle was saying, founder of Vanguard- transaction cost, tax cost can really eat away.PETER BERNSTEIN: Jack Bogle is right. And the management fee. There's a whole question in hedge funds- the fees are enormous and they have got to be spectacularly good to justify the fees. So you don't go active unless you have every confidence and really understand what this manager is going to do. For individuals, they have active management mostly in the mutual fund area. There are very few, very few. I own no actively managed fund, they're all index funds. I have a lot of money in index funds, because I'm a skeptic about active management.CONSUELO MACK: One of your quotes is, we really do not know what the future holds. Risk in our world is nothing more than uncertainty about the decision that other human beings are going to make, and how we can best respond to those decisions. What are some of the decisions that human beings are making now that either represent, that are changing the markets that represent opportunity or risk?PETER BERNSTEIN: This is an important idea. You think, oh, the markets are going to give us 11% over the long run or whatever. The markets are going to give us whatever somebody else will pay for what we own. And you really don't know what that's going to be. It's a very important distinction.CONSUELO MACK: When you look at, again, how these capital ideas are evolving, what are some of the key evolutions that we should know about that will help us to become better investors?PETER BERNSTEIN: I think it sounds simple and repetitious, but that risk is the centerpiece. That we can't manage returns, we're going to get what we're going to get. But we can manage our risk. And I think that people think in terms of, where do I want to be and what should I own and what do I want to buy? And that's where they begin, but they should begin by thinking about how much can I stand the heat of the oven? And really think about that hard. Harry Markowitz, the man who started this whole business in 1952, he was sent to read a book about how to value stocks. He didn't know anything at all. And it said you should buy the single best stock that you can find. Very famous book. And he said, but I have to think about risk as well as return, it's a very simple idea. But from that, this whole body of thought developed. And from that the people whom I respect and whom I covered in the book, begin from there and constantly test themselves. Yale, to cite it again, has a meeting every year in which they think of, if everything goes wrong, how serious is this going to be for us, what effect will it have on the university, how much will the endowment suffer, will this affect Yale's position, and they go through this whole thing, getting a worst case look. And how long would it be before we come back to where we were? And they do this rigorously every year. And then the whole decision for the next year is based on what that shows.CONSUELO MACK: So that's something that individuals should be doing every year?PETER BERNSTEIN: Yes. If everything goes down the tube, where am I? For a lot of people, they may be okay because their portfolio is a relatively small part of their assets and if they lost it, it would be a shame, but it wouldn't be as bad as losing their job or losing their home. So they maybe should be taking more risk than they think they should be, because they can afford to do it. Once you've got it made, then it's silly to take more risk.CONSUELO MACK: Oh that's interesting, because a lot of people, you assume if you're comfortable and you have the assets that you need to live on, then you can afford to take more risk to get higher returns.PETER BERNSTEIN: But you don't have to. And risk means that you might lose, whereas if it doesn't matter much any way, a year's income or something, shoot the moon.CONSUELO MACK: One of the most famous quotes that I've used in this show time and time again that you gave me is that you're not truly diversified until you own something that you're really uncomfortable with. And we talked about it on other shows. So what is it that most people are uncomfortable with that they should own some of?PETER BERNSTEIN: International, commodities. Some people think bonds are the only safe place to be, won't buy stocks and vice versa. I sat next to a young woman the other day who was a broker who is managing her parents' money and I mentioned that we owned quite a lot of bonds because we've got enough money, thank God, and we're older, and she said you own bonds? Like it was some kind of illness. So you've got to have them all, because you don't know. CONSUELO MACK: So looking out over the next couple of years, Peter, I know you look at the kind of, what's the worst thing that could happen and how do you protect yourself in that event? So what's the worst thing that you think could happen and where would it come from?PETER BERNSTEIN: Understand, I begin, I don't know. I really mean it, I don't know. Nobody knows. I'm not being humble. But the thing that worries me the most is the dollar. I don't know whether anything is going to happen. But all the necessary ingredients are in place to have a dollar crisis. If foreigners were loaded with dollars, say enough is enough. And once the sense develops in the market that they've said enough is enough, why should I hold this asset anymore? And the whole world economic system really rests on this assumption that people are willing to hold dollars. It doesn't mean it can't appreciate a little bit or gradually. But what if it keeps going down, why should I hold it? And it's very easy to move out of the currency today, to somewhere else. And there are alternatives around, and there is gold. So I don't know whether this is going to happen and I'm persuaded by the people who think the odds are small. But the consequences are enormous.CONSUELO MACK: Huge. So as an American investor, as an American citizen, you know, how does one protect themselves in any way against that eventuality?PETER BERNSTEIN: A- you own securities denominated in other currencies, you invest internationally, that's the primary way. Short-term Treasury bond because if this happens, interest rates here are going to go through the roof. Short-term Treasuries, which are worth holding anyways to hedge against difficulty, and gold. Gold is very expensive to own, but a little bit goes a long way if it blows up.CONSUELO MACK: All right. Peter Bernstein author of your tenth book now, Capital Ideas Evolving. Thank you so much for joining us.PETER BERNSTEIN: Thank you.CONSUELO MACK: It's a real treat to have you here.PETER BERNSTEIN: This was great, thank you.CONSUELO MACK: Peter Bernstein, one of the greats. We want to extend our condolences to Peter's wife Barbara, who was also his invaluable business partner and editor. Next week in another installment of our Great Investors series, our subject is David Swensen, star chief investment officer of Yale University's endowment, who sat down with us for an exclusive television interview. If you saw the first part of our interview with him, you will not want to miss the second. Until then, to watch this program again, just go to our website, wealthtrack.com. Starting on Monday you can see it as streaming video. Thanks for visiting with us, and make the week ahead a profitable and a productive one.



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