Bill Bernstein: Take Risk Off The Table

November 26, 2013

It takes guts to trim equity exposure when the going is so good.


It’s all but impossible to get a stalwart passive investor like Bill Bernstein to engage in the tradition of sharing his best idea for the upcoming year, but that doesn’t mean he won’t serve up kernels of wisdom along the way.

Bernstein laid out sensible advice when he visited recently with IndexUniverse Managing Editor Olly Ludwig: The former neurologist and author of several books on investing said that after five years of rising stock prices that has lifted the S&P 500 Index into record territory, it makes sense to trim equity allocations in preparation for a rainy day.


IndexUniverse: Can I coax you into talking about investment strategies for the next year?

Bernstein: No, I don’t label my ideas with calendar years. All that I see happening is what we’ve been talking about for the past few years, which is that the Fed is pumping liquidity into the system. The Fed is aiming this garden hose at a bucket that’s 20 yards away, which is the economy. It’s getting some water in the bucket, but it’s getting a whole lot more water on the surrounding pavement. And the surrounding pavement is risky assets.

IU: So what’s the distinction between getting the water in the bucket versus on the pavement?

Bernstein: The water in the bucket is protecting people who are out of work and trying to keep them from begging on the streets and from going bankrupt because they can’t pay their medical expenses.

IU: Regarding the Fed’s presence, and trying to get water into the bucket, are you worried about some kind of an inflationary episode taking shape?

Bernstein: I would have worried about that four or five years ago. But banks are deleveraging and people are deleveraging. Banks are shrinking their loan portfolios. Banks aren’t lending money to people who don’t have jobs the way they used to seven years ago. They stopped writing mortgages for $750,000 to Las Vegas waitresses who were making $18,000 a year. And what will happen is that cycle will reverse. People will start becoming euphoric again.

IU: So you’re just watching it; it’s going in slow motion. What should investors do given the rise in “risky assets,” as you put it?

Bernstein: You want to at least keep your asset allocations stable. That means that you’ve sold a bit for the past two years—just slowly raising cash.

And if you’re like me, you like leaning even more against the wind, so that when you see valuations like this, you want your equity allocation to be less than it was two years ago. So if you were 55 percent/45 percent two years ago, maybe today you want to be 45 percent/55 percent or at least 50/50. Believe me, this is not rocket science.



IU: This is about expected returns, which are diminishing as these stock indexes keep hitting all-time highs.

Bernstein: Exactly. And that’s my idea for 2014. It will also be my idea for 2015, 2016, 2017 and even 2037, if I’m around.

IU: Until there’s “blood in the streets,” as you like to say?

Bernstein: Yes, exactly—until the process reverses.

IU: So how systematic do you make this “taking risk off the table”?

Bernstein: It’s really a problem in engineering. If the stock market goes up X percent, you want to decrease your asset allocation by Y percent. What’s the ratio between X and Y? If the market goes up 50 percent, maybe I want to reduce my stock allocation by 4 percent. So there’s a 12.5 ratio between those two numbers. Well, that’s what it really all boils down to: What’s your ratio between those two numbers?

IU: So 50 percent increase in the  market might make you want to take 4 percent of the risk off the table?

Bernstein: Something like that: 4 percent, 2 percent or 5 percent; pick your number, pick your ratio.

IU: It seems like a typical investor isn’t going to look at it the way you just did. I’m thinking of some headline I read about Carl Icahn saying the market has gone up considerably. There might be a very big pullback. It’s infused with drama. You’re not buying that, are you?

Bernstein: No, no, no. Bob Shiller said there was irrational exuberance in the market in 1996. And then Greenspan took up the phrase that Shiller invented. Shiller was right; he was just four years early. So the answer was not to sell all your stocks in 1996.

If you did that, you probably didn’t do well. But you needed to start cutting back in ’96, a little more in ’97, a little more in ’98, a little more in ’99, a little more in 2000. The idea is that if you worked your way, say, from 60/40 down to 40/60 when 2000 came, well, you felt pretty smart.

IU: And this is precisely what intelligent money management should look like? It sure looks good in the rearview mirror, but it takes a certain amount of courage to be doing that before the bottom falls out.

Bernstein: Yes, when the intelligent investor does some trimming back, he usually feels like a dummy for the next year or two. And when he trims back again, he feels like a little bit more of a dummy. And he feels dumb for awhile each time after he does it. But then there comes a point, three to five years hence, when he feels awfully smart.

IU: It’s delayed gratification.

Bernstein: Exactly.



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