Bill Bernstein: Revisiting ‘The Four Pillars of Investing’

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On today’s episode of The Long View podcast, we welcome back William Bernstein. This is Bill’s third appearance on the podcast. In fact, he was our very first guest back when we started The Long View in 2019. Bill is a neurologist turned investment advisor. He is also the author of several books, including The Intelligent Asset Allocator, The Four Pillars of Investing, If You Can: How Millennials Can Get Rich Slowly, and The Delusion of Crowds. Bill has just come out with a new edition of The Four Pillars of Investing. So, we wanted to have him on to discuss the new book and what’s changed since that book’s original publication more than 20 years ago.

Background

Bio

The Four Pillars of Investing, Second Edition

The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk

If You Can: How Millennials Can Get Rich Slowly

The Delusion of Crowds: Why People Go Mad in Groups

“Bernstein: ‘I Don’t Think the System Needs Nudges. I Think the System Needs Dynamite,’” The Long View podcast, Morningstar.com, May 7, 2019.

“Bill Bernstein: We’re Starting to See all of the Signs of a Bubble,” The Long View podcast, Morningstar.com, March 10, 2021.

The Four Pillars of Investing

Robert Kaplan

Who Is Charlie Munger?

Antti Ilmanen

Expected Returns: An Investor’s Guide to Harvesting Market Rewards, by Antti Ilmanen

“Bernstein’s ‘4 Pillars of Investing’ & How They Work To Boost Returns,” by Anupam Nagar, economictimes.indiatimes.com, July 31, 2021.

“Are You Leaving Money on the Table From Your Funds’ Returns?” by Amy Arnott, Morningstar.com, July 12, 2022.

“William Bernstein on Deep Risk, Shallow Risk, and Investing for the Long-Term,” by Larry Frank, Sr., betterfinancialeducation.com, Aug. 24, 2022.

Where Are the Customers’ Yachts? Or a Good Hard Look at Wall Street, by Fred Schwed

Retirement

“Playing Inflation Russian Roulette in Retirement,” by William Bernstein, advisorperspectives.com, Nov. 29, 2022.

“Riskless at Age 104,” by William Bernstein, advisorperspectives.com, March 20, 2023.

“William Bernstein on Holding Both Treasury Bonds and TIPS (or Savings I Bonds),” by Jonathan Ping, mymoneyblog.com, April 16, 2023.

(Please stay tuned for important disclosure information at the conclusion of this episode.)

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.

Ptak: On today’s episode of The Long View podcast, we welcome back William Bernstein. This is Bill’s third appearance on the podcast. In fact, he was our very first guest back when we started The Long View in 2019. Bill is a neurologist turned investment advisor. He is also the author of several books, including The Intelligent Asset Allocator, The Four Pillars of Investing, If You Can: How Millennials Can Get Rich Slowly, and The Delusion of Crowds. Bill has just come out with a new edition of The Four Pillars of Investing. So, we wanted to have him on to discuss the new book and what’s changed since that book’s original publication more than 20 years ago.

Bill, welcome back to The Long View.

William Bernstein: My pleasure.

Ptak: Well, thanks again for doing this. We’re really excited to chat with you. We figured a logical place to start was the book, The Four Pillars of Investing. You’re putting out an updated edition of the book that I think everybody will be really excited to read. Can you talk about what your key motivations were in updating the book?

Bernstein: Well, it’s been two decades since the book was written, and a few things have happened in the markets in the past couple of decades. And I’ve learned a few things. We all know what’s happened in the markets in the past couple of decades. There’s been a lot of volatility, some real financial panics—at least two big ones, maybe even three. But also, I’ve learned a few things. And one of the things I learned, I got from a man by the name of Robert Kaplan, who is a geopolitics author. He is a specialist in Middle East politics. And he said something in an interview, which really resonated with me, which is that half of everything is geography, and the other half is Shakespeare. And that resonated with me, because I realized that it applies to investing pretty much as well—that half of investing is mathematics, and the other half is Shakespeare. And what I mean by the Shakespeare of investing is the fact that history, particularly economic and financial history, but geopolitics as well, is a very cruel mistress. And the other part of Shakespeare is the biggest enemy you have in investing, which is the face that’s staring back at you in the mirror. And if you’re the kind of person who can solve differential equations or do continuous time calculus as easily as most people brush their teeth, and you ignore the Shakespeare half of investing, you’re going to get portfolio insurance, you’re going to get long-term capital management. You’re going to have your head handed to you. So, that’s the first thing that I wanted to get across in the book.

