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Bogleheads on Investing with William Bernstein – Episode 13

Post on: September 30, 2019 by Rick Ferri

Dr. William (Bill) Bernstein is a medical doctor, author, investment adviser, and financial historian. His research is in the field of modern portfolio theory and economic history. Bill has published extensively on investing and finance.

His first book, The Intelligent Asset Allocator, makes the case for broad diversification in a passive portfolio, as does his second book, The Four Pillars of Investing. Bill’s economic history books include The Birth of Plenty, is a history of the world’s standard of living, and A Splendid Exchange: How Trade Shaped the World, a history of world trade.

Dr. Bernstein holds a Ph.D. in chemistry and an M.D.; he practiced neurology until retiring from the field in the 1990s and became a full-time researcher, investment adviser, and author.

This podcast is hosted by Rick Ferri, and is sponsored by the John C. Bogle Center for Financial Literacy.

You can discuss this podcast in the Bogleheads forum here.

Listen On

Rick Ferri: Welcome to Bogleheads on Investing, podcast number 13. Today we havea special guest, Dr. Bill Bernstein. Dr. Bernstein is a neurologist, financial historian, author, advisor, and overall really smart guy.


Rick Ferri: Welcome to Bogleheads on Investing, podcast number 13. My name is Rick Ferri, and I’m the host of this podcast. This episode, along with all episodes, are brought to you by the John C. Bogle Center for Financial Literacy, a 501(c)(3) corporation. Today my special guest is Dr. William Bernstein, a favorite of the Boglehead community. Dr. Bernstein is a neurologist, financial historian, author, advisor, and a walking encyclopedia. Jack Bogle used to refer to Bill Bernstein as the smartest guy in the room. I always joked that when I have lunch with Bill, the three of us have a great conversation. So with no further ado, it is my great pleasure to have on the Bogleheads on Investing podcast Dr. Bill Bernstein. Welcome Dr. Bernstein.

William Bernstein: Hey, glad to talk to you Rick, and, by the way, my first name is not doctor.

Rick Ferri: It isn’t? But everybody refers to you as doctor.

William Bernstein: It gives me the creepy crawlies. I get PTSD, and I pretend I’ve got a white coat on, you know.

Rick Ferri: You know, I, I work with a lot of doctors, and a lot of them are a lot less formal about being called doctor than it was say 25 years ago. Do you find that?

William Bernstein: Yeah, I think so. There’s no question, I mean, I think that physicians these days are a whole lot more emotionally mature—at least young physicians are—than they were thirty and forty years ago.

Rick Ferri: Just funny anytime I even put in an email you know Dr. Smith or Dr. Jones, male or female, it’ll always come back and say no no no no no, call me by my first name. So I’ve just stopped doing the doctor thing. They don’t seem to mind. But I, when I was young, you called the doctor doctor. So Bill, Bill how are you?

William Bernstein: I’m fine Rick, and how about you?

Rick Ferri: I’m doing well. So speaking of doctors, but you were a neurologist at one time. Is that correct? Did I say that … correctly?

William Bernstein: Correct. For 25, yes.

Rick Ferri: 25 years. And did you do operations? Like, I’m just curious did you go deep into the brain?

William Bernstein: No, no. There is a difference between a neurologist and a neurosurgeon. A neurosurgeon is the guy or gal who operates, and neurologists are medical doctors. We work a lot with neurosurgeons, and they work a lot with us, but we, we don’t operate, and it, it loses me the opportunity to tell a really good joke which is that, you know, people look at me and say how hard was it to learn finance at your age. And I, I like to tell them that well, yeah, finance is hard, but it’s not brain surgery.

Rick Ferri: Ha, ha, ok. Yeah, at one point you decided enough of all of the the noise on Wall Street and you were gonna go out and investigate this on your own because you had come to the realization that what was going on out there on Wall Street was not working, at least not for you, and you started going down the path of learning on your own which a lot of physicians are now, at which I find great by the way, a lot of people are self learning, like you did. But you, you just kept on going after you went down that path, and and you got so into it that you decided to start writing books, and you actually opened up an investment company. Can you elaborate on that?

William Bernstein: Well sure. I mean I live in a country that doesn’t have a functioning social welfare system, so I had to, you know, basically save and invest on my own. And I had scientific training, and I approached investing the way I thought that any scientist would, which is, you know, you read the basic texts, the peer-reviewed literature, you collect data, you build models. And I went and did all those things, and by the time I finished doing this in the early 1990s, I realized that I had something that was useful to other small investors. And so I wrote my first book, The Intelligent Asset Allocator, as basically an online book in 1995. And I give credit to Frank Armstrong for telling me that I should do that. And the rest just followed from that. You can’t write about finance without two things happening: number one is people ask you to start managing money; and, number two and more subtly you come to the realization that you can’t write about finance without writing about the history of finance and the history of economics. And so that opened up yet another career which is, you know, writing books about economic growth and trade and things like that.

Rick Ferri: Yeah, and I want to go down that path a little bit because I want to eventually talk about brexit and trade deals that we go that are going on with China, and how all that affects us. But so from your lens, having written, is it four?, history books now or economic history.

