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A Day to Remember

William Bernstein

JUST AS ANYONE around on Sept. 11, 2001, Nov. 22, 1963, or Dec. 7, 1941, remembers where they were when they first heard the news, one date resonates for investors of a certain age: Oct. 19, 1987.

As a young practicing physician, I was just finishing up the day’s charting when I took a call from one of my colleagues: “Did the Dow fall enough for you today?” Indeed it had, by 508 points, or nearly 23%, and 36% off its peak of some weeks before.

Gulp. My net worth had plunged nearly six figures in just a few hours. In my unhappy state, though, it occurred to me that if I was comfortable owning stocks at Dow 2700, shouldn’t I be even more comfy owning them at Dow 1800?

And so I held my breath and increased my stock exposure. This one salutary move, though, did not exactly herald a full flowering of financial wisdom. I continued to make mistakes: reading market-timing newsletters, trying to pick both stocks and active fund managers and time the market, and allowing my spirits to rise and fall on a daily basis with share prices. I even got taken in by 1989’s spurious cold fusion excitement and went long palladium futures.

Fortunately, my financial journey got better from there. Not long after, I came across the books of Burton Malkiel and Jack Bogle, and began to immerse myself in the world of academic finance, particularly Eugene Fama and Kenneth French’s work on market efficiency and factor investing. I taught myself to spreadsheet, which was far less ubiquitous back then than it is now. My portfolio, whose stock exposure now consisted entirely of low-cost passively managed funds, prospered. Perhaps most fortuitously, in the early 1990s, I came across Charles Mackay’s Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, which immunized me from the dot-com bubble that blew up a few years later.

Even so, I could have done things better. Here are two lessons that took me decades more to learn—and which could have made my financial journey far smoother:

First, a suboptimal portfolio you can execute is better than an optimal one you can’t.

Yes, it’s true that, over most long periods, the more stock-heavy a portfolio, the higher its returns will be. The problem is that we humans are overconfident about most things, and none is more deadly to financial success than overestimating our risk tolerance. It’s one thing to fire up a spreadsheet and simulate losing a large chunk of assets, but quite another when it happens in real-time. A good analogy is how experiencing a plane crash in a simulator compares with the real thing.

Never forget humorist and financial journalist Fred Schwed’s famous injunction: “There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”

Over the past four decades, I’ve learned that the prime prerequisite for a successful portfolio is that it survives. One occasionally comes across newspaper articles about a recently deceased janitor, secretary or kindergarten teacher’s estate that surprises a charity with a multi-million-dollar bequest. Such stories always feature two common elements: first, the departed’s frugality (anecdotes involving bus and subway transport are mandatory journalistic elements); and, second, that they invested over periods of around half a century.

By the same token, it’s not uncommon to read about star money managers who flame out after a few years of shooting the lights out. The difference between these two narratives? The first group made sure their portfolios survived long enough for compound interest to work its magic. The best way of ensuring that is to have a portfolio that can be held through the inevitable episodes of economic and financial excrement hitting the ventilating system.

To wrap this first lesson up, I’ll risk one more analogy. The financial markets are a car that conveys your assets across town from your present self to your future self. The roads are slick with ice and studded with giant potholes. If you drive fast, you might indeed get to your destination a lot quicker. But it’s usually a bad idea.

Second, mentally compartmentalize your portfolio.

For decades, whether it was my money or that of clients, I hewed to the conventional academic and financial practitioner wisdom of designing a single overall portfolio encompassing all assets. I still go through that exercise, and it still drives the security purchases and sales we make for ourselves and for our clients.

But here’s what I’m doing behind the scenes: I’m mentally dividing a given portfolio into two completely separate pools, the safe assets necessary to sustain body and soul—more on that in a bit—and the risky assets aimed at consumption decades hence. This mental shortcut is commonly called the “two bucket” approach to asset allocation. You have a retirement bucket for your basic needs, along with a risk bucket earmarked for your aspirational desires—think BMW or first-class travel—and for future generations.

Investment guru and writer Charles Ellis observes that you can win the investment game in one of three ways: by being smarter, working harder or being more emotionally disciplined than the other participants.

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The first two are clearly impossible. Wall Street is packed with folks with 175 IQs working 90 hours per week. But winning the emotional game is doable. The secret is to be able to say to yourself after share prices have halved, “I don’t need to tap my stocks for decades. In fact, if I manage my portfolio well enough, in the long run that money will be going to my heirs and charities.” If you can do that, you’ll sleep soundly, your stocks will eventually recover and, when they do, you just might sell some and fatten your safe portfolio a bit. Remember, your portfolio’s prime directive is to survive, and there’s no better portfolio longevity tonic than a nice pile of “sleeping money.”