The second thing that I wanted to get across in the book, which is a product of the volatility of the last couple of decades, is that, yes, compounding is magic, but you have to observe Charlie Munger’s prime directive of compounding, which is never to interrupt it. So, you have to design your portfolio not with the normal 98% of the world and 90% of the time in mind. You have to design your portfolio with the worst 2% of the time in mind so that you don’t interrupt compounding, which basically translated into plain English means that you probably should have more safe assets than you think you should have. In other words, a suboptimal portfolio that you can execute is better than a stock-heavy optimal one that you cannot execute.

Benz: Would you say that this new edition of Four Pillars has a greater recognition of the importance of emotion and circumventing short-wiring your own emotional tendencies?

Bernstein: Yeah, the older I get, the less I depend on the mathematics of investing and the more attention I pay to the psychological and the emotional aspects of investing. There are a lot of people out there who can talk the talk inside of a spreadsheet, but when it comes time to walk the walk, when it looks like the world economy is going to shut down or the banks are going to go kerplunk, they don’t do so well. That’s the message I’m trying to get across in the book, is you have to design your portfolio with those times in mind.

Ptak: I think we’re going to dig into that a little bit more as we continue with the conversation. I think correlation and the idea of ill-timed risk is very much germane to what you just mentioned, sections of the book upon rereading you thought, “I got it right the first time around,” and you’ve left it pretty well intact in this latest edition?

Bernstein: Any answer that I give you to that is going to sound pretty self-serving, but I’ll do my best. The focus of all of my finance books has, of course, been on a passive approach, which has certainly worn well over the past couple of decades, as your rankings have demonstrated year after year after year. The second thing that I think I got right was the emphasis on discipline and just how important it is to stay the course on the fact that the times when you’re going to have the highest returns are going to be the times when you feel the worst. And that has worn better than I ever imagined it would have two decades ago. I really didn’t imagine the kind of volatility we saw over the past 20 years.

Benz: You told us before this conversation that there’s one question about the book that you’re dying to answer, and that’s, is there anything important that you forgot to put into the book?

Bernstein: Well, it’s not so much that I forgot to put it into the book, but it’s just that, FTX and Sam Bankman-Fried blew up well after I had the rough draft submitted. And had I known about FTX, it would have really reinforced a point that I made over and over again, not only in this book with respect to star money managers, but also with respect to charismatic businessmen in my previous book, The Delusion of Crowds—which wasn’t largely a financial book—and that is that anytime someone is so charismatic that they get wall-to-wall media coverage, be on your guard. That’s not to say that Warren Buffett and Elon Musk are going to blow up. But more often than not, when you see wall-to-wall coverage of a money manager or of a corporate CEO, you have at least a 50% probability of encountering a major fraud on their road. And that was what I wanted to. And when I saw Sam Bankman-Fried getting interviewed and I saw his face every day on my news feed, I knew something was going to happen. And I wished I’d given that warning in the book, not necessarily about him, but just the general warning. And it’s true. If you think about the coverage that Cathie Wood has gotten, that Elizabeth Holmes has gotten, that Sam Bankman-Fried got, those were all warning signs.

Ptak: I wanted to shift and ask you about risk and return. You devote a large section of the book to the relationship between risk and return, which is not as straightforward as it might seem. One example you mentioned in the book is that of corporate bonds, which have earned about 0.8% more per year than comparable maturity Treasuries, give or take. But in your opinion, still might not be worth that premium. Can you talk about why that is?

Bernstein: I owe this insight to Antti Ilmanen at AQR. In one of his books, Expected Returns, the book before Expected Returns in a Low Expected Return World, he makes the point that it’s not just that you have the risk of bad returns, it’s bad returns in bad times. And that’s the problem with corporate bonds, is when corporate bonds do poorly, they do poorly at the worst possible time. So, for example, if you run the usual sorts of regression analyses and you look at the long-term behavior of corporate bonds, they look like a mix of 10% stocks and 90% Treasuries. The trouble is that when the excrement hits the ventilating system, that mix goes up. And in a bad state of the world, corporates look like 30% stocks and 70% Treasuries. And that’s not good. In other words, the things that you thought were money, like the short-term debentures of a Procter & Gamble or an Intel, turn out not to be money after all because of liquidity concerns. And if you want to use those assets to buy stocks when they’re cheap or just to pay for your groceries or your rent, you are going to be taking a haircut. So, that 0.8% or 0.6% returns premium you get over Treasuries from high-grade corporate bonds just isn’t worth it.

