Motley Fool Hidden Gems Investing - The Four Pillars of Investing with William Bernstein

Episode Date: September 10, 2023

“The essence of investing is not maximizing returns, but rather maximizing odds of success.”  William Bernstein is a financial theorist, neurologist, and the best-selling author of “The Four Pillars of Investing: Lessons for Building a Winning Portfolio,” now in its second edition. Motley Fool Senior Advisor Robert Brokamp caught up with Bernstein to discuss: - Why a 2% real return is “quite spectacular” - The math and Shakespeare of investing - Why value stocks may have fallen out of fashion - What the history of the stock market reveals about modern bubbles Host: Robert Brokamp Guest: William Bernstein Producer: Ricky Mulvey Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. It's also how the rich get richer. If you have enough safe assets, if you have enough treasury bills to live on for three years or five years or better yet, a decade, you're not going to panic when the rest of your asset class, the rest of your holdings, the risky assets, the stocks that you own fall by 50 or 60 percent. You're not going to pull the trigger and sell those at the bottom. I'm Mary Long, and that's William Bernstein, financial theorist, neurologist, and bestselling

author. Our very own Robert Brokamp caught up with Bernstein to talk about the psychology of investing and the weighty influence of crowds, how to test a financial advisor, the best deal in retirement planning, and what's changed in the two decades since Bernstein first wrote the investing classic, The Four Pillars of Investing, Lessons for Building a Winning Portfolio. The Motley Fool was founded in 1993 by two brothers and their friend who believed that with enough effort and dedication, most people could learn to manage their finances on their own and they might be better off for doing so given how poorly Wall Street and the typical local stockbroker often treated the individual investor. It occurred to me that around the

same time, maybe a few years earlier, your life was taking a similar turn. You were a practicing neurologist who was just beginning what would become a whole new career as an author of several well-respected books about investing and financial history, as well as becoming the principal in a wealth advisory firm. So tell us how that career switch happened. Well, around that time, a generation ago, I realized that I lived in a country that didn't have a functioning social welfare system and taking it and that I was going to have to save and invest on my own. And I approached that the way that I thought that any person with scientific training would do, which is that I built models, I collected data. And when I was

done doing that, I realized that I had actually done something that was useful to the small investor because 30 years ago, those kinds of tools simply weren't available to small investors. Now they're available with the click of a mouse, but back then they weren't, and I discovered that I enjoyed writing, and so about that time, the web connected to my rural place of residence, and I threw some of this stuff onto the web, and people responded to it, and that's how I got my career as a financial writer and then a historical writer on top of that, because you can't write about finance without writing about the history of finance. Yep. And that, in fact, is one of the four pillars of your book, The Four Pillars of Investing, originally published in 2002. Now, 21 years later, you've published an updated version of The Four Pillars. So what would you say are the biggest differences between the first and second editions? Three things. In the first place,

I have slowly come to understand over the past 30 years that the mathematical models only take you so far. And in fact, they can fool you. The financial markets, some people would like to believe, behave like an electrical circuit or an airfoil. And the more math you know and the more you depend upon the math, the better off you'll be. And in fact, beyond a certain point, the opposite is true. People, it turns out, can focus too much on the math and not focus on the other half of investing, which is the Shakespeare of investing. And all you have to think about to realize that problem or to see that problem is the history of long-term capital management, which is what happens to you when you're really, really good at the math and you're not really good

at the Shakespeare. So that's the first thing. The second thing was taking to heart Charlie Munger's dictum of compounding, which is that yes, compounding is magic, but that the prime rule of compounding is never, ever to interrupt it. And the time when you're most likely to interrupt the compounding is in the worst 2% of the states of the world during financial panics, when all of the things that you thought were solid beneath your feet crumble. And so the second thing that I've learned over the past 20 or 30 years is that if you're going to have an investment policy and investment strategy, you have to design it to survive those times. And it has to be a good deal more conservative than you think that it otherwise would be. The third thing that's changed over the

past 20 or 30 years, and this is something that's happened really very rapidly over the past 10 years, is that you can invest competently in almost any institution. The advice that I gave in the first edition of the book was to stay as far away as you could from the full service brokerage houses, you know, the Merrill Lynch's and the Morgan Stanley's of this world. Well, it turns out that you can put together a perfectly good investment portfolio with those institutions simply by using exchange traded funds and keeping your expenses to a minimum. You know, before in the first edition of the book, I was kind of accused of being a shill for the Vanguard group, because that was really the only place that you could get rock-bottom expenses.