William Bernstein: Yeah, yeah, I’m working on my fourth. I’ve written three so far, and there’s a fourth that’ll be coming out in about a year’s time from now.

Rick Ferri: So Bill the first economic history book you wrote was The Birth of Plenty. Just briefly [tell us] what you learned in that book, and then how that led to the next book.

William Bernstein: It’s a long shaggy-dog story, but one of the reasons why I became interested in not only in economic history but also in finance itself is because I knew 35 years ago that the most successful economies and the world’s most successful securities markets existed in countries that spoke English. All of the daughter countries, great daughter countries of England, the United States, Canada, New Zealand, Australia, South Africa, all had very successful economies, and all have securities markets with higher returns. Very few other countries matched that—Sweden, Switzerland came, came fairly close. And I wondered why that was. And it turns out it’s nothing to do with the English language, but what it does have everything to do with is English common law. And I quickly came to the realization that it was English institutions and particularly the common law, rule of law, and equality under the law that, that were behind the prosperity. And of course, that’s not an original i[dea] to me. Doug North got, you know, a Nobel Prize for realizing that 30 years ago. That’s how I came to write Birth of Plenty, which was a a modestly successful book. And as I was, had just finished that book I get this phone call from a man by the name of Brando Skyhorse, who, it turned out, was an acquisitions editor for Grove Atlantic Press. And he said, you know I’d like you to write a book about, about economic history of trade, the economic history of trade. And so I said well in the first place I don’t know anything about it, um in the second place I’m not interested in it, and in the third place you’ve got the wrong Bernstein. The person you wanted was of course Peter Bernstein.

Rick Ferri: Peter Bernstein, of course.

William Bernstein: Yeah, and and there was this, this awkward silence at the end of the line, and he said, well we, we had lunch with him last week, we did offer him the project, and he said that he was busy—he was writing his history of you know the Erie Canal at the time—and, and Peter said, but there’s this other Bernstein who you ought to read. So I said I don’t know. There’s other things I want to write, and I went out into the the family room or my wife was finishing her coffee and the New York Times crossword puzzle. And she puts down her coffee, and she puts down New York Times crossword puzzle, and she says, you know who Grove Atlantic Press is? And I said, uh no, and she said well you you’ve heard of the Atlantic Monthly, and I said, yes I know the Atlantic Monthly, and she said, you know, and you know what Grove Press is, and I said well yeah you know Doris Lessing and P.J. O’Rourke and Henry Miller and people like that, and she said, right, she said, if you value your career as a nonfiction writer you will write whatever it is they want you to.

Rick Ferri: Okay.

William Bernstein: That’s how I came to write A Splendid Exchange, which succeeded beyond my, my wildest dreams. It was very well received, and, you know, I mean one occasionally gets bad reviews on places like Amazon, but the major, you know the major media reviews that I got were uniformly, uniformly positive, and it’s also been the source of any number of really interesting speaking gigs over the past ten years.

Rick Ferri: Bill from the perspective of trade, we’re in a interesting situation in history right now where we’re beginning to see trade wars that one could argue we are starting, not only between us and China, but there might be issues with brexit, for example between the UK and a continental Europe and Ireland. You see trade wars, if you will, and trade problems potentially increasing in the future. Based on your work and your knowledge of it, what do you see these things going.

William Bernstein: Well, not, not in a good place. To, to say the trade wars are easy to win is akin to wearing a bright neon sign on your forehead that says I don’t know the first thing about history. We had trade wars in the 1930s, and not only were they disastrous from a geopolitical point of view, but they were disastrous from the military point of view as well. You can make a very good case that the Smoot-Hawley tariff and the tariffs, the other, of the other tariffs that, that gave arise too in retaliation were a direct cause of World War II. And it’s not an accident that the people who set up the, the, what became the World Trade Organization were people in the State Department, who swore never again. You know, we’re never going to have this again. We want an international order that prevents the geopolitical catastrophe you get from trade wars. It does appear highly likely that, that Britain will go crashing out of the EU. And if that happens, it will not be an entirely negative event for the following reason, which is that it will prove to be a relatively cheap, object lesson about what happens when you follow protectionism to its final conclusion. If you think you can, you know, destroy the international trade order and thumb your nose at it, or, or, or an organization like the EU and get away with it, you’re going to be sadly mistaken. You know, I’ve always thought it was useful to have a couple of communist regimes around like North Korea and Cuba as object lessons to the rest of the world, you know, in terms of the risks and the costs of a truly communist government.

Rick Ferri: Well, that’s an interesting perspective Bill. So basically there’s a lot more to trade wars than just trade.

William Bernstein: There’s, there’s a very predictable sequence of events that occurs when you start a trade war. In the first place, you’re shooting yourself in the foot because it’s a tax on your consumers. To anyone who doubts that, I suggest you go out and try and buy a washing machine right now. So that’s the first thing that happens. Secondly it damages your own domestic corporations who need foreign inputs because they’re going to be spending a whole lot more. The third thing that happens is that you get retaliatory tariffs. And then the fourth things that happens is you get shooting wars. And history is rife with trade wars that evolved into shooting wars. I mean the Dutch and the British fought four of them a couple of centuries ago—just over the issue of trade. Why did the Japanese attack Pearl Harbor? Well they attacked Pearl Harbor because we embargoed their oil. Yeah you’re just, you’re playing with fire. It’s a stupid thing to do.