Benz: You also discuss less-correlated assets in the book, and you make the point that less-correlated assets, like catastrophe bonds and precious metals, will pay out less in returns and investors should know that going in. Can you elaborate on that to explain why?

Bernstein: It just falls directly out of basic finance theory and the connection between risk and return. The lower a correlation an asset has with stocks overall, the more it becomes an insurance product. And you have to pay for insurance, and you pay for that insurance with lower returns. The classic example of this is gold, or for that matter, precious metals equity, the common stocks of mining companies. If you look at their long-term returns, they are low. They’re very close to zero in real terms. And that makes perfect sense if you think about it, because those asset classes are valued because they provide you with insurance in the worst states of the world, not necessarily with inflation, because it turns out that gold and precious metals equity doesn’t always do well when there is high inflation. But when there is a banking crisis and people lose faith in the monetary system, that’s when gold and precious metals equity really shine. And you pay for that insurance. If someone is going to insure you against stock market losses, don’t expect to get it for free.

The extreme example of that are volatility-related products or buying puts. You can protect yourself against falling stock prices by buying puts, but those are very expensive. And as a general rule, you’re better off just selling some stocks and owning Treasuries rather than paying for puts, because you’ll bleed to death over a long enough period of time if you buy puts.

Ptak: I think one quality you point to that less-correlated assets possess, they boast the fact that when they experience losses, they’re less likely to be ill-timed, but they’re also less predictable. Investors don’t seem to handle unpredictability very well. They lose patience or they panic, and their dollar-weighted return suffers as a result. Given that, couldn’t it be argued that it’s better for them to stick with assets they can at least handle even if they’re more correlated rather than play around in things like managed futures that are beyond their comprehension they might make mistakes with?

Bernstein: Well, your colleague, Russ Kinnel, has done a marvelous job of demonstrating that with the magnitude of the dollar-time-weighted gap. In other words, how far short do mutual fund investors fall from the actual return of the fund? So, just ordinary total stock market funds do pretty well. They have a pretty small gap on the order of about 0.5% or 1%. When you look at sexy growth stocks, that gap rises, and when you look at tech stocks, the gap is probably double digits. At the other end of that spectrum are target-date funds, and I’ve seen some data that suggests that the dollar-time-weighted gap for target-date funds is actually negative. That is that the investors in these funds actually get a slightly higher return than the return of the fund itself, and that’s simply because these funds are so dull.

Benz: We want to talk about return forecasts, which you delve into in the book. At the end of last year, you estimated that the 60/40 portfolio stood to earn 2.8% per year after inflation. Your previous three forecasts, which published in the first three editions of Four Pillars, were a little bit conservative. What do you think makes this time different?

Bernstein: The reason why I was wrong in the sense that I underestimated returns was simply because that was a period of falling interest rates. If anything’s happened over the past two decades that’s of note in the financial world, falling interest rates from a reasonable natural real rate of say two plus 2% down into strongly negative territory until about a year and a half ago. And when that happens, bond prices are going to rise and stock prices are going to rise. So, any estimate that you made going forward is going to be a little low. I just don’t see that continuing from this point forward. And, of course, we saw that happen in 2022. We did see that forecast realized returns in 2022 were a good deal lower than you would have forecast because you got an upward movement in interest rates that no one expected.

Ptak: You estimated in the book that stocks would earn a 3.6% real return per year over the next three decades. This would have been as of the end of last year. I want to say that maybe the 30-year real Treasury yield was around 1.7%, maybe just shy of that. So, that’s how you get the 3.6%. If that 3.6% real return came to pass, it would be the worst 30-year showing over the past century, I believe, is a figure that you cite in the book. What gives you reason for pessimism that real returns are going to be so poor?

Bernstein: I get that 3.6% return simply by adding together the dividend yield of stocks and the real long-term growth of dividends, which if you add those two numbers together, it’s not 1.7% and pretty close to 2%. So, you get about 3.6%. Yes, that’s going to be lower than it’s ever been. But you used an important word in that question, which is the word century. At the beginning of the 20th century, stocks yielded 5%. Well, when the dividend yield of stocks falls from 5% to 1.7%, you’re going to get a nice juicy jump in your realized return. That’s not going to happen again. That is very unlikely to repeat itself. In order to see that same 1% jump, you’re going to have to see the dividend yield of the stock market fall from, let’s say, its current 1.7% down to about 0.6%. Could happen, but I sure wouldn’t bet the farm on it.