Well, now you can get rock-bottom near-zero expenses almost anywhere at almost any institution. And if you're careful, there's no reason why you can't have an account at one of the big, bad, old wirehouses, let alone at Schwab or Fidelity, which are just fine, too. So you've touched on a few key components of the four pillars. Let's dig a little bit more into each of them. Pillar one is investment theory. you touched on a little bit really being aware of your risk tolerance. And I think really your key principles probably could be summed up with two of my favorite lines from your book. And one

is the essence of investing is not maximizing returns, but rather maximizing odds of success. And the other is the aim of retirement saving investing is not to get rich, but to minimize the risk of becoming poor. Yeah, that's the first pillar, which is the connection between risk and return. You can't expect high returns, the kinds of high returns you get with stocks, without seeing your portfolio take a serious haircut every now and then. And there's no way of avoiding that because there's no way that anybody can time the market. And then if you want perfect safety, you're going to have to be satisfied with low returns. Now, right now, you can get perfect safety in retirement or as near as perfect safety as you could get

by investing in a ladder, for example, of treasury inflation-protected securities. And you can get a 2% real return, which historically doesn't sound like very much, but it's quite spectacular, because a 2% real return gives you a 30-year success rate with a withdrawal of nearly 4.5%, which is as good as you can expect. So that's the first pillar, is realizing the connection between risk and return. and also understanding how to put together portfolios in a prudent manner. Another point that you emphasize is that part of the theory is developing expected returns from your portfolio, helps with retirement planning and other things like that.

So how do you think people should do that? And what do you see as reasonable expectations from stocks and bonds nowadays? Well, the expectation is of 2% real returns from bonds. By the way, I tend to throw that around a bit too glibly. when I say real returns, I mean after inflation. And a 2% return after inflation may not seem like very much, but that's historically what bonds have returned in the past. And anytime you can get the historical rate of return, you should grab it. As recently as two years ago, you were lucky to get even a negative 1% return on intermediate term bonds, a real return, that is

to say, after inflation. That's pretty darn good. Now, you can also expect probably 3% or 4% on top of that from investing in stocks. But in order to get that return, it doesn't come for free. You're going to have to pay for that with a lot of stomach acid from time to time. And one of the third pillar of the book is the psychological pillar. And one of the fundamentals of psychology is that we tend to be very overconfident. We're overconfident about our ability to pick securities. We're overconfident about our ability to pick successful money managers. But the importance of those fades into insignificance when compared to the overconfidence about our ability to tolerate risk. When the sun is shining, everybody's a long-term investor in

stocks. But when the clouds turn dark, people behave a lot differently. And as that famous financial economist Michael Tyson famously said, everybody's got a plan until they get punched in the mouth. Right. And just to be clear, that 3% to 4% from stocks is inflation adjusted. So you would take, you know, if inflation is 3%, you're looking at 6% to 7%, which is below the historical average, why do you expect below-average returns from stocks? Because the realized, well, let me back up a second, because there's a couple of building blocks there that need to be unpacked. First of all, you're going to get 2% real return from bonds. You should expect to get a 3% or 4% premium on top of that, so as you said, 5% or 6%. But that's a 5% or 6% real return. If you

at inflation on a nominal basis, it's closer to 10%. Now, that's not as high as you've gotten historically. And the reason why is very simple, is that everybody talks about returns since 1926, since that's when the CRSP and Ibbotson basis incept. But the problem is, is that over that past almost century, that the dividend yield has fallen by a factor of four, price earnings have fallen by a factor of two or three. So you've gotten a real boost from that change in valuation. And the only way you're going to get that historical return is if valuations continue to increase. So that means that in another century, we'll be looking at PEs, normal PEs of 60, dividend yields of a half a percent. That's not going to happen.

It certainly makes sense if you are. Oh, go ahead. At least I don't think it's going to happen. It could. But I wouldn't bet the farm on it, that's for sure. Right. And that sort of gets to my point, and that is, if you're thinking of, all right, what's my portfolio going to provide so I can plan for retirement? It makes sense to assume lower returns. You want to assume lower returns. You don't want your retirement riding on hoped-for extraordinary returns, because then you'll reach your 60s and maybe haven't saved enough. Exactly. The real question is, how much risk are you going to take? If you assume those returns, that's, by the way, the median expectation. But that means there's a 50%

chance you'll get below that expectation. And there's a 5% or 10% chance you may get 4% or 5% under that expectation, because that's just the nature of the statistics of stock returns. All right, let's move on to the second pillar, and that is the history of investing. And you wrote that bubbles and busts are inevitable features of financial markets ever since the 17th century. So tell us what a bunch of Englishmen from the 1600s, specifically Goldsmiths and Francis Bacon, have to do with why we continue to have these occasional wild swings in the stock market. Well, it all goes back to the history of the East India Company and its individual predecessors. You had these guys coming back from the Far East with enormous piles of silver and

