Bill Bernstein: Rule No. 1 Is Stick To Your Plan

March 09, 2015

Investing successfully is not outguessing the market. And it’s really not about getting rich; it’s about not dying poor, Bill Bernstein, the plain-spoken advocate of passive investing says.

In a recent chat with Managing Editor Olly Ludwig, Bernstein said that more than anything, success depends on sticking to your plan. That’s true whether you favor pure-beta funds or some variation of that in the growing realm of “smart beta” strategies. As you take measure of markets, what are the key takeaways right now?

Bill Bernstein: Well, I would say that the expected return of a balanced portfolio is the lowest it’s been in financial history. We’re looking at 3 or 4 percent on stocks, and we’re looking at zero percent on bonds. Those are real inflation-adjusted figures. And when you aggregate those two?

Bernstein: Two percent—I think net of expenses, you’re going to be very lucky to get 2 percent over the next 20 years. What does that mean; just grin and bear it?

Bernstein: Yes. And the only way to get more return is by taking more risk. Good luck with that. You’re a student of smart beta and you’re steeped in the factors. What do you make of the growing popularity of these strategies?

Bernstein: First of all, let’s start with the fact that it was first really described in 1994 by Fama and French in the Journal of Finance in June of that year. And, immediately what happened is that the value factor went into one of the steepest reversals it’s ever seen. And people were just merciless toward Fama and French, saying these pointy-headed academics were describing something, and as soon as it got described it went away. It was because the “bozos” knew about it; and if the bozos know about it, it doesn’t work anymore.

But of course, over the ensuing 10 years, it did extremely well. If you were a value-oriented—or now you would call it a smart-beta-oriented investor—you’ve done very, very well. And if you average out the whole period from 1992 to now, you’d have been very smart to be value-oriented. Smart beta can mean any number of things. When you say “smart beta,” are you specifically referring to value and size, or are you going beyond that to include factors like momentum, quality, etc.?

Bernstein: I’m talking about anything that deviates from market-cap weighting in a quantitative fashion. And the biggest one, of course, is value. But there’s the small size, there’s profitability, there’s momentum. All these things can be smart beta, and they’re all being mined by the big fund providers—whether it’s DFA or RAFI or whomever. They’re all mining pretty much the same thing. Are there any of these factors that you consider to be more “mine-able?”

Bernstein: Yes; value—and especially when you measure it by price-to-book multiples, because it’s more stable compared to, say, earnings or momentum, where the needle is vibrating pretty wildly. The size factor is also fairly stable. Are different “factors” something you mine on an ongoing basis, or are they something of a core holding, as MSCI is pitching them these days?

Bernstein: What you’re really asking is, how do you manage the risk? The answer is, you don’t have a choice. You have to have a long-term strategy that you adhere to. You’re exposing yourself to risks. Risk No. 1 is systemic market risk; risk No. 2 is non-systemic, the extra risk you’re taking. So the question is, how do you manage those two risks?

You don’t manage it by flitting in and out and trying to figure out when it’s going to do well and when it’s not. The way to limit risk is to say: “I’m a 60-40 kind of investor and I’ve got this extra risk in my portfolio, so I’m not going to be 60-40, I’m going to be 55-45 or 52-48.” So you contrive the risk of your strategy by lowering your beta. It sounds like you’re talking about what I consider the holy grail of investing, which is limiting the variability of your returns, and that means making your plan and sticking to it.

Bernstein: Yes. The way you’re going to get rich is not by investing like Warren Buffett. The way you’re going to get rich is by working hard; not spending a lot of money and saving. The name of the game is not to get rich. The name of the game is to not die poor. And the way you avoid dying poor is just by adhering to your strategy. Eloquently framed. So are you taking measure of this growing excitement over China A-Shares that cover the mainland market? Access is still rather limited, and quotas are getting hit and some ETFs are trading like closed-end funds at a premium, but there’s this notion that this market is the “bee’s knees.” Any thoughts?

Bernstein: Sure. The question is, who are you on the bus with—the pension actuaries or the soccer hooligans? I think that question answers itself. You’re investing with people who are buying a story; you’re not investing with people who crunch numbers. So what does that mean; that the smarter money is a little circumspect? And that if China and China A-Shares are part of the risk pie, it’s going to be modest and managed in a very disciplined manner?

Bernstein: Whenever there’s easy money to be made, people will be taken advantage of. A country that doesn’t protect its children from lead-based paint in toys is not a country that’s likely to protect the interest of minority foreign shareholders. But you’re not averse to allocating some assets to China; it’s just that you’re not buying “the story?”

Bernstein: Well, yes—in general, I think emerging markets should be part of everybody’s portfolio. I think they’re quite reasonably priced—they may be the cheapest part of anybody’s equity portfolio right now.

The only way you can really avoid China is by buying an actively managed fund. You pick the smartest guy and that didn’t work out so well. So you buy an emerging markets index fund, and if you buy an index fund, guess what? You’ll have to own a bit of China; so grin and bear it. And you may well benefit to some extent, notwithstanding the reservations you have?

Bernstein: Exactly. The lottery tickets may come in, but in general, it’s not a good idea to buy lottery tickets.

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