Benz: Switching over to factors, which you also discuss in the book, you conclude that the reason that value stocks have done poorly is because investors have been especially willing to pay up for growth. And as evidence, you cite the spread between value and growth valuation measures, which has gotten abnormally wide, has stayed quite wide. Why wasn’t this predictable in advance—that investors would continue to want to pay up for growth stocks?

Bernstein: Because most things in finance aren’t predictable. And the return on the value premium is as unpredictable as almost anything else. I like to look at the value spread, but even that isn’t terribly predictable, perhaps at extremes, as we saw in 2000 and as we saw at the end of 2001. But even those extremes are obvious only in retrospect. Of course, what happened was that in 2022, that dynamic completely reversed. We saw a very impressive value premium in that year.

Ptak: You also reject the idea that over-popularity of the value factor is responsible for its slump, this notion that people are loving value to death. You reasoned that if that was the case, the spread between value and growth would be narrow, not wide. But what if competitive advantages lasting longer than they used to and outrageously profitable business models being more than the norm than before? Couldn’t that possibly explain why we have seen the spread between value and growth widen to the extent that it has?

Bernstein: Well, you’ve just done a great job of making the opposing case and that I could well be wrong about the value spread predicting a positive value premium going forward. That’s the reason why you don’t put all your chips on the same number. I think that in finance, even the best bets you make are at best 60/40, most of the time they’re closer to 51/49. So, you just have to resign yourself to the fact that you’re going to be wrong a large part of the time in exchange for being right most of the time. And even then, the margin isn’t going to be that much.

Benz: Bill, we’ve continued to see international stocks underperform U.S. And a question that’s crossed my mind, and I wonder if you’ve looked at this, do you think that the non-U.S. markets are increasingly a bet on the value factor? And is that one of the key reasons why we’ve seen the underperformance there?

Bernstein: There’s no question that that’s true. The U.S. stock market is now dominated by IT stocks. And that certainly isn’t true in Europe. One of the most tragic episodes, of course, was what happened with Wirecard. The Germans, and particularly the German regulatory apparatus and the German government, want desperately to have a national IT champion. And they so desperately wanted that that they ignored the blatant fraud and gangsterism of the Wirecard company. So, that’s certainly true. On the other hand, if you believe that value stocks, in the very long run, have higher returns, then you can console yourself with the possibility that the U.S. tech market is now grossly overpriced in terms of its earnings. And we’re seeing that, for example, in artificial intelligence stocks, stocks that have a connection with ChatGPT. And I think that we’re seeing a bubble in that particular sector of the market.

Ptak: I wanted to ask you about small-cap stocks, which have also done poorly compared with the stocks of larger companies, at least that’s true in the U.S. They’ve actually underperformed large company stocks and have been quite a bit more volatile. I think I went back maybe, I don’t know, 20 or so years in coming up with that. Has the spread, in your opinion, of the valuation of small-cap stocks and large-cap stocks also widened? Or is there reason to question the robustness of the size factor altogether?

Bernstein: I’ll say two things about that. Number one is your first statement is definitely true, that that valuation gap has widened. You don’t even have to look at a valuation gap. All you have to look is at the P/E of small-value stocks, both in the U.S. and abroad. And in the U.S., it’s just in the high-single-digit. It’s solidly within the single digits, in the range of 7 to 8 in emerging markets and in developed-markets stocks as well. The other thing that I want to point out, though, is that while value and small have been disappointing in the past couple of decades in the U.S., they’ve definitely done well. There’s been a premium abroad in that. So, there’s been about a 2% premium for small-value stocks and small stocks, both in developed markets, foreign markets, and emerging markets. And the reason for that, I think, simply is simple statistics. When you’re looking at a broad index of small-value stocks in the emerging markets or in the developed markets, you’re dealing with a lot of national markets all averaged together. So, you’re more likely to see the premium than you are in the U.S. where you’re just dealing with one national market. So, that premium in the U.S. is going to be noisier, and it’s not surprising that occasionally you’re going to see negative returns, but you didn’t see that abroad.

Benz: The book delves into the topics of shallow risk and deep risk. For those listeners who might be unfamiliar with those concepts, can you briefly describe what each represents and also how one would try to mitigate those risks?