Rick Ferri: Well, let’s move on to Masters of the Word. I recall, I, I’ve read the book before you published it—thank you for letting me do that—and I thought it was a fascinating book.

William Bernstein: Well, it sank like a stone. I had a good time writing it, and I, what I learned about it is that you know writing a long-form history book is really about the process, and if you don’t enjoy the process, you shouldn’t be writing the book. And it would have been nice if I had gotten the frosting on the cake of a successful book, but at the end I learned an awful lot. And the reason why it, it sank was simply because media academics, who are the people who are going to be reviewing the book, didn’t like it because I didn’t pay proper homage to McLuhan and Kittler and Derrida and people like that, who I didn’t find terribly relevant to my story. So it was a, was a lesson in a number of regards.

Rick Ferri: So just to regress a little bit that the book was about the history, if you will, of communication and that how that affects society.

William Bernstein: Yeah. The basic thesis of the book was that access to communication technology is what determines politics. So, for example, in the ancient world very few people knew how to read and write. Not only did they not have the time to do it, but the the writing systems that were in place were extremely complex and took a long period of time, so no one could afford the time to learn them. So if you were a scribe, if you could read and write, which had to have been less than 1% of the population, you were the combination of a software engineer and the venture capitalist and an investment banker, all rolled up into one, you were the, the person who could basically gave everybody else their orders. And that changes around six or 700 BC, when the Greeks inherit the Phoenicians writing system, which doesn’t have vowels, and they put vowels into it. And all of a sudden with the presence of vowels and consonants a clever five-year-old can learn how to read. And at the time of, say, Pericles probably 50% of Greek citizens, who are all of course, all men, could read and write. Well, it’s not an accident that democracy develops in ancient Greece. And you can jump a couple of millennia ahead of that, and you could look at Nazi Germany and see that their degree of control over the population basically stems from the fact that they controlled the leading-edge communications technology of the era, which was of course radio. You know, Brett Stevens wrote a very fine column about that in the New York Times last week. Not an accident that the totalitarianism has its high-water mark in the 30s and 40s with the rise of radio.

Rick Ferri: But radio was just a one-way communication. It went out but it didn’t come back.

William Bernstein: Exactly. If you wanted to say something back to the radio, you were out of luck.

Rick Ferri: So then enter the internet, and suddenly now it goes both ways and things change again.

William Bernstein: Exactly, exactly, now the question is, is the other really interesting story was, you know, were some of the things that people don’t talk about very much. It contributed to the fall of communism. Obviously it was a miserable economic system, and that didn’t help, but the, the Russians the Soviets weren’t nearly as smart as the Germans because the German made radios that made it an almost impossible to receive foreign broadcasts, okay, the Russians built these very sophisticated shortwave broad receivers that could get, you know, Voice of America, Radio Liberty, the BBC. And when you read people like Lech Walesa and Vaclav Havel, the first thing they tell you is that if it wasn’t for Radio Liberty and Radio Free Europe, which of course were CIA plants, they wouldn’t have gotten anywhere.

Rick Ferri: And so here we have a situation where instant news everywhere, all around the world. You know, if there’s, if there, one tear gas canister gets shot in Hong Kong, the whole world knows about it within ten seconds. How is that changing things?

William Bernstein: Well, it makes the cost of totalitarian suppression much higher. The, the Hutus in, in Rwanda, you know, twenty five years ago could use the radio to direct their genocide, and the people on the other side didn’t have any way of publicizing what was happening. Well, if they tried that today, there would be cell phone videos that would be flooding the internet, and people would have intervened a whole lot faster. I think, you know, the one thing you can, you know, you can talk about the negative effects of social media, but one thing I’m quite certain of, which is that the internet and cell phones have made genocide a whole lot harder.

Rick Ferri: Let me ask about what you’re working on now. I know you’re you’re working on another book.

William Bernstein: Well yeah, I’m working on a modern version of a book that I’m sure you’ve read too, which is one hundred and seventy eight years old, called Memoirs of Extraordinary Popular Delusions and The Madness of Crowds by Charles Mackay, who was a Scotsman. And the book is famous, as we both know, in finance because it described the three great bubbles of the 17th and 18th century: the tulip mania, which Mackay got completely wrong; and the South Sea and Mississippi company bubbles, which he did a fairly good job with—or at least a fair job with. And I can remember reading that book in the 1990s and thinking to myself, my god, this is fascinating, but I’m never gonna see anything like this of course. And then all of a sudden, right in front of my eyes, I saw the same kind of behavior as Mackay observed with tech stocks and the popular mania that surrounded them. And it saved me a lot of, a lot of money, and, and I’m certainly not the only person who had that experience, or, by many decades, was the first person to have that experience because the book has been in print ever since 1841. And the 1932 edition, the forward to it was written by Bernard Baruch, who had his bacon saved in 1907 by it. So that’s the first thing that impressed me about it. And then the other thing that really impelled me to write the book was the rise of the Islamic State in the Middle East and how the Islamic State and their predecessor, ISIS or ISIL, or however you want to refer to it, and how they were able to attract people from, tens of thousands of people from around the world—some of them from very comfortable Western societies—to hell on earth, and to fight and to die there. And of course, Mackay wrote about religious manias too. And so, I had to write a book that married the two of them, those together, because they were both popular manias, both financial manias, and religious mania is propagated by this, the same social mechanisms. So I wanted to write about that, and that’s what I’m finishing up on.

