Old bridge

Rational expectations (Bernstein)

I’ve read very few books three or more times.* Just finished rereading Rational Expectations by William Bernstein for the third time. It is my favorite book on investing and one I find myself returning to time and time again.

Below I outline a few thoughts from the book.**

How to Design Your Portfolio

Your allocation depends on answering four questions (in order of impact):

1) What overall mix of risky and riskless assets do I want?

2) How much of my risky assets do I invest in the U.S., developed ex-U.S., and emerging markets?

3) How much tilt do I want towards evidence-based factors (e.g., value, quality)?

4) How much exposure do I want to “ancillary” asset classes?

There