Bernstein: Shallow risk is what we saw in 2008-09. It’s what we saw in 2020, where you see sharp market breaks that don’t produce any long-term damage. A deep risk, as you might imagine from the name, is something that produces a large fall in value, a large fall in real value that lasts for a generation or more. And the two biggest examples you can think of that’s happened with has been Japan since 1990. But what people forget is we also saw that in the U.S. with long bonds between 1940 and 1980, when the dollar invested in long-term government bonds, even with reinvested dividends in 1940, fell to one third of its real value by 1980. That’s deep risk. So, how do you mitigate that?

You have to look at financial history and ask yourself, what are the real sources of deep risk? And there are a number of clauses, and I list several of them in a couple of my books, including this book. But the biggest one by far statistically, or the most frequent one, is going to be inflation. Inflation is basically a phenomenon in almost all countries. The only country that I can think of that hasn’t experienced a large amount of inflation in the past 100 years has been Switzerland.

So, how do you protect yourself against inflation? Well, for starters, you keep your bond duration short so that when rates rise, you can roll them over at the higher rate. And stocks, although stocks don’t do well initially with inflation, what you see is that over the very, very, long term, they do. So, if you look at countries, particularly in Latin America or in Europe post-World War II that had high inflation, stocks did pretty well in the long term. The most spectacular example of that was the Weimar inflation, the wheelbarrow inflation from 1920 to 1923, that four-year period when prices rose by a factor of 1 trillion. That’s trillion with a T. Well, it turns out that German stocks did just fine during that period. It was a wild ride. But for those four years, they actually had a positive inflation-adjusted return.

I’ll say something else about stocks as a hedge against inflation, which is that value stocks are a particularly good hedge against inflation. Because if you think about it, inflation melts away the real value of a company’s debt, and that flows directly to its real bottom line. Then, finally, I like the stocks of commodities-producing firms. I don’t like commodities-futures firms for a number of reasons that are pretty arcane. And they’ve not really done very well over the past couple of decades because of that. But the stocks of commodity-producing firms, although they correlate more highly with the stock market than commodities futures do in the long run, I think they’re a better hedge against inflation.

Ptak: Are there gradations of deep risks that inflation poses? For instance, was it a deeper risk in the 1970s after inflation had raged? Or was it a deeper risk just prior to the recent inflation bout we’ve experienced?

Bernstein: Well, it’s a matter of magnitude and duration. What happened in 2022 was almost sui generis. You’d have to look hard and fast to find anything that was quite as bad as the carnage in a single year. I think that if you had a long U.S. Treasury bond fund, you lost about 30% or 35% of your real return. And that’s pretty spectacular. That is not likely to go on very much longer because of the actions of the Fed. What happened from 1940 to 1980 was much slower, but in the aggregate, it was much worse than what we saw in 2022 simply because you had inflation and rising interest rates occurring over a period of four decades.

Benz: Following up on that, some are predicting a new era of higher interest rates and inflation. Does this mean that the Fed will be far less dovish? And if so, what do you think the implications will be for the correlation between stocks and bonds, which until pretty recently had been reliably negative?

Bernstein: The reason why the correlation was positive was simply because bond prices drive stock prices. And so, when people are not afraid of inflation, whenever the interest rates fall, that will drive up stock prices. But whenever stock prices fall, people see bonds as a safe haven. So, basically, what you had was not only bond prices driving stock prices, but on the way down, the opposite was occurring, which was that stock prices drove bond prices, and so you got a positive return from bonds when stocks did the worse, so you got a negative correlation.

What happens when the primary driver of falling stock prices is rising bond rates, then you got a positive correlation. So, if you look at the period, say, between 1970 and 1990, when inflation was a concern, you saw a positive correlation between stocks and bonds. And then, between 1990 and about 2020 or so, you saw a negative correlation because of the flight-to-safety phenomenon. Going forward, the Fed is probably not going to be terribly accommodative, so one would predict that the positive correlation between stocks and bonds that we saw in 2022, and we saw during the ‘60s, and ‘70s, and ‘80s is going to persist. So, really, I think it all hinges on how accommodative the Fed is. You see a positive correlation when the Fed is not accommodative, when they’ve taken away the punch bowl, and you see a negative correlation when the stock is permissive, and I don’t think we’re going to see a permissive Fed for a while.