The implications of this strategy are manifold, and apply differently at different ages. The young person might say, “Wait a minute. My portfolio is tiny. My safe assets won’t even last me three months.” While that’s literally true, she still owns a large amount of bond-like assets in the form of her human capital, which dwarfs her retirement portfolio. What does it matter if her portfolio craters today? Three or four decades from now, it’ll be fine, and the money added to it at today’s low prices will likely be some of the best investments she’ll ever make.

The retiree, because she has no human capital left, is in a completely different place, and she had better have a nice pile of safe assets to see her through the hard times. How big should that pile be? Consider the graph below, which shows the 10-year after-inflation (or “real”) total return of the S&P 500 in periods when there are losses:

What this graph tells us is that, if you had owned stocks, the spending power of your stocks fell significantly over 10 years on three separate occasions—by about 25% in the 1930s, 35% in the 1970s to 1980s, and by 45% during the 2007-09 global financial crisis. Further, notice that, despite the fact that overall long-term U.S. stock returns have held up well over the past century, the inflation-adjusted drawdowns seem to be getting worse.

Why is this? At the beginning of the 20th century, each dollar invested in stocks yielded about five cents in annual dividends. Even if stock prices fell, that 5% yield nicely cushioned the loss in share prices. Over the decades, that yield has fallen to well below two cents, which is a much thinner cushion.

Almost a century ago, economist John Maynard Keynes said this about owning stocks: “It is from time to time the duty of the serious investor to accept the depreciation of his holdings with equanimity and without reproaching himself.” (Italics added.) Think you can time the market and avoid these drawdowns? Guess again. There is now almost a century of academic research demonstrating that no one has consistently done so, and the boneyard of Wall Street is littered with the remains of those who gained fame with one lucky call and then made spectacularly lousy forecasts for decades thereafter.

Now, let’s see what this all means for the young investor and for the retiree.

Theoretically, even if the young investor puts 100% of his savings into stocks, those savings are so small relative to his bond-like human capital that his overall stock allocation is still quite small. Even knowing all that, our young investor with 100% stocks in his 401(k) plan may not be able to emotionally handle half of it disappearing for some years. Our young investor, then, needs to discover his real-world risk tolerance. Start with, say, a 50% stock-50% bond retirement portfolio, and see how you respond during a bear market. Were you able to buy more and up your stock allocation to, say, 75% stocks-25% bonds? If so, then great. Wait until the next time, rinse and repeat. Did you just barely hang on? Then 50-50 is probably about right. Did you panic and sell? Then even 50-50 is too aggressive.

For older investors like me, things are a bit more complex. Let’s start with the simplest, and most felicitous, case. There are likely millions of retirees who have won the retirement trifecta with income from Social Security and an old-style corporate pension whose monthly payments meet or even exceed their living expenses and taxes. Their investment portfolio, then, really doesn’t belong to them. Rather, it’s destined for their heirs, charities and maybe even Uncle Sam. (Which applies, as well, to the essence of estate planning: You can piss the money away, your heirs can piss the money away or the government can piss the money away. Your job is to pick the pisser.) The stock allocation of these fortunate individuals really doesn’t matter at all to them and, by the time they’re retired, they should have a good idea of their risk tolerance. If they’ve hung on in the past with 100% in stocks, then God bless.

The same is also true of retirees who need, say, less than 2% of their portfolio to meet living expenses. Since the dividend flow on their stocks should provide this, and since dividends do not decline very much for very long even in severe bear markets, then even a nearly 100% stock allocation with a small sliver of cash for emergencies, if tolerated emotionally, is fine, too.

Below that level of assets, things are a little dicier. For the retiree, holding 10 years of living expenses in safe assets is barely acceptable, 15 years is better and 20 years’ worth is optimal. Once you’ve filled your retirement safe-asset bucket, you can begin filling and growing your risk-and-aspirational bucket. Never forget, if you’re going to survive retirement, your portfolio first has to survive. If you play portfolio Russian Roulette, by taking more risk than you can handle during a frightening economic and investment crunch, you’ll inevitably pay the price.

Thirty-five years after my 1987 baptism by fire, this is how I’ve come to view the great lifetime financial endeavor of amassing and then spending money. I often tell people that, when you’ve won the game, stop playing with the money you really need. Perhaps all would be fine if I kept 100% in stocks. But I’m now in my 70s and more interested in financial survival, which is why today I keep at least 20 years of living expenses in bonds and cash investments. That won’t make me rich. Instead, I’ve done something more important: minimize my odds of dying poor.

