What Has Time Taught Bill Bernstein?

In 2000, Bill 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.

Then, however, the 2000-02 tech-stock crash made Bernstein a prophet. That his book was clearly written, laced with humor, and addressed evergreen topics ensured its ongoing success. Over the past decade, it has been widely read by both do-it-yourself investors and financial professionals. (One Chartered Financial Analyst recently called it his "guidebook" for learning how to do wealth management.)

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?

The biggest difference, perhaps, is that Bernstein has become much warier of investment science. Never a true believer in black boxes, he is now an outright skeptic. Complicated risk measures are rarely as instructive as the common standard-deviation statistic, he writes, and thinking of risk in purely verbal terms as being "bad returns in bad times" might be better still.

He is even less fond of quantitative asset-allocation schemes. Memorably, Bernstein wrote that rather than place return, risk, and correlation estimates into a mean-variance optimizer, and then following the program's recommendations, readers should "stuff half [their] money in a mattress and lend the other half to [a] drug-addled nephew." (He may not have intended that literally.) This from a man who named his website efficientfrontier.com.

But that was back in the day. As with many serious self-taught investors, Bernstein has a quantitative background (Ph.D. chemistry, M.D.) and was initially attracted to investing because it had numbers. The field looked suitable for a man of his talents. As many other engineers and scientists have discovered, succeeding at investments isn't entirely the same as succeeding at science. Having a good feel for numbers is a necessary condition for investing well, but it is not sufficient.

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.

Aside from his two themes of using numbers carefully, and of mastering emotions, Bernstein adds several new topics. Among them are his definition of "real" risk (also known as "deep" risk), which concerns long-term damage to capital rather than short-term volatility measures; a lengthy discussion of the investment life cycle; strategic versus tactical asset allocation; and recommendations for when and when not to use exchange-traded funds. He also gives return forecasts for various asset classes.

Although I have spilled a couple of Rational Expectations' secrets, there's plenty of content remaining, at $19.50 for the softcover version, $9.99 for Kindle, and free for Kindle Unlimited subscribers. As with its predecessor, this book figures to have a long shelf life.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.