gold and even jewels that were the profits from their trading operations, from dealing with fine spices and porcelains and things like that. And they would arrive in London with all of this loot. And London at that point didn't have a banking system. Remember, this was England even before the Civil War in the 17th century. And so they needed a safe place to keep all of this loot. And the people who knew how to do that, to keep very precious things safe, were goldsmiths. So they would give their loot to these goldsmiths, and the goldsmiths would give them a certificate. And these certificates actually started trading as money. And then it occurred to the goldsmiths, hey, wait a minute.

We can loan these certificates out at an enormous rate of interest, 10%, 15%. And they didn't have to – if they had 10,000 pounds worth of silver or 10,000 pounds of silver, which is how we get pound sterling in their safes or whatever they used for safes back then, they could print $20,000 or $30,000 worth of certificates and earn an enormous amount of interest. The only problem occurring, of course, was that if somebody – they only had 10,000 pounds in their safe, and people bearing certificates for 10,001 pounds came in, they were bankrupt. That was a bank run, all right? So this system where you have certificates or money circulating, the money that they could basically print circulating in excess of the reserves is called the fractional reserve system, which we have yet today. We don't run on a two- or three-to-one ratio. Now banks run on about a ten-to-one ratio. And it's an inherently unstable system. You see bank runs from time to time, as occurred with Silicon Valley Bank, and has occurred more disastrously with the Northern Trust in England several years ago.

So this is a system that is prone to booms and busts, which play through to the stock market. And then in 1621, I believe, Francis Bacon published a book, many consider it sort of the beginning of the scientific method. How has that contributed to booms and busts? Well, because when you have a scientific method, you can invent marvelous technologies. When you have a good model of the world, suddenly within a century or two, you have thermodynamics, you have electromagnetic theory, and you get the internal combustion engine and the telegraph and the radio. And if you want to know where stock returns come from, it comes from the invention of things like that. That's how the economy grows, and that's how stocks become the place to be, because stocks accrue the earnings from the profits of all of these marvelous inventions. Without Bacon's scientific method, without the Novum Organum, which was the book that he published that described it, we wouldn't have any of the marvelous things that we have now. We'd be living the same way that people lived 400 years ago, which wasn't a very good place to be.

And of course, these are all wonderful things, but they often lead to some sort of a boom, right? Whether it was the dot-com boom, whether it was, as you've written about in previous books, the railroad boom, or it could be financial technologies, right? Collateralized loan obligations from the Great Recession of 2007 to 2009. Part of it is what causes the booms and busts. Exactly. The first person to really cotton on to this in an intuitive sense was a man by the name of Hyman Minsky, who was an economist who lived a generation or two ago, and he formulated something called the instability hypothesis, which means that when people's animal spirits are optimistic, banks loan money, and gradually they loan money in riskier and riskier and riskier

and riskier fashion, and then eventually collapse. You get a bust like we saw, for example, in the housing crisis in 2007 to 2009. And then all of a sudden, bankers and investors get religion, they become a lot more conservative, and loans start becoming much safer. And then people realize that by taking more risk, they can earn higher and higher returns, and the cycle starts anew. And so the instability hypothesis states that instability eventually results in stability when things collapse and people get religion about risk. And then stability causes people to eventually start levering up again.

So stability causes instability and instability causes stability and round and round you go. And the cycle seems to last about 10 years, 10, 15 years. If you tabulate all the booms and busts over the past four centuries, that's roughly the interval that you see. It's not viable, you can't set your watch by it,

but that's about what it looks like. Let's move on to pillar three, the psychology of investing. When I think about what has changed since the first publication of The Four Pillars, I would say that one of the biggest differences is the increased prominence of behavioral finance. You had a couple of side comments in the book about how maybe it's getting too much attention or maybe just too many people out there holding themselves as experts. But I think your take on the subject can be summed up when you write that the human species is the ape that imitates, tells stories, and seeks status. So what do you mean by that? And what's the impact on how people invest? Yeah, I think the part of behavioral finance

that has been under-emphasized, it's not the individual psychology or what gets referred to as the neuropsychology, it's the social psychology. And the seminal experiment that I think that is the way to understand finance was one performed by a guy by the name of Solomon Ash. And he put a bunch of people in a room and he had them match line lengths. And it was a relatively simple task that was just difficult enough that you could do it right about 99% of the time. There was a very small error rate. And what he found was, is that when he put people into a room where other people were shouting out the wrong answers, the error rate skyrocketed. All right. So when people around you are making mistakes, then you are likely to make mistakes too. And there's a very famous

