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Courage Required

William Bernstein

EVEN AFTER BEAR markets in 2020 and 2022, investors’ appetite for stocks remains as robust as ever. But what if stocks had not just a rough year or two, but a dismal stretch that lasted more than a decade? Below is an excerpt from the second edition of my book The Four Pillars of Investing, which was published earlier this month.

In August 1979, BusinessWeek ran a cover story with the headline “The Death of Equities,” and few had trouble believing it. The Dow Jones Industrial Average, which had toyed with the 1,000 level in January 1973, was now trading at 875 six-and-a-half years later. Worse, inflation was running at almost 9%. A dollar invested in the stock market in 1973 purchased just 71 cents of consumer goods, even allowing for reinvested dividends.

According to the article, “The masses long ago switched from stocks to investments having higher yields and more protection from inflation. Now the pension funds—the market’s last hope—have won permission to quit stocks and bonds for real estate, futures, gold, and even diamonds. The death of equities looks like an almost permanent condition—reversible someday, but not soon.”

Contrast today’s universal acceptance of stock investing with the sentiment described in the BusinessWeek article, when diamonds, gold and real estate were all the rage. The price of the yellow metal had risen from $35 an ounce in 1968 to more than $500 in 1979 and would peak at more than $800 the following year, equal to roughly $3,000 in today’s dollars. Still, there are similarities between the 1970s and today. Now the wise and lucky own houses in cities with desirable real estate. Back then, those who had purchased their houses for a song in the 1950s and 1960s were by 1980 sitting on real capital wealth beyond their wildest dreams. Stocks and bonds? “Paper assets,” sneered the conventional wisdom.

The article continued: “At least 7 million shareholders have defected from the stock market since 1970, leaving equities more than ever the province of giant institutional investors. And now the institutions have been given the go-ahead to shift more of their money from stocks—and bonds—into other investments. If the institutions, who control the bulk of the nation’s wealth, now withdraw billions from both the stock and bond markets, the implications for the U.S. economy could not be worse. Says Robert S. Salomon Jr., a general partner in Salomon Brothers: ‘We are running the risk of immobilizing a substantial portion of the world’s wealth in someone’s stamp collection.’”

In the late 1960s, more than 30% of households owned stock. But by the 1970s and early 1980s, that number was only 15%.

Next, the article attacked the very idea that stocks might themselves be a wise investment: “Further, this ‘death of equity’ can no longer be seen as something a stock market rally—however strong—will check. It has persisted for more than 10 years through market rallies, business cycles, recession, recoveries, and booms. The problem is not merely that there are 7 million fewer shareholders than there were in 1970. Younger investors, in particular, are avoiding stocks. Between 1970 and 1975, the number of investors declined in every age group but one: individuals 65 and older. While the number of investors under 65 dropped by about 25%, the number of investors over 65 jumped by more than 30%. Only the elderly who have not understood the changes in the nation’s financial markets, or who are unable to adjust to them, are sticking with stocks.”

Did the older people stick with stocks in 1979 because they were out of step, inattentive or senile? Hardly—they were the only ones who still remembered how to value stocks by traditional criteria, which told them that stocks were cheap, cheap, cheap. They were the only investors with experience enough to know that severe bear markets are usually followed by powerful bull markets. A few, like my father, even remembered the depths of 1932, when our very capitalist system seemed threatened and some stocks yielded steady 10% dividends.

The BusinessWeek article ended by adding insult to injury: “Today, the old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared. Says a young U.S. executive: ‘Have you been to an American stockholders’ meeting lately? They’re all old fogies. The stock market is just not where the action’s at.'”

The BusinessWeek article shows just how markets can go to extremes—a valuable lesson in and of itself—as well as a demonstration of several more salient points. First, it is human nature to be unduly influenced by the last 10 or even 20 years’ returns. It was just as hard to imagine that U.S. stocks were a good investment in 1979 as it is to imagine that they might not be as good now.

This is doubly true for bonds. Before the bond market carnage of 2022, investors had gotten used to the nearly relentless four-decades-long fall in rates and thought of bond prices as a one-way bet. They forgot that the four decades between 1941 and 1980 saw, in economist John Maynard Keynes’s famous phrase, “the euthanasia of the rentier.” (Rentier is an archaic term for bondholder.)

Second, when recent returns for a given asset class have been very high or very low, put your faith in the longest data series you can find—not just the most recent data. For example, if the BusinessWeek article had explored the historical record, it would have found that between 1900 and 1979, stocks had returned an inflation-adjusted 6%.