Rick Ferri: And is Bitcoin and cyber currency part of that? I had to ask.

William Bernstein: Uh, it gets about two sentences or three sentences. It’s just, it’s, quite frankly, it’s, it’s not big enough to make it into my book. It still, it still makes headlines, but you don’t very often meet people who will talk your heads off about it, you know, at a cocktail party, which is typically what happens during a mania of any sort.

Rick Ferri: Back in the 1990s people were experts. You go to your local barber to get a haircut, and they were experts on tech stocks. I don’t think you have that with cyber currency. I don’t think anybody claims to be an expert. I think they all know what they’re doing is speculation.

William Bernstein: Although, the really interesting thing is that it seems that every other Uber driver that I encounter wants to talk about the inverted yield curve.

Rick Ferri: Oh, that’s true. Yeah, negative interest rates good to be a big thing right now as well. A lot of people tend to want to talk about negative interest rates which, you know, speaking of that, let’s get into this a little bit. Negative interest rates are new phenomena. I mean, as far back is what I can tell, right, years going back, I mean interest rates may have been low because inflation was low, but we’re negative interest rates get countries like Germany and Japan, Switzerland. I mean where does that all go?

William Bernstein: Well, I tend to look at negative interest rates more as a symptom than as a root cause of anything. It’s obviously not good for fixed income investors. But what it’s a manifestation of is several different things all coming together into a perfect storm. Thing number one is something that I, I like to write about, which is that, you know, societies get wealthier, the rate of return falls. And that’s true of both stocks and bonds. Inequality comes into it as as well. You know, you, you have more and more capital getting hidden away into people’s accounts. And it’s not getting spent. You know, people don’t have money to spend on rents and houses and food the way they should, certainly on their children’s education because, you know, almost all of the increase in income is going to the one percent. And what do the one percent do with their money? Well, they put it away the stocks and bonds. That’s the first thing that’s happening. The second thing is we’ve got a tepid economy, and so the demand side for capital is down, so the rate falls because of that. And then finally you’ve got central banks getting into the act and buying up fixed income assets onto their balance sheets. So all three of those things are, are causing the reduction in interest rates. I’m not sure there’s anything to do about it. But it’s just it’s just a fact of life. The one thing that it does do is it makes people enthusiastic about long bonds because that’s the, an asset class that’s done very well with the fall in interest rates. And, you know, I think that T-bill rates are certainly not as low as they’ve ever been. They were actually, depending on how you measured it, negative during the Great Depression very early on. But, you know, a long-term, a 30-year Treasury bond is yielding, what, 2.3% or 2.4%. That’s historically anomalous and so it makes people very excited about, you know, long bonds and particularly about leveraged bonds in the portfolio because they’ve done so well. It’s, you know, they’re an excellent waste, way to chase prior performance.

Rick Ferri: Larry Summers wrote something recently in talking about negative interest rates, and he said something that caught my ear. Basically he said if you have very low interest rates, it keeps a lot of companies around that have no business being around, that they should go under. And because they’re not going under, it, the system is going to become clogged with a lot of dead-weight companies that should have gone bankrupt, but won’t go bankrupt because interest rates are low.

William Bernstein: Yes and in the Austrians, the Austrians, that was something the Austrians liked to write about, you know. Shumpeter certainly wrote about that, and I’m pretty sure that Hayek wrote about it, you know, wrote about it too, which is the danger of low interest rates is, is not inflation, ok, in other words, when you, you can get inflation if you lower interest rates because people start spending. But if you’re, you know, beyond the zero lower bound, then simply what happens is that you get asset class bubbles. And so a lot of companies wind up getting capital or keeping their capital that, as Larry Summers says, have no business being around.

Rick Ferri: Yeah, one of the things I’ve noticed is that the tax cuts that corporations got. The money, the extra capital that they had, that came in, there wasn’t really any big spike in capital spending with that money. But what there was was buybacks, there were dividend increases, but, you know, the idea of giving companies the tax cut was they would come back and spend more money, invest more money for the future. That doesn’t seem to be what they’re doing.

William Bernstein: Yeah, we’re in a capitalist fool’s paradise now. And I’m not talking about that politically; what I mean by is a capitalist is anybody who has capital. That’s you and me. And we’re in a fool’s paradise because we’ve got these bloated portfolios that are inflated by low interest rates, and we feel rich. It seems that we’re rich, but in fact the earning power of what we own—and certainly the the dividend stream from what we own, and the interest stream from what we own—is not all that impressive. If you had to live, you have to live on your income now you’re in trouble.

