The Four Pillars of Investing
Lessons for Building a Winning PortfolioBy William J. BernsteinMcGraw-Hill
Copyright © 2010 The McGraw-Hill Companies, Inc.
All right reserved.
ISBN: 978-0-07-174705-9
Contents
Chapter One
No Guts, No GloryThere are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description that I might offer here even approximate what it feels like to lose a real chunk of money that you used to own. Fred Schwed, from Where Are the Customers' Yachts?
I'm often asked whether the markets behave rationally. My answer is that it all depends on your time horizon. Turn on CNBC at 9:31 A.M. any weekday morning and you're faced with a lunatic asylum described by the Three Stooges. But stand back a bit and you'll start to see trends and regular occurrences. When the market is viewed over decades, its behavior is as predictable as a Lakers- Clippers basketball game. The one thing that stands out above all else is the relationship between return and risk. Assets with higher returns invariably carry with them stomach-churning risk, while safe assets almost always have lower returns. The best way to illustrate the critical relationship between risk and return is by surveying stock and bond markets through the centuries.
The Fairy Tale
When I was a child back in the fifties, I treasured my monthly trips to the barbershop. I'd pay my quarter, jump into the huge chair, and for 15 minutes become an honorary member of adult male society. Conversation generally revolved around the emanations from the television set: a small household god dwarfed by its oversized mahogany frame. The fare reflected the innocence of the era: I Love Lucy, game shows, and, if we were especially lucky, afternoon baseball. But I do not ever recall hearing one conversation or program that included finance. The stock market, economy, machinations of the Fed, or even government expenditures did not infiltrate our barbershop world.
Today we live in a sea of financial information, with waves of stock information constantly bombarding us. On days when the markets are particularly active, our day-to-day routines are saturated with news stories and personal conversations concerning the whys and wherefores of security prices. Even on quiet days, it is impossible to escape the ubiquitous stock ticker scrolling across the bottom of the television screen or commercials featuring British royalty discoursing knowledgeably about equity ratios.
It has become a commonplace that stocks are the best long-term investment for the average citizen. At one time or another, most of us have seen a plot of capital wealth looking something like Figure 1-1, demonstrating that $1 invested in the U.S. stock market in 1790 would have grown to more than $23 million by the year 2000.
Unfortunately, for a number of reasons, no person, family, or organization ever obtained these returns. First, we invest now so that we may spend later. In fact, this is the essence of investing: the forbearance of immediate spending in exchange for future income. Because of the mathematics of compound interest, spending even a tiny fraction on a regular basis devastates final wealth over the long haul. During the last two hundred years, each 1% spent each year reduces the final amount by a factor of eight. For example, a 1% reduction in return would have reduced the final amount from $23 million to about $3 million and a 2% reduction to about $400,000. Few investors have the patience to leave the fruits of their labor untouched. And even if they did, their spendthrift heirs would likely make fast work of their fortune.
But even allowing for this, Figure 1-1 is still highly deceptive. For starters, it ignores commissions and taxes, which would have shrunk returns by another percent or two, reducing a potential $23 million fortune to the above $3 million or $400,000. Even more importantly, it ignores "survivorship bias." This term refers to the fact that only the best outcomes make it into the history books; those financial markets that failed do not. It is no accident that investors focus on the immense wealth generated by the economy and markets of the United States these past two centuries; the champion—our stock market—is the most easily visible, while less successful assets fade quickly from view.
And yet the global investor in 1790 would have been hard pressed to pick out the United States as a success story. At its birth, our nation was a financial basket case. And its history over the next century hardly inspired confidence, with an unstable banking structure, rampant speculation, and the Civil War. The nineteenth century culminated in the near bankruptcy of the U.S. Treasury, which was narrowly averted only through the organizational talents of J.P. Morgan. Worse still, for most of the past 200 years, stocks were inaccessible to the average person. Before about 1925, it was virtually impossible for even the wealthiest Americans to purchase shares in an honest and efficient manner.
Worst of all, in the year 2002, the good news about historically high stock returns is out of the bag. For historical reasons, many financial scholars undertake the serious study of U.S. stock returns with data beginning in 1871. But it's worth remembering that 1871 was only six years after the end of the Civil War, with industrial stocks selling at ridiculously low prices—just three to four times their annual earnings. Stocks today are selling at nearly ten times that valuation, making it unlikely that we will witness a repeat of the returns seen in the past 130 years.
Finally, there is the small matter of risk. Figure 1-1 is also deceptive because of the manner in which the data are displayed, with an enormous range of dollar values compressed into its vertical scale. The Great Depression, during which stocks lost more than 80% of their value, is just barely visible. Likewise, the 1973—1974 bear market, during which stocks lost more than one-half of their after-inflation value, is seen only as a slight flattening of the plot. And the October 1987 market crash is not visible at all. All three of these events drove millions of investors permanently out of the stock market. For a generation after the 1929 crash, the overwhelming majority of the investing public shunned stocks altogether.
The popular conceit of every bull market is that the public has bought into the value of long-term investing and will never sell their stocks simply because of market fluctuation. And time after time, the investing public loses heart after the inevitable punishing declines that stock markets periodically dish out, and the cycle begins anew.
With that in mind, we'll plumb the history of stock and bond returns around the globe for clues regarding how to capture some of their rewards.
Ultimately, this book is about the building of investment portfolios that are both prudent and efficient. The construction of a house is a valuable metaphor for this process. The very first thing the wise homebuilder does, before drawing up blueprints, digging a foundation, or ordering appliances, is learn about the construction materials available.
In the case of investing, these materials are stocks and bonds, and it is impossible to spend too much time studying them. We will expend a lot of energy on the several-hundred-year sweep of human investing—a topic that some may initially find tangential to our ultimate goal. Rest assured that our efforts in this area will be well rewarded. For the better we understand the nature, behavior, and history of our building materials, the stronger our house will be.
The study of financial history is an essential part of every investor's education. It is not possible to precisely predict the future, but a knowledge of the past often allows us to identify financial risk in the here and now. Returns are uncertain. But risks, at least, can be controlled. We tend to think of the stock and bond markets as relatively recent historical phenomena, but, in fact, there have been credit markets since human civilization first took root in the Fertile Crescent. And governments have been issuing bonds for several hundred years. More importantly, after they were issued, these bonds then fluctuated in price according to economic, political, and military conditions, just as they do today.
Nowhere is historian George Santayana's famous dictum, "Those who cannot remember the past are condemned to repeat it," more applicable than in finance. Financial history provides us with invaluable wisdom about the nature of the capital markets and of returns on securities. Intelligent investors ignore this record at their peril.
Risk and Return Throughout the Centuries
Even before money first appeared in the form of small pellets of silver 5,000 years ago, there have been credit markets. It is likely that for thousands of years of prehistory, loans of grain and cattle were made at interest; a bushel or calf lent in winter would be repaid twice over at harvest time. Such practices are still widespread in primitive societies. (When gold and silver first appeared as money, they were valued according to head of cattle, not the other way around.) But the invention of money magnified the prime question that has echoed down through investment history: How much return should be paid by the borrowers of capital to its lenders?
You may be wondering by now about why we're spending time on the early history of the credit markets. The reason for their relevance is simple. Two Nobel Prize-winning economists, Franco Modigliani and Merton Miller, realized more than four decades ago that the aggregate cost of and return on capital, adjusted for risk, are the same, regardless of whether stocks or bonds are employed. In other words, had the ancients used stock issuance instead of debt to finance their businesses, the rate of return to investors would have been the same. So we are looking at a reasonable portrait of investment return over the millennia.
The history of ancient credit markets is fairly extensive. In fact, much of the earliest historical record from the Fertile Crescent—Sumeria, Babylon, and Assyria—concerns itself with the loaning of money. Much of Hammurabi's famous Babylonian Code—the first comprehensive set of laws—dealt with commercial transactions.
A small ancient example will suffice. In Greece, a common business was that of the "bottomry loan," which was made against a maritime shipment and forfeited if the vessel sank. A fair amount of data is available on such loans, with rates of 22.5% for a round-trip voyage to the Bosphorus in peacetime and 30% in wartime. Since it is likely that fewer than 10% of ships were lost, these were highly profitable in the aggregate, though quite risky on a case-by-case basis. This is one of the first historical demonstrations of the relationship between risk and return: The 22.5% rate of interest was high, even for that period, reflecting the uncertainty of dealing with maritime navigation and trade. Further, the rate increased during wartime to compensate for the higher risk of cargo loss.
Another thing we learn from a brief tour of ancient finance is that interest rates responded to the stability of the society; in uncertain times, returns were higher because there was less sense of public trust and of societal permanence. All of the major ancient civilizations demonstrated a "U-shaped" pattern of interest rates, with high rates early in their history that slowly fell as the civilizations matured and stabilized, reaching the lowest point at the height of the civilizations' development and rising again as they decayed. For example, the apex of the Roman Empire in the first and second century A.D. saw interest rates as low as 4%.
As a general rule, the historical record suggests excellent investment returns in the ancient world. But this record reflects only those societies that survived and prospered, since successful societies are much more likely to leave a record. Babylonian, Greek, and Roman investors did much better than those in the nations they vanquished—the citizens of Judea or Carthage had far bigger worries than their failing financial portfolios.
This is not a trivial issue. At a very early stage in history we are encountering "survivorship bias"—the fact that only the best results tend to show up in the history books. In the twentieth century, for example, investors in the U.S., Canada, Sweden, and Switzerland did handsomely because they went largely untouched by the military and political disasters that befell most of the rest of the planet. Investors in tumultuous Germany, Japan, Argentina, and India were not so lucky; they obtained far smaller rewards.
Thus, it is highly misleading to rely on the investment performance of history's most successful nations and empires as indicative of your own future returns.
At first glance, it might appear that the above list of winners and losers contradicts the relationship between risk and return. This is an excellent example of "hindsight bias"; in 1913 it was by no means obvious that the U.S., Canada, Sweden, and Switzerland would have the highest returns, and that Germany, Japan, Argentina, and India, the lowest. Going back further, in 1650 France and Spain were the mightiest economic and military powers in Europe, and England an impoverished upstart torn by civil war.
The interest rate bottom of 4% reached in Rome is particularly relevant to the modern audience. Never before, and perhaps not since, have the citizens of any nation had the sense of cultural and political permanence experienced in Rome at its apex. So the 4% return at Rome's height may represent a kind of natural lower limit of investment returns, experienced only by the most confident (or perhaps overconfident) nations at the top of their game.
The Austrian economist Eugen von Böhm-Bawerk stated that the cultural and political level of a nation could be discerned by its interest rate: The more advanced the nation, the lower the loan rate. Economist Richard Sylla notes that a plot of interest rates can be thought of as a nation's "fever chart," with upward spikes almost always representing a military, economic, or political crisis, and long, flat stretches signifying extended periods of stability.
As we'll see, the 4% Roman rate of return is about the same as the aggregate return on capital (when stocks and bonds are considered together) in the U.S. in the twentieth century, and perhaps even a bit more than the aggregate return expected in the next century. (The 4% Roman rate was gold-based, so the return was a real, that is, after-inflation, return.)
The same phenomenon was observed in Europe. The primitive and unstable societies of medieval Europe initially had very high interest rates, which gradually fell as the Dark Ages gave way to the Renaissance and Enlightenment. To illustrate this point, Figure 1-2 shows European interest rates from the thirteenth through the eighteenth centuries.
One of the most important European financial inventions was the "annuity," that is, a bond that pays interest forever, without ever repaying the principal amount. This is different from the modern insurance company annuity, in which payments cease with the death of the owner. European annuities were usually issued by a government to pay for war expenses and never expired; instead, they were handed down and traded among succeeding generations of investors. Newcomers tend to recoil at a loan that yields only interest with no return of principal, but the annuity provides a very useful way of thinking about the price of a loan or bond. It's worth spending some time discussing this topic, because it forms one of the foundations of modern finance.
If you have trouble dealing with the concept of a loan which pays interest forever but never repays its principal, consider the modern U.S. 30-year Treasury bond, which yields 60 semiannual payments of interest before repaying its principal. During the past 30 years, inflation has averaged more than 5% per year; over that period the purchasing power of the original dollar fell to less than 23 cents. (In other words, the purchasing power of the dollar declined by 77%.) So almost all of the value of the bond is garnered from interest, not principal. Extend the term of the loan to 100 years, and the inflation-adjusted value of the ending principal payment is less than one cent on the dollar.
The historical European government annuity is worthy of modern consideration for one compelling reason: its value is extremely simple to calculate: divide the annual payment by the current (market) interest rate. For example, consider an annuity that pays $100 each year. At a 5% interest rate, this annuity has a value of $2,000 ($100/0.05 = $2,000). If you purchased an annuity when interest rates were 5%, and rates then increased to 10%, the value of your annuity would have fallen by half, since $100/0.1 = $1,000.
(Continues...)
Excerpted from The Four Pillars of Investingby William J. Bernstein Copyright © 2010 by The McGraw-Hill Companies, Inc.. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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