In addition, make a habit of estimating expected future returns. At the time that the article was written, stocks were yielding more than 5% and earnings were continuing to grow at an inflation-adjusted rate of 2% per year. Anyone able to add could have calculated a 7% expected real return from these two numbers. Between the article’s publication and the end of 2022, the S&P 500 actually returned 8% after inflation, the additional 1% coming from the increase of valuations typical of recoveries from bear markets.

While it’s easy to imagine buying at the bottom, when the time comes you will be faced with three formidable roadblocks. First, there’s human empathy, which, at least financially, is one expensive emotion, since channeling the fear and greed of others often comes dear. The corollary to human empathy is our evolutionarily derived tendency to imitate those around us, particularly if they all seem to be getting rich with tech stocks and cryptocurrency.

My own unscientific sampling of friends and colleagues suggests that the most empathetic tend to be the worst investors. Empathy is an extraordinarily difficult quality to self-assess, and it might be worthwhile to ask your most intimate and trusted family and friends where you fit on its scale. To use a Yiddish word, the more of a mensch you are, the more likely you are to lose your critical faculties during a bubble and to lose your discipline during a bear market.

Second, there’s the “rat hole problem.” It’s impossible to know where the “bottom” really is until it’s far in the rearview mirror. Let’s say that your bear market strategy is to purchase more stocks every time the S&P 500 falls by 20%. The S&P closed at 1,565 on Oct. 9, 2007, so you would have purchased stocks at 1,253, again at 1,002, and a third time at 802 (1,002 × 0.8).

Would you really have had the moxie to make that last purchase, having suffered severe losses on your first two? The S&P fell even further after that last purchase, finally bottoming on March 9, 2009, at 677.

Performing the same exercise with the Dow Jones Industrial Average from the market peak in September 1929 at 378 yielded no fewer than nine successive purchases, just barely missing a tenth one on the July 9, 1932, low of 42.

In 1931, Benjamin Roth, a small town attorney, recorded in his diary that while it was easy to see that stocks were cheap, “The difficulty is that no one has the cash to buy.” Or as Benjamin Graham said, “Those with the enterprise haven’t the money, and those with the money haven’t the enterprise, to buy stocks when they are cheap.”

Third, stocks don’t get cheap in a vacuum. Alarming narratives always accompany dramatic price declines. In both the 1930s and in 2008–09, the entire economy seized up and appeared to be plunging off a cliff. After Senator Richard Burr was briefed by Treasury Secretary Hank Paulson and Federal Reserve Chair Ben Bernanke about the parlous state of the banking system, he told his wife to withdraw as much cash as possible from their bank.

During the 1970s, Americans saw their savings corroded on almost a daily basis by inflation. The 1979 BusinessWeek article described how only seemingly addled old folks owned stocks, and bonds were widely deemed to be “certificates of confiscation.” In March 2020, it was easy to imagine a world economy devastated by a lethal pandemic for which a vaccine seemed somewhere between distant and impossible.

Do not underestimate the courage it takes to hold stocks during the worst of times, let alone to purchase more. Holding and buying assets that everyone else is running from takes more fortitude than many investors can manage.

It helps to realize that not only are humans the apes that imitate, but we are also the apes that tell stories. Humans understand the world, first and foremost, through narratives, not data and facts. Narratives often evolve into a societal contagion that can prove expensive to the unwary investor.

As the BusinessWeek article and subsequent history demonstrated, cheap stocks excite only the dispassionate, the analytical and the long-lived. If you can manage two of those three, you should be well rewarded. Keep these three points in mind:

  • The modern capitalist system, which relies on elastic credit from both private and government banks, is fundamentally unstable. Because of this, the typical investor will live through at least a few bubbles and a few panics.
  • Markets don’t become too expensive or too cheap without good reason. Just as market manias are based on euphoric narratives, pessimistic stories suffuse market bottoms. Ignore both kinds of narratives.
  • Adhere to the math of investing, and manage your emotions with a goodly pile of safe assets. To make it through the market bottoms—the main hazards on the “highway of riches,” the road that conveys wealth from your present self to your future self—you’ll need patience, cash and courage, and in that order. Safe assets can be thought of as a concentrate of courage. Despite their low yield, in the long run the fortitude they supply make them arguably the highest-returning assets in your portfolio.

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 and also four volumes of history, the latest of which is The Delusions of Crowds. The new edition of The Four Pillars of Investing includes a foreword by Jonathan Clements, HumbleDollar’s editor. Bill’s life’s goal is to convey a suitcase full of books and a laptop to Provence for six months—and call it “work.” His previous article for HumbleDollar was When Cash Is King.

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