Rick Ferri: Yeah. Which gets us to, where do you put your money? You know, with the potential for even lower interest rates in the US. No, I know that that’s not a popular opinion about interest rates, where interest rates are going, but we have 1.4% on the ten-year, and I think the probability of the ten year dropping below 1% is as high as the probability of it going over 3%. So I mean we could have even lower interest rates going forward. You know, we have earnings that are slowing, dividends increases, which are better than what they were in the past, but they’re slowing too. We have no more tax cut on the corporate side, we already had that, buybacks are beginning to slow. Where do you put your money Bill?

William Bernstein: Ha, ha, I put my money where I’ve always put it, which is in a prudent mixed portfolio. I don’t know where else to, to put it. I’m not gonna put it under the mattress. I’m not gonna buy, you know, a couple of, you know, a ton or two of gold. You, you keep, I’ve always, you know, I’ve always kept my, my fixed income durations fairly low, so that if things spike up, I don’t lose too much money there. And, you know, you have to, you own some equities. Equities abroad are not badly priced. European, Japanese equities are at least reasonably priced. Emerging markets equities are even more than reasonably priced, you know. On the other hand I’m going to be spending in dollars, so I’m not going to be investing, you know, much more than 40% of my money abroad.

Rick Ferri: Anytime I put something on the Bogleheads about expected returns from equities or fixed income going forward, I always get a lot of push-back. Oh you don’t know what they’re going to be, it’s, you know, you know, nobody knows what the returns are going to be. But in order to invest your money, in order to come up with an asset allocation, and some sort of an investment plan, you need to have estimates of return for equities and estimates of return for fixed income and estimates of return for cash. And I know I have my estimates, which I use. What are your estimates.

William Bernstein: I think that right now bonds, notes, anything you know beyond the couple of months, probably has a negative expected real rate of return. You know, can’t be any other way. I mean if you’ve got, you know, if you, if you think that inflation over the next ten years is going to be less than 1.1%, you know, I’ve got a bridge that I want to to sell you. I think US stocks have probably an expec…

Rick Ferri: I may want to buy that bridge, by the way, if it’s paying tolls to get across. I, I might be interested, so let me know afterwards.

William Bernstein: Okay, I’ll name the bridge after, after we’re off the call. And you know, I think that cash probably has a yield which is not too much less than the inflation, so not too much less than than zero. And then finally US stocks maybe about 3% real, and foreign stocks maybe 4% real, and emerging markets maybe a little bit more than that.

Rick Ferri: You know, in the US, uh, my view of a rate of return on equities—and I’ll use nominal instead of real—is about six percent on equity and two and a half percent on bonds. If you’re looking at corporate bonds, you maybe, you’ll get three because you have two percent inflation. I know you might be looking at lower than that, but if you use two percent inflation, two percent real GDP per capita growth—if we get it—and then two percent dividend yield; you put it all together you’re just zero out any p/e multiple expansion, and you get about a six percent return on equity. So that’s how I get to six percent on equity in the long term. And then the two and a half percent on bonds is simply whatever the ten-year Treasury bond is now plus a ten-year corporate to combine together, you know, 50/50, you know, looking forward over the next 10 years it’s a pretty good predictor of what that return will be. I mean, am I far off?

William Bernstein: No no you’re not, and the trick is no matter what estimate you give or I give, especially for stocks, you, you have to take it with a grain of salt. I mean someone took me to task in, in the questions portion of your post. You know what they wanted to ask me was how did I get stocks so wrong over the past 10 years. Because 10 years ago, I mean it was 19 years ago, it was 19 years ago I predicted like two and a half percent for stocks and they were actually seven percent. Well you know, over nineteen [years], if the standard deviation of stocks is 16 percent a year, it may quite easy over 16 years, then the standard error is going to be 4 percent. So, I was a little more than one standard error off, okay.

Rick Ferri: But, but, but, you’re a doctor.

William Bernstein: Yeah, well there’s still standard … you know, but but I still have to obey the laws of statistics. So, I mean even over 30 years I can give you a 30-year estimate, but even over 30 years, I mean, square root of 30 is like five and a half. So one standard deviation on that estimate is three percent, two standard deviations is six percent. So, if I say a real return of three percent, well it could be nine percent, or it could be minus three percent.

Rick Ferri: So, getting back to what you said about the Boglehead question, we can go there now because we had a number of questions from the Bogleheads forum—a lot of them are investing questions—so we can get more into the nitty-gritty of each asset class and factor investing and TIPs and and so forth. Let me go ahead and go to the Boglehead forum. And I’ve, because I always post on the Boglehead forum, Bogleheads.org, who my guest is, and then I ask the forum members, who are registered, to ask intelligent questions that are not related to them personally, that I can ask. So here we go with the first question. So Bill I had a number of Bogleheads asking about factors, like value, momentum, quality, and you’ve written a lot about this in some very prestigious academic journals, about factor investing. You’re well-known to have yourself—in your client portfolios—use factor type funds, but factors have not done well in the last, say, 10 years. And first of all, could you comment on that, and then comment, if you can, if you have any thoughts about the valuation of various factors going forward.

William Bernstein: I knew I was going to be asked this. I went and did what any person does in that position, which is you go and you look at the Ken French website, you download some data, and you massage it. The primary way you look at how …

Rick Ferri: No, I never do that I …

William Bernstein: You wouldn’t do that?