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HERE ARE THE SIX other articles published by HumbleDollar this week:

  • If big tech stocks fall from favor, active managers may suddenly look like market-beaters. Don’t count on that outperformance continuing for long, says Charley Ellis.
  • “If you choose to age in place, take a realistic look around and decide what needs to change,” advises Rick Connor. “With minor modifications, you can often remain at home for many years.”
  • Bill Ehart thought he’d squandered $4,000 on a trip to Ukraine intended to launch a new career. Seven years later, the journey is still paying dividends.
  • “I confronted my brother and was shocked by his attitude,” recounts Jiab Wasserman. “He admitted no wrongdoing. He claimed that he just meant to borrow the money temporarily.”
  • Want to avoid family fights and large, unnecessary medical bills? Howard Rohleder’s advice: Draw up a living will and health care power of attorney.
  • “The top 10 companies in the S&P 500 account for more than 30% of its overall value,” notes Adam Grossman. “That 30% level has only been eclipsed twice in the past 50 years.”

Also be sure to check out the past week’s blog posts, including Mike Zaccardi on covered calls, Sanjib Saha on returning to learning, Ron Wayne on getting organized, Mike Flack on the cost of internet service, Kyle McIntosh on fixing his finances and John Lim on the Federal Reserve.

Bill Bernstein is a recovering neurologist, author and co-founder of Efficient Frontier Advisors. He’s contributed to peer-reviewed finance journals and has written for national publications, including Money magazine and The Wall Street Journal. Bill has produced several finance books, including The Four Pillars of Investing, and also four volumes of history, the latest of which is The Delusions of Crowds. His life’s goal is to convey a suitcase full of books and a laptop to Provence for six months—and call it “work.” Bill’s previous article was When Cash Is King.

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Michael
Michael
2 days ago

“…. and more interested in financial survival, which is why today I keep at least 20 years of living expenses in bonds and cash investments.”

Wonderful to find you on this site, Dr. Bernstein. That has been my approach. I have enough in equities for growth while the fixed-income/cash cushion provides a peace of mind in retirement that is absolutely priceless.

RCP
RCP
2 days ago

I love your comment about deciding who gets to piss away your money. But you left out one other option, with a lower probability that it will be pissed away: donating to legit charity.

betsy larey
betsy larey
3 days ago

I disagree with the concept of holding 20 years in cash/cash like assets. I guess you can if you have a pension, but for those who owned a business that leaves us out. I have 3.5M in stocks and 3 years of cash. Zero bonds, no debt and two paid for houses. I take 5% a year. In good years I spend above that, in down years I don’t.
You know what they say about bonds, heads they win tails I lose. I used to hold 40% and all my good ones were called.
When the market crashed in 07 I sold them all and bought stocks. We’ve never had more than 3 down years in row so I think that concept works well. Just my 02, I have a higher risk tolerance than most.

OldShooter
OldShooter
3 days ago

Re “star money managers who flame out after a few years of shooting the lights out.” This may be perfectly rational behavior. Consider that a manager’s real goal is to maximize his fees, not to maximize the performance of his/her fund. If I run a relatively conservative fund for a long time, how does my fee income compare to running a very hot fund for a shorter period of time? The manager may know perfectly well that shining brightly typically precedes a spectacular fall, but so what? If that bright shining star attracts enough investor money, hence fees, it may finish well ahead of the slow, steady, alternative strategy. One might suspect that fund incubation has that effect — find the flashy stars and ride the arcs.

MarkT29
MarkT29
3 days ago

I remember 1987 also. I was a young engineer working at a company that had what was at that time an unusual thing in corporate America, an internal mail system. It had several classes of mail, including 3rd class which was used for bulk mailing lists you could subscribe to on topics of interest. Not as advanced as a forum or blog like this, your inbox got every posting.

When the market crashed I remember some panicked posts from people worried they had lost so much in their 401K. I had read some books on investing which stressed the market returns over time came with fluctuations, sometimes years in duration. So I replied to the thread that the crash was good news! It meant that for a while we’d be buying stocks on sale; and that if someone had planned to retire near-term they should have already dialed down their market risk. I don’t know if it helped or persuaded anyone, but I stayed 100% in stock (including thru 2000 and 2008) until a few years before retiring.

Lest I pat myself too much on the back, there are things I wish I could change. In HS I had read the entertaining book “Supermoney” by Adam Smith. One chapter was devoted to this amazing investor, Warren Buffett, who had wound down his private partnership but was running a public company called Berkshire Hathaway that was getting great returns. So I had heard about Buffett back in the day, if only I had bought a few shares…

Last edited 3 days ago by MarkT29
David Powell
David Powell
3 days ago

Thanks very much for this, Bill. I feel less regret about my own early mistakes and more confidence in the path I’ve chosen approaching retirement.

Cammer Michael
Cammer Michael
3 days ago

Firstly, I tend to agree with the two bucket approach. But there is a problem with it. Today, a portfolio of CDs and govt bonds (not bond funds) is likely to yield on average 2%. But inflation just hit 7%. So there is a significant rent or tax on safe money.
In the meantime, stocks continue to roar ahead, and this is an emotional rush.