Ptak: If bonds are moving in closer lockstep with stocks, do you think the answer is to chuck them in favor of less-correlated assets, or is it to shorten up your durations quite a bit favoring things like cash? How should one respond to that sort of scenario?

Bernstein: I would go with your last strategy, which is to chuck duration. I’ve always been a fan of short bonds. That hasn’t been a winning strategy until about 2022, but I would rather forgo the opportunity of benefiting from the flight to safety that you see with long bonds. Long bonds particularly benefit from that. I would rather forgo that benefit if it means avoiding a catastrophe like 2020, 2022, when stocks and bonds fell by a large amount in tandem.

Benz: You write in the book that there is no asset-allocation fairy. Can you explain what you mean by that?

Bernstein: What happened back in the 1970s and ‘80s and ‘90s is people fell in love with mean-variance optimization, the Markowitz algorithm. It looked like all you had to do was collect asset-class returns and standard deviations and the correlation grid, which is the inputs to the Markowitz algorithm. And you could predict the future-efficient frontier, that is the allocation that gave you the most amount of return for a given degree of risk or for a given degree of return that stopped you with the lowest degree of volatility. And it turns out that the inputs to that produce enormous changes in the outputs and that the algorithm, if you’re going to use historical returns, then favors the asset classes with the highest returns. What happens is, because of mean reversion, that gets thrown into reverse going forward. Because of mean reversion, the best-performing asset classes have a slight tendency to be the worst ones going forward. And so, if you apply the algorithm, the Markowitz algorithm, if you try and use a black box to determine your asset allocation, you are probably going to plant your face. So, people have gotten away from that. So, there’s no asset-allocation fairy. And what I mean by that is that there’s no one black box or technique that is going to give you the best forward optimal asset allocation. The best thing you can do is to pick an allocation that’s reasonable and then stick with it. That’s better than using a black box.

Ptak: While theory would hold that young investors should be fully invested in stocks—in fact, I think some theorists have said that they should leverage up and own as much in stocks as they possibly can through things like LEAPS—you think it can make sense for them to gradually build up to full investment. Can you explain your reasoning?

Bernstein: There is a wonderful quote from Fred Schwed’s marvelous book, Where Are the Customers’ Yachts? And I’ll read it. Christine, I’m sure you’ve heard this one at least a half-dozen times from me; and Jeff, maybe even you once or twice. And here’s the quote, “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. If you’re a young investor, you’re an investment virgin, you’ve never lost a real chunk of money, and you have no idea how you’re actually going to respond to stocks falling by 30% or 50%.” And what tends to happen to at least a lot of people is that they read about stocks having long-term returns, they go 100% equity in their 401(k), and then they get slammed with a 2008-09, and they swear off stocks for the rest of their life. It is far better to start with conservative allocation and see how you respond to it. And if you respond badly to it, then maybe you shouldn’t even have a 50/50 stock allocation. On the other hand, if you’re blasé about it, if you buy more, then God bless, maybe you can go to 75/25. And if the next time it happens, you respond just as well, maybe you can go close to 100% stocks for your contributions. But you have to first find out who you are before you become an aggressive stock investor.

Benz: I want to switch over to discuss people who are later in their lives who are thinking about retirement or maybe already in retirement and talk about the questions they should ask themselves to arrive at an appropriate asset allocation. These are presumably more seasoned investors who know themselves a little better, but assuming they want to try to construct a sensible in-retirement portfolio, what’s the starting point? What are the questions they should ask themselves?

Bernstein: Basically, the person who is approaching retirement has to ask themselves four questions. Number one, what is their burn rate? Is it 1% or 2% or is it 5% or 6%? And the higher your burn rate, the more conservative you should be and the more you should favor annuitizing products, and we’ll probably get to that in a minute. The second thing, of course, is how old are you? Someone who is a FIRE person—financial independence, retire early—and wants to retire at age 40, better have a fairly aggressive allocation with a very low burn rate. The third thing, of course, is their risk tolerance. And then, the fourth thing, which relates to the risk tolerance, is how they balance off safety versus a bequest. For example, do you want to endow a wing at the hospital? Well, then you should invest very aggressively, and you better have a fairly low burn rate. On the other hand, if you’re primarily concerned about your safety, then you want to have a more conservative asset allocation. So, there’s a whole lot of things that are there in the mix and there’s really no one size fits all. You have to answer those four questions and then figure out where you are on that spectrum.