Rick Ferri: You would accuse us of doing things like that.

William Bernstein: Ha, ha, well it just shows how warped I am. And what you do, the simplest database you can look at is just the global database of US stocks, and you sort purely by price-to-book, which is historically the way they looked at value versus growth, or obviously other ways, as you well know, to, to do it. They do a 30-40-30 sort, so they look at the 30% that are the cheapest by price to book, the 30% of the most expensive—and then there’s 40% in the middle. So if you look at the price to book ratio, or actually the inverse of that, the book to market ratio of the cheapest stocks versus the expensive stocks. It’s always going to be much greater than 1, okay, because that’s how you’re defining it, all right. And it turns out that the average value over the past 50 years is about 4.8, okay. That ratio is 4.8, so in other words, the cheapest 30% have a book to market value that is about 4.8 times the most expensive stocks, which is about what you’d expect, okay. And, it turns out that when you look at what happens to that ratio over time it corresponds precisely to how value has done versus the market or value has done relative to growth, however you want to look at it. So for example, if you look at the period from say 1995 to 2000, which was a terrible period for value, you find that ratio rising from about 4 to about almost 10, okay, which was historically unprecedented. That was, you know, the height of the, the bubble in growth stocks around 2000 or so. And then if you look at what happened to that ratio over the next 10 years or so, you find that it went from 10 all the way down to about 3.8, okay. And those were salad days for value stocks, you know, you were shooting fish in a barrel. Everybody got excited about value stocks because they’d beat growth bought stocks by several percent per year. Well, what has now happened since about 2011 or so is that ratio is gone off from about—I don’t know— 3.6, or 3.8 all the way up to almost 6, okay. So, what has happened to the value premium? It’s done very poorly, all right. Well, it turns out the current value about 6 is more than a bit above its historical average, which is another way of saying that value stocks are now cheaper, alright. And I think that people are getting very discouraged with value investing, and that’s a good sign because that corresponds to John Templeton’s point of maximum pessimism.

Rick Ferri: Yes, but only when the blood is dry.

William Bernstein: Exactly, exactly.

Rick Ferri: And I think the blood is drying, but it’s not dry yet. But you said something—I don’t know what it was five or six years ago—and we were having the same conversation about value, and it was too easy back then. And, the way you say, we need blood in the street in order for the value, the true value, investors to to to earn a return. I was talking with Wesley Gray—I had him on as a guest—and, you know, he’s a quant from the University of Chicago—Alpha Architect is his company—and I had him on as a guest, and, and he was saying the people who make money in value earn their value premium. What we have now is basically a cult of value renters, where we had a lot of people come in and buy value stocks using these newfangled ETFs, and, you know, there was a whole lot of value investing for the wrong reasons, because they were trend followers getting value premiums down to this 3.8, like you said, you know, a lot of money going into it at the wrong time. But now, it’s come back the other way. There’s blood in the street a lot of blood in the street. I don’t know if the blood is dry yet, or maybe there’s going to be more blood, but, you know, to me I agree with you that we’re getting to a point where, gee, it’s almost safe to invest in value again.

William Bernstein: Yeah, I mean I don’t know if we’re at that point, but, you know, you never know when you’re at that point. The smart thing you do is you just, you know, you stay, you stay true to your, your discipline. It was JP Morgan who very famously said that a bear, a bear market is when stocks are returned to their rightful owners. And, …

Rick Ferri: Exactly, there you go.

William Bernstein: And I think the same thing is true of the value, the value premium. We’ve, what we’ve had over the past five to six years is a lot of, you know, dentists getting sold by their broker on factor investing and smart beta, and you need to wash those people out in order to to earn the value premium.

Rick Ferri: How come you always pick on dentists? Because I remember every joke that you make, instead of picking on doctors you’ve begun, dentists. Instead of picking on surgeons, as you pick on dentists. Is that something that like in your other occupation some rivalry between dentists and medical doctors?

William Bernstein: Yeah, it may be, you know, in medical specialty, in medical training you refer to purely procedural specialists as dentists; it’s not a compliment.

Rick Ferri: Ha, ok. I remember you had a joke about the Luby’s, two dentists sitting together at Luby’s, talking about stocks, and the market will never be, or index funds will never take over the whole market if there are two dentists sitting together having lunch at Luby’s trading stocks, or something like that.

William Bernstein: Very close. You, you, you, you, you got, you got the vowels and the the consonants, right idea. What what I believe I said was two dentists having lunch in Lubbock.

Rick Ferri: Oh, Lubbock, okay.

William Bernstein: Yes, yes.

Rick Ferri: Anyway, so we can go on to another question that the Bogleheads have. One of the Bogleheads asks how you feel about international REITs and international bonds. There’s always a lot of controversy about those two asset classes. How do you feel about that?