Last edited 3 days ago by Cammer Michael
Jack Hannam
Jack Hannam
3 days ago

Thanks for an intriguing review of important concepts! In “The Ages of the Investor” you described a thought experiment to illustrate “Demographic Roulette”. Workers invested 20% of their salary on the last day of each year into the S&P 500 with dividends reinvested. The question was, for all workers who started work on January first of each year, between 1925 and 1980, how many years did it take for them to accumulate a portfolio worth 20 years of salary. While the cohort which started work in 1949 took 37 years to reach that goal, the one which started in 1980 took only 19 years. And, no other cohorts since those who started in 1980 had reached this goal as of 2012 when your book was published. You called this “demographic roulette”. I’m curious if any cohorts since 1980 have reached the goal yet.

John Yeigh
John Yeigh
3 days ago

Awesome article. For those of us with ‘seemingly’ sufficient assets for a comfortable retirement, our challenge is the tradeoff between the portfolio in 1) the third to last paragraph – 100% stocks, accept volatility, and live on the dividends versus 2) the last paragraph – 20 years of cash which implies a huge cash allocation of perhaps 50% or more. The potential for extended inflation implies that option 2 may not yet have truly “won the game.”

parkslope
parkslope
3 days ago
Reply to  John Yeigh

My interpretation of Dr. Bernstein’s second bucket is that he holds at least 20 years of expenses in safe assets that takes into account his estimate of the difference between inflation and the return on his investments in cash and bonds. Under- or over-estimates of the difference between inflation and the return on his safe investments are dealt with by rebalancing buckets one and two. As you pointed out, to have truly won the game, one’s equity bucket must be large enough to allow for rebalancing even during a period of protracted inflation.

Last edited 3 days ago by parkslope
Nick M
Nick M
3 days ago

“When you’ve won the game, stop playing” seems like it shouldn’t apply in any reasonable investing scenario. Investing isn’t gambling, or at least it need not be, and treating it like it is seems like a recipe for market timing behavior. Also, what does that phrase even mean in practice? Should I hold only low yielding bonds and suffer the ravages of high inflation, creating a constant and guaranteed permanent loss in purchasing power? This is why Rick Ferri said “there are no risk-free investments after taxes and inflation.” Investing, like life, is full of risk. Paying attention to one particular risk doesn’t make the others go away. Better to acknowledge that every decision has an associated risk. Reevaluate those risks occasionally, and make small changes over time; but to “stop playing” I would argue is impossible.

Kevin Knox
Kevin Knox
3 days ago

How delightful to see your words of wisdom (and wry, much-appreciated humor) on this site Dr. Bernstein! And this piece is an especially timely concise piece that to my eye anyway combines the best of your essential booklet “If You Can” with insights from more advanced books you’ve authored such as “Deep Risk.” Thank you for being such a beacon of insightful sanity in the fraught world of personal finance and investing for so many decades. Dr. Bernstein featured on a site founded by Jonathan Clements: it doesn’t get any better than that.

TomandDeb Leigl
TomandDeb Leigl
3 days ago

Excellent article! It’s so interesting that after decades of investing and learning what an investor should and should not do…….it still comes down to a few commonsense disciplines. I’ve learned these from Jack Bogle, the crew at Vanguard and others. My wife and I are enjoying a wonderful retirement because we took “The Road Less Traveled” and learned to do our own investing…..and continue to follow those simple commonsense disciplines!

William Perry
William Perry
3 days ago

Enjoyable and informative article. Thank you. You have added to my reading list. I am currently reading a January 2022 release ” Magic Money, An economist’s secrets to more money, less risk and a better life”. Both you and Professor Kotlikoff offer sage advice on many of the same topics following the Humble Dollar traditions.

Neil Imus
Neil Imus
3 days ago

Great article that makes a lot of sense to me as a retiree just a few years younger than you. The biggest problem I see, however, is inflation. Keeping 20 years worth of expenses in a “bonds and cash” “safe” bucket isn’t really so safe if we have high inflation during those 20 years. After a year of losing 7% of the value of cash, inflation concerns are top of mind. I think the terrifyingly bad 10-year real returns during the 1970’s and 1980’s shown on your chart above are an indication of the inflation problem.

Stu
Stu
3 days ago
Reply to  Neil Imus

I agree Neil. I think that every portfolio should have a component that would help insulate the effects of inflation. I see common stocks as one such component. Recently, the surge in market capitalization is, partly the result of the Fed pumping more money into circulation than the corresponding creation of goods/services (which is the true definition of inflation; not so much the current supply/demand imbalance) has resulted in equity and real-estate asset appreciation.

So, I believe that you can mitigate the effects of inflation by owning assets whose value will appreciate along with inflation. the easiest way to do that for most people is with equities.

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