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Bonds, Be Gone

Bill Bernstein's advice for investment adults.

John Rekenthaler, 09/26/2013

Taking the Long View
Bill Bernstein has released his third "paperback" in his Investing for Adults series. As with the first two installments of the series, this one is terrific. (At $5 for the Kindle version and $10 for print, the price is also very much right.)

The book's title is Deep Risk: How History Informs Portfolio Design. That boggled my mind, too, but the concept is straightforward. Bernstein dispenses with volatility-based asset allocation, advocating instead a different, longer-term approach to building portfolios. Investment adults, he argues, are those who outgrow the stage of fussing over market movements. For assets that they intend to own for several decades, adults pay little attention to the "shallow risk" of investment volatility. They focus instead on avoiding the "deep risk" of permanent damages.

(That's an ironic argument for a man who runs Efficient Frontier Advisors, and whose website looks like this--


--On the other hand, it's consistent with the notion of growing into investment adulthood, as Bernstein snapped up the naming rights for Efficient Frontier many years back, in his early years as an investment thinker.)

There aren't many investment adults. The industry's science, after all, was built to address shallow risk. Research papers are written, and Nobel Prizes awarded, for demonstrating how to achieve the greatest amount of return for the least amount of standard deviation. Banks measure their portfolios via the shallow-risk calculation of Value at Risk. Financial advisors use tools (including those from Morningstar) that attempt to minimize monthly volatility and maximize returns. It's a shallow-risk world.

Also, adulthood isn't easy. Instinct and the media urge action, not staying the course. Plus, not everybody can afford to be patient. It's all very well to adopt a measured, long-term attitude, but philosophy is scant consolation if circumstances force the investor to sell into a weak market. Warren Buffett can (and does) shrug off shallow risk; the principals at Long-Term Capital Management could not.

For those who do become investment adults, the key lesson is more stocks, less bonds. Per Bernstein's analysis, there are four deep risks that may strike: 1) hyperinflation, 2) severe deflation, 3) government confiscation, and 4) devastation/war. In recent history, the first, that of hyperinflation, has been easily the most common of the dangers, and in such cases bonds (aside from the new, inflation-protected variety) have been a complete disaster. 

Even moderate rather than hyperinflation can cause big problems for bonds. For U.S. investors in the mid 20th century, Treasury bonds were truly terrible. From January 1941 through September 1981, per Bernstein's figures, U.S. Treasuries shed 67.3% of their real value. That is, an investor who stashed $10,000 in early 1941 into U.S. Treasury bonds, with instructions that all coupons be reinvested in additional bonds, found upon her return 40 years later that she owned $3,270 in inflation-adjusted terms.

is vice president of research for Morningstar.

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