Ptak: Many academic researchers are big on annuities as a component of the retirement plan, particularly very basic fixed annuities, which provide a lifetime stream of income. You’re not a fan. Why is that?

Bernstein: Well, for at least two reasons. Number one is because you are taking a massive inflation risk with a fixed annuity, which has a nominal payout. The reason why you buy an annuity is for longevity insurance, but guess what? If 30 years of inflation turns the U.S. dollar into funny money, even that longevity protection goes away. So, that’s number one. You’re taking a massive amount of inflation risk, particularly a large amount of inflation risk with a deferred annuity because there you’re not getting paid for many, many years. The payout may look nice and fat and spectacular 20 years before it pays off, but when the payout finally comes, you may be sorely disappointed by its purchasing power. So, that’s number one.

Number two is the credit risk that you’re taking. These are all commercial products and people are very fond of pointing out, yes, these products have state guarantees, but of course, they’re funded by the insurance industry. There is nothing magic about a state guarantee. Most states have fairly low caps on the amount that is protected. And then, finally, even those guarantees can fail. And if you don’t think that that can happen, you should go Google “Executive Life Insurance.” And that failed very spectacularly. And the reason why it failed was because the state insurance commissioner decided to shaft the beneficiaries and then very shortly thereafter wound up at a private equity firm, and the kind of private equity firm that was involved in Executive Life’s flameout.

Benz: You favor a laddered portfolio of TIPS bonds—Treasury Inflation-Protected Securities—instead for that sort of guaranteed income that is in fact inflation protected. So, how should a retiree decide how much to put into such bonds?

Bernstein: As I explained before, it really depends upon what their burn rate is. If their burn rate is fairly low, they don’t need TIPS. Now my burn rate is low, but I still own them simply because I really like sleeping at night. On the other hand, if your burn rate is in excess of 4%, then I think that a ladder of TIPS, or at least a TIPS fund with a maturity that somewhat matches your financial horizon, your survival horizon, is also not a bad idea as well. So, really it depends upon what your burn rate is. A low burn rate, you don’t need TIPS; the higher your burn rate, the better an idea they become.

Ptak: Does the timing matter when someone builds a laddered TIPS portfolio? For example, TIPS had negative real yields just a few years ago, which seems pretty important to somebody that’s building a TIPS ladder. What do you think?

Bernstein: Yeah, it matters a lot. Just because you believe in market efficiency and the fact that you can’t predict interest rates doesn’t absolve you from the duty to estimate its expected return. So, about 18 months ago, the five-year TIPS was yielding almost minus 2%. It was minus 1.90%. It’s not a good idea to buy TIPS when yields are that low. You’re guaranteed to lose 2% of your spending power every single year. Is that market-timing? I guess I plead guilty to that. The nice thing about real rates and TIPS rates is that occasionally the Fed does have to do its job and take away the punch bowl. And when that happens, that’s a good time to buy TIPS. So, there’s still an attractive purchase right at this very moment. I think that the average yield through the yield curve on TIPS is about 1.6%. You could do a lot worse than that. This isn’t a bad time to buy them.

Benz: We’ve discussed the fact that yields are up broadly speaking, and it seems to me that there could be more people coming into retirement thinking, “I’m just going to build a portfolio that delivers whatever yield I’m looking for, maybe favoring dividend-paying stocks and higher-yielding bonds,” whatever. Is that a good way to go about it?

Bernstein: Probably not. If you think in terms of, you’re to be living off the dividend or the interest return on your stocks and bonds, you’re going to find that you’re getting squeezed from one direction or the other. If you use the dividends from your stocks, those will hold up with inflation, and they’re relatively stable. The only trouble is you’re going to get a low dividend yield. On the other hand, if you want to buy high-yield bonds, sure, you can get 7% or 8% on those, but the inflation-adjusted value of those is going to fall every single year. And about once every 10 years, you’re going to take a real haircut on their capital value during a financial panic when they start to default. So, there’s no free lunch here. And the same thing is true, by the way, of dividend-paying stocks. When stock yields a high dividend, you’re getting high current income, but you’re also giving up a lot of growth.

Ptak: Why do you think sequencing risk is such a big deal for retirees that is encountering bad returns early in retirement? Should new retirees be particularly alert to sequencing risk today, in your opinion?