example that everyone knows about from Francis Galton. He went to a livestock fair more than a century ago, and he had a bunch of independent observers estimate the weight of a dressed ox. In other words, they showed them the ox, and then they had to guess how much meat basically you could get off the ox. And the average guess was very close to the real weight. It was within a pound or two of the actual weight. This thing weighed over a thousand pounds. And a man by the name of Joel Greenblatt, who I think a lot of people in finance will recognize, he's written a lot of very popular books, did the same experiments with a jar of jelly beans that he showed a class, and he put, I believe, 1,776 jelly beans in the glass. And this elementary

school or middle school class, the average, just like in Galton's experiment, came within a few jelly beans of what the real answer was. But when he had people then, when he had another class discuss, or maybe the same class, I forget which, discuss what their guesses were, and people started feeding off of that, their answer was off by more than 50%. Okay. So this is what happens when you're around other people. And so the best way to invest is to block yourself in a dark room and don't talk to anybody. Don't read the newspaper. Don't talk to your friends because they're going to lead you astray. All right, let's move on to pillar number four, and that is the business of investing. And in your book, you tell the tale of a mythical land in Eastern Europe

called Chernobyl, where someone could get sick and they go to a doctor, and then you find out later that the doctor didn't have to go to medical school and doesn't even have a professional duty to the patients. What's the comparison there to the world of financial advice? Well, it's very simple. To become a stockbroker, you have to pass the Series 7 exam. It doesn't say you have to have graduated from high school. That's the first problem. And the second problem is a more general one, which is that people do not go into finance for the same reason that people become elementary school teachers or they become Marines, all right? They go into finance because, as Willie Sutton talked about robbing banks, that's where the money is. And the moral and ethical standards of people in finance is not the same as the moral and ethical standards of people who become Marines or elementary school teachers, and I'll leave it at that.

I totally understand. So it is interesting to me. It's almost unbelievable, really, that you can be someone who is giving financial advice, but you are not legally obligated to put their best interests first, what is legally called the fiduciary standard. And it's amazing to me that they get away with it. Yeah, if you're a registered investment advisor, you do. But if you're a stockbroker, you basically don't.

FINRA and the SEC have worked on a number of upgrades to what's called the suitability standard for stockbrokers, but it's toothless. When you talk to a stockbroker, hold on tight to your wallet. So, that's all true. I generally agree with you. But not everyone has the time or inclination to be their own financial planner and investment advisor. So what do you recommend that people do? Well, the very first thing you should do is ask them, are they willing to sign the fiduciary pledge? Just find it online, download it, and ask your financial advisor to sign that.

And if they're not willing to sign that or they talk about how irrelevant it is, make a 180-degree back turn and run as fast as you can. All right? That's the first thing. And there's sort of a little practical test that I recommend to people as well, which is bring to them your own little portfolio. And let's say that you've got a three-fund portfolio of an index of international stocks and U.S. stocks and an indexed bond fund, and ask them what they think of it. And if they look at you and say, you know, I think that's pretty good. I might add an asset class or two to this. They're probably okay.

If they look at you and they say, no, I can beat the market, I can pick stocks, I can pick better money managers than this, that's another warning sign as well. Yeah, and then in your book, you cite a Harvard study where they sent out basically people as subjects would go to financial advisors, and about a quarter of them had a very proper, well-diversified portfolio of index funds, and the vast majority of the financial advisors said, oh, no, let's sell all these and let's put you into some high-priced, actively managed funds. Exactly. Never mind the capital gains you'd incur by doing that either. Right. All right. So in the book, you provide some excellent model portfolios,

some very detailed lists of mutual funds, index funds, ETFs people should consider. So I highly recommend people read the book to get some more specific ideas on how to manage your portfolio. But let me talk just about some general stuff that you wrote about. Tell us about what you call the treasury bill theory of equanimity. Well, that gets to what I was talking about earlier, about how you behave in the worst 2% of the times, determines whether your portfolio survives in the long term, and you can reap the benefits of the magic of compounding. and treasury bills have low returns, terribly low returns. But in the long run, they may well be the

highest returning asset class in your portfolio because they're what enables you to sleep at night and to, for that matter, buy groceries when you may be well maybe losing your job during the worst of times. And the way I like to summarize that is there's a reason why Warren Buffett holds 20% of the assets of Berkshire in treasury bills or cash equivalents for just that reason. It's also how the rich get richer. If you have enough safe assets, if you have enough treasury bills to live on for three years or five years or better yet, a decade, you're not going to panic when the rest of your holdings, the risky assets and stocks that you own fall by 50% or 60%. you're not going to pull the trigger and sell those at the bottom. That is basically how the