William Bernstein: Well, you know, as far as international bonds go, I just don’t like them—even forgetting about the fact that most of them have negative yields right now—and the reason is you have a choice when you’re owning international bonds. You can either not hedge them, in which case you’ve got a relatively safe bond, a sovereign bond, but it’s got overlaid on top of it industrial-grade currency risks, so that’s not a bright idea. Or, you could hedge it back to the US dollar, and then what you wind up when you do that is just a very expensive domestic bond. So neither of those two things make sense. Now, a long time ago I did occasionally invest in foreign denominated bonds that were not hedged, and I did that when, whenever I went to Europe, and I thought that it was cheap, okay. So you know, if you were lucky enough to visit Europe, let’s say in the early to mid 80s, when you had a ten franc dollar or a British Pound that was trading fairly close to par—you know, back in the day when the pound was actually worth something. And when those currencies had fat yields attached to them, yeah, that was a, you know, an opportunistic play. But I haven’t seen anything attractive in that regard over the past 20 years for the simple reason that foreign currencies have been fairly expensive in general over the past 20 years. And now, you know, with the interest rates it’s, I wouldn’t, I wouldn’t do it at any currency valuation because of the low interest rates. So that’s international bonds. International REITs, yeah, I think it’s a good way of diversifying a REIT portfolio and diversifying in, in general, or say also trading at relatively attractive valuations relative to US REITs.

Rick Ferri: Now that’s not exactly REITs, it’s real estate, where there are management companies and there are development companies and so forth.

William Bernstein: Right.

Rick Ferri: Well. Okay, one of the Bogleheads asks about the duration of your bonds. Should you, should they continue to hold only short duration bonds, as they are getting near retirement? And, and here’s the line that I think is funny: that’s a no-brainer in today’s interest rate environment. I remember you and I having a conversation about this ten years ago. We were on a Bogleheads panel together, and we were talking about bonds. Somebody asked, you know, where should you have the duration of your bond portfolio, and I think you said ten years ago, it’s a no-brainer, you know, have them in short-term, and I, I disagreed with you on that. I said, well, I don’t know, but I’m just gonna, if your liabilities are intermediate term, you should probably have intermediate term bonds. So I’m gonna go back to you now. Is it a no-brainer to have short term bonds in your portfolio?

William Bernstein: Well, I can’t be right about everything. And, you know, I was certainly wrong about that. But I think as a general rule you want to take your risk in, you know, in, in, in stocks and not in bonds, and I think that going out in intermediate term, intermediate term bonds is too much of a risk if rates spike up and, let’s face it, there’s not a lot of juice left in that play.

Rick Ferri: And there’s huge convexity right now and bond, I mean, it just one little move up in interest rates on intermediate term and you’re gonna have some. I mean the duration have expanded on a five-year, ten-year Treasury bond, the duration because interest rates are low or, you know, duration is a factor of the bond maturity date, the, the coupon payment, and, you know, where interest rates currently are. So if interest rates are, you know, at 5 or 6% and you had a jump of 1%, it wouldn’t hurt the bond portfolio as much as it does now where interest rates are less than one and a half.

William Bernstein: Yeah exactly. I would say, you know, when it comes to bond duration, I would say two things. I would put, you know, two and two together and make four. The one thing that I would, I would say is that your bonds are what allows you to sleep at night, okay. When everything else is, is going down the you know what, you want to have something that you can look at and say, yes that pays for next week’s groceries or next month’s rent or mortgage payment. And your bonds allow you to do that. So you, you, you don’t want to take as much, you know, that much risk with your bonds. The second thing I would add on to that is to realize that between 1940 and 1980 the real return of long-term US Treasuries—and that includes, you know, reinvested interest—was minus 60 percent, all right. And you don’t want that happening to your, your, the safe assets, the things that are allowing you to sleep at night.

Rick Ferri: I have friends who are in Europe who are investment advisors and they’re dealing with negative interest rates. And what you said about being able to sleep at night by having bonds, that we’re actually getting on the other side of that curve over in Europe, where people now are actually not sleeping at night because of their bond holdings and negative interest rates. So it’s even if they’re short terms, this is an interesting phenomena that’s taking place in the global financial markets that has never taken place before. And this is where I think we’re in a a new area. If we get into negative interest rates like the rest of the world, people are not going to be looking at bonds as though there is sleep at night type investment. Do you agree?

William Bernstein: Yeah, now again I’m putting myself, let’s say, in the position of a northern European person who is spending local currency. If I see, if I see negative interest rates, okay, I’m also seeing something else, which is that because of, you know, the European Union and because of increased integration, most of the things you want to do in Europe have actually not gone up in price—and may have fallen in price. I, every time I go to Europe these days, I’m amazed at how reasonable it is. And so, you know, the one exception to that, of course, is if you have to buy a house or an apartment, all right, but I’m assuming you already own a house or an apartment and all you have to do is meet your living expenses, and you want a fixed income substitute. Well that’s the point where I trot on down to the bank, and I rent a great big fat safety deposit box, and I put my cash in it, okay, and then I’m not getting negative interest rates.

Rick Ferri: So one of the Bogleheads come back and he asked if, under what circumstances would you recommend going longer-term on bonds? What would have to happen for you to go longer-term?

William Bernstein: Oh, I’d want to see a great big steep yield curve. I want to be rewarded for going long. And I want to be rewarded a lot.