Bernstein: Yeah, it’s simple mathematics. If you have a high burn rate, say, in excess of 5%, and you have bad returns for a period of 10 years, then at the end of those 10 years, your portfolio is going to be very seriously attenuated. And by the time stock prices turn around, it may be too late, because you’ve got so little assets that will benefit from those high returns. So, the retiree, of course, wants high returns first and low returns later, which is the reverse of the sequence that a young saver wants. A young saver wants lousy returns up front so they can acquire stocks at a low price. And of course, there is this concept of the reverse glide slope of Michael Kitces and Wade Pfau, which I’m a fan of, and which makes perfect intuitive sense. If you’re 65 years old, you’re going to have to pay for 30 or 35 years, maybe, of living expenses between you and your spouse, or if you’re 60 years old, certainly you will. But on the other hand, if you’re 80 years old, the odds are you only have to pay for 10 years of expenses. So, you only need 10 years of safe assets. The older you get, as you spend down your safe assets, your stocks are going to grow in value. So, just organically, your stock allocation is going to rise, and that’s perfectly fine, because the older you are, the less bonds you need.

Benz: There’s the reverse glide path idea to address sequence risk. Do you think that people should also think about maybe taking a smaller withdrawal rate during a period in which their portfolio has declined? That seems like common sense, too.

Bernstein: Yeah, it is common sense, and of course, there’s a price you pay for that, which is a fall in consumption. But if you can live with lowering your spending when stock returns are bad, then you’re certainly going to be extending the survival of your portfolio in retirement.

Ptak: How does human nature and risk tolerance fit in here? If someone gets notably skittish in periods of market duress, how should that affect the portfolio?

Bernstein: Well, the more skittish you are, the lower your stock allocation should be. I’ve come across the odd person who faced death in combat, in military combat, and threw up when their portfolio fell by 5%. On the other hand, I know people who can happily lose 50% of their assets in stocks, and it doesn’t bother them a bit because they’re reasonably certain, I’m not sure, but they’re reasonably certain that stocks are going to recover. This is a topic that I’m kind of fond of talking about, which is, this is really how the rich get richer, which is that if you have enough Treasury bills that you can pay your groceries and your rent for a decade or more, then you are going to sail through a stock market decline a lot better than the person who has no safe assets and is going to have to sell depreciated stocks in order to pay for their basic needs. That’s the kind of person who sells at the bottom. The kind of person who buys at the bottom is the person who has that great elixir of equanimity, which is Treasury bills. There is a real reason why Warren Buffett has 20% of Berkshire in T-bills and cash equivalents. That’s how he gets richer.

Benz: Are there any asset types that should be automatically off the table as retirement approaches because they entail too much risk, or do you think it’s all a matter of position sizing?

Bernstein: Yeah, I think that’s basically it. The assets that you want to stay away from, if you have a marginal burn rate, which is in excess of 5% in retirement, you just want to stay away from risky assets. It’s not that you shouldn’t own any of them, but you should have a lower allocation to stocks. And I don’t consider any particular stock assets as being particularly liable that you should decrease their allocation just because they’re particularly risky if you’re worried about risk. All stock assets are risky, and some are a little riskier than others. But what’s the difference between having 50% of your portfolio in the total stock market or say 30% or 35% of your stock portfolio in small value stocks, which are very risky, but the risk to your portfolio of 35% small value stocks is the same as the risk of having 50% in the total stock market.

Ptak: There are really two main jobs with retirement de-accumulation—constructing the portfolio and then figuring out where to go for cash flow on a year-to-year basis. How would you recommend people approach the second part of the job? Should they reinvest the income distributions and then rebalance for cash flows?

Bernstein: I think that if you have an asset-allocation policy, which is written in stone, what you wind up doing is in the years you’re selling stocks to lower your stock allocation back down to its policy, and in the bad years, when stocks do poorly, you’re simply spending down your bonds, which will raise up your stock allocation back up to its policy. So, if you maintain a constant stock-bond allocation in retirement, that just happens organically. It happens naturally. The question I guess you’re really asking is, do you reinvest the dividends and interest from your bonds and your stocks? And the answer is, you really don’t have to.

Ptak: Well, Bill, this has been a fascinating discussion. Thanks once again for returning to The Long View and being our guest. It’s been a real pleasure to talk to you.

Bernstein: My pleasure. Let’s do it again in another 10 years.

Benz: Always great to chat with you, Bill. Thanks.

Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. While this guest may license or offer products and services of Morningstar and its affiliates, unless otherwise stated, he/she is not affiliated with Morningstar and its affiliates. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)