rich get richer. The rich have enough safe assets to sleep through the bad times so that the risky assets can grow to the sky. In the book, you talk about tilting your portfolio toward things like small caps, international stocks, and value. Let's just focus on value. All three of those have actually lagged, generally speaking, over the last decade or so, in some cases longer. What's your take on why growth has outperformed value? And in your opinion, should people be tilting more toward value now that they look at least relatively cheaper? Yeah, that's the real question, is why has value lagged over the past 20 or 30 years? There's two possible explanations. One is that everybody now knows about the value effect,

the value premium. So they've piled into that and arbitraged away the advantage. They've raised the relative prices of value stocks to the point where they no longer beat growth, in fact, lag behind it. That's the first possible explanation. And the second possible explanation is that they've just fallen out of fashion, in which case they will have gotten cheaper relative to growth stocks, even more cheap than they normally are. And all of the data that I've seen points to that last explanation, that value stocks, in fact, have gotten relatively cheaper and should offer higher returns going forward. So that's not offered with a Midas-Muffler guarantee. Most good things in finance are best of 55-45 bet. So I wouldn't bet the farm on that one, but it's something that if

I had to bet one way or the other, I would bet on value stocks and not with my entire portfolio as Well, I would still own some growth stocks or at least the total stock market. But the second part of this is what we're talking about is true only in the U.S. If you look at foreign stocks and you look at emerging market stocks, over the past whatever period you want to look at, long period you want to look at, five years, 10 years, 20 years, 30 years, value stocks and small stocks have outperformed. Just a couple of more questions here. your book is mostly about investing, but you do touch on retirement planning every once in a while. And in this area, there's one clear piece of advice that you have. People should delay

Social Security to age 70. Yeah, absolutely. I mean, the only reason to not do that is if both you and your spouse are in poor health or if you're unmarried and you're in poor health. And of course, if you absolutely, I mean, if you're going to wind up living under a bridge because you couldn't take social security at 62. Sure, take it at 62 if you absolutely have to. But the actuarial assumptions that increased social security benefit you get from age 70 is based on actuarial data, which is way, way, way out of date. And if social security ever gets around to fixing that,

it's not that advantage will not be as great. So take it, grab it while you can still grab it. Yeah. And of course, the benefit is if every year you delay to 70, the benefit increases around 8%. It's inflation adjusted. And it's also at least partially tax-free. So it is an outstanding way to build in a bit of inflation protection and longevity protection into your portfolio. Absolutely. There is no better deal in terms of retirement planning than delaying Social Security to age 70. And this is something that gets forgotten when people talk about things like annuities. Don't even think about buying an annuity until you've paid up out of

your retirement account to make it to age 70. All right. So our final question, and it's not a topic covered in your book, but for most people, in order to invest in safe retirement, they first need a job. And these days we're hearing an awful lot about how artificial intelligence is going to displace millions of workers, right? Now, given your neurology background, you know a thing or two about how the brain works. Plus, for what it's worth, besides your MD, you have a PhD in chemistry. And just to impress our listeners, you also know how to fly a plane. So I figure you have an opinion about how much AI will be able to replace future workers, be they doctors, pilots, technicians, authors, or whomever. Are you at all concerned? Are you

worried about the future of maybe like your children and your grandchildren and their ability to earn a living? It's hard not to worry about that, but I don't worry about it as much as most people do because we've seen this movie before, all right? Were you told 60 years ago that all of the, you know, bank tellers' work would be done by ATM machines and that there wouldn't be a such thing as telephone operators, you know, in the year 2023? You'd have thought, oh my God, we're going to have a horrible unemployment problem. And in fact, people have made this prediction over and over again, that this technology or that technology is going to destroy all of these jobs. And what always happens is that other jobs and better jobs and

more jobs get created. And it's kind of the same as the other prediction, which turns out to be chronically wrong, which is that we're running out of natural resources. We've been running out of oil ever since Drake discovered oil in western Pennsylvania 150 years ago. And people have been predicting that on a reliable basis. And it now appears more likely than not that we're going to wind up keeping a lot of our oil reserves buried in the ground forever. So I think it's a possibility. Maybe it is different this time, but usually it isn't different this time. Well, Bill, as expected, this has been a fascinating discussion. Thanks so much for joining us. Pleasure's all mine.

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long. Thanks for listening. See you tomorrow, Fools.