Rick Ferri: As we continue with our fixed income discussion, how do you feel about municipal bonds? A lot of people are talking about these embedded liabilities, and the quality of municipal bonds going down, bankruptcies, and so forth. Where do you stand on municipal bonds?

William Bernstein: Well, you know, the thing that’s always said about municipal bonds is that during the Great Depression very few of them went bankrupt, very few municipalities went bankrupt because they can tax. But during the 1930s, as the question points out, you know, municipalities didn’t have these absolutely massive pension obligations that threaten to bankrupt them. I think that high-quality municipal bonds are certainly not that risky in the aggregate. You know, if you own you own, say, one of the Vanguard municipal bond funds that are so inexpensive that they can get the same yield as other, as other funds do, but at much higher quality, I think that, you know, there you shouldn’t necessarily avoid them. But I think that less than half of your bond portfolio should be in munis, and less than half your munis should be obviously in a single state’s munis, as attractive as that may be if you’re in California or New York. You’re taking too much concentrated risk by, you know, owning all of your munis in, in one state.

Rick Ferri: One other item that you’ve talked about in the past is owning commodity producing assets, like gold miners and such. Is that still on your radar screen, to buy things like the gold miners and—not, not buying gold—but commodity producers as a diversification hedge?

William Bernstein: Yes absolutely. And in fact, when you look at the data on how commodities producers do during hyperinflationary periods, they do extremely well. Now realize always that in, there are three things you have to understand about stocks and inflation. Number one is that in the short term, you see unexpected inflation, stocks do take a hit, okay. But in the much longer term stocks are a claim on real assets; they make products that get priced in real terms, they own assets that get priced in real terms, in real terms. And, when you look at how well stocks have done internationally during periods of hyperinflation, on average they do very well. I mean, the worst most, not the worst, but the most famous example of hyperinflation was the Weimar hyperinflation between roughly 1920 in the end the beginning of 1920 and the end of 1923. And when you look at German stock returns during that period, they had a positive real rate of return, all right. And that’s true been true of any number of countries. I mean, Israel and Chile, for example, during the 80s and 70s, 80s, and 90s, had extremely high inflation, but the real rate of return on their equities was, it was equal to that of, you know, the United, of the United States. So that’s the first thing. And then the second thing is that the stocks that do particularly well are two kinds of stocks. One is value stocks do well with inflation because their liabilities get get inflated away and flow to their bottom line because value stocks tend to be more leveraged or indebted than, than growth stocks are. But more importantly they, you know, commodities producers also do extremely well. They don’t all do well, but a few of them do well enough that they save your bacon. So if you invest, for example, in base metals equities, in oil stocks, and gold stocks, one of those three is going to do well enough that your bacon is going to get saved. Now how much of your portfolio do you devote to that sort of thing? Not very much, just enough to take the pain, you know, take the edge off of the pain, you know. If you have a horrible financial crisis, and gold stocks do well, instead of your portfolio losing 30%, maybe it only loses 25%.

Rick Ferri: Isn’t there a lot of overlap between value investing and commodities, like oil producers, and so they tend to show up in a lot of value indexes.

William Bernstein: That’s true. Gold stocks don’t, though.

Rick Ferri: Bill you’ve been a, always been a wonderful guest at the Bogleheads conferences. When you go, you generously give your time to answering questions. And if I could just get you to comment about the Bogleheads, and where do you see everything going now that Jack unfortunately has passed away?

William Bernstein: Well, you know, let me make a general statement about the Bogleheads, which is that you will not encounter a group of even, you know, small investors or institutional investors who are more sophisticated, you know, who understand stochastics who understand portfolio theory, who understand efficient markets, and, you know, who are smart enough not to be distracted by the news. It’s, it’s almost an alternative the universe. It’s it’s almost like you’re on a different investment planet, and it’s a, it’s a very nice place to be. Um, the, the conference this year filled up very slightly slower. Instead of filling up inside of six hours, it sold out inside of like, it’s less than a day, I think, maybe even better. So I think it’s going to do just fine. I think that, you know, we’re all going to miss Jack. But obviously there’s a lot, you know, there are a lot more reasons why people come to the Bogleheads than, than to hear Jack talk, as great as his talks were.

Rick Ferri: You know, we continue to march. We have to continue to spread the word. We had the, the, the person who is holding the flame, and now here we are with—if you don’t mind me dating myself—we, we with our Bic lighters have to follow. That’s what it’s all about.

Bernstein: I thought you were going to say Zippo lighters, but, alright.

Rick Ferri: I mean, a Bic lighter, if I recall yeah, but you, I know it, yes, Zippo is a little bit. It actually predates me. There shows the age between you and I. So there you go. Listen Bill, thank you so much for being our guest on the Bogleheads. Great to have you, and I’m really looking forward to seeing you at the Bogleheads reunion, and thanks for being on the show.

William Bernstein: Okay, it was my pleasure, and I look forward to seeing you as well. You take it easy.


Rick Ferri: This concludes the 13th episode of Bogleheads on Investing. I’m your host, Rick Ferri. Join us each month to hear a new special guest. In the meantime visit Bogleheads.org and the Bogleheads wiki, participate in the forum, and help others find the forum. Thanks for listening.


About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant



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