Monday, July 28, 2014

Bill Bernstein

In 2000, Bill (not Peter) Bernstein published his first book, The Intelligent Asset Allocator. It yanked away the punch bowl from the New Era's party. While other investment publications (most notably, the best-seller Dow 36,000) advocated euphoria and heavy doses of then-popular growth stocks, The Intelligent Asset Allocator preached the unfashionable virtues of diversification, caution, and contrarianism. Among its recommendations were REITs and gold stocks. It was, in short, a hopeless cause--the rare investment tome that sold what would succeed, rather than what had already thrived. Obscurity beckoned.

This summer, Bernstein published a sequel: Rational Expectations: Asset Allocation for Investing Adults. Much of the material--the basics of Modern Portfolio Theory, asset allocation, and the efficient-market hypothesis--is familiar, although freshly presented. The changes interested me most, however. They addressed my favorite investment question (typically aimed at fund managers, but applicable to authors as well): What have you learned since you started in the business?

Bernstein writes, "As Warren Buffett famously observed, investing is not a game in which the person with an IQ of 160 beats the person with an IQ of 130. Rather, it's a game best played by those with a broad set of skills that are rich not only in quantitative ability but also in deep historical knowledge, all deployed with Asperger's-like emotional detachment."

In fact, continues Bernstein, being extremely bright and technically accomplished can actually be detrimental to investment performance. As with prom queens, who overstate the importance of beauty, the quantitatively adept will sometimes overestimate the value of their own gifts. The geniuses at Long-Term Capital Management, for example, had rather too much faith in their ability to outsmart the marketplace and rather too little recognition of the possibility that they might be wrong. Bernstein suspects that many of his readers may fit a similar profile and pleads with them to "fill in what may be the shallow areas ... a working knowledge of financial history and a healthy dollop of self-awareness about [their] discipline under fire."

Put another way, a powerful mindset is at least as important for investing success as is a powerful mind. This realization did not come immediately to Bernstein because the mindset came naturally to him. He was willing to follow what the data suggested, regardless of how his actions looked to others, and regardless of whether the market seemed to agree--even if the market's disagreed for several years. (As with other contrarians, Bernstein spent much of the late 1990s doubling down on losing value stocks, and looking ever more foolish in doing so.)

Most people, however, are wired differently. In Rational Expectations, Bernstein painstakingly explains what was mostly implicit in his first book: Emotions destroy investment performance. Somehow, some way, investors must suppress them. The suppression might come from the blessing of nature; from ongoing investment education; through shielding mechanisms such as holding a blind trust; or, most commonly, by cutting back on stocks and holding a lower-volatility asset allocation. One way or another, though, it needs to happen.

Paradoxically, writes Bernstein, the task is hardest for people who are otherwise admirable. He states, "The most emotionally intelligent and empathetic people I know tend to be the worst investors. After all, the very definition of 'empathy' is to feel the emotions of others, which is deadly in investing." Bernstein relays the story of hospital patients who have brain lesions that disconnect their sense of fear; in investment simulations, those patients handily outperform the general population. For most people, investing successfully is a deeply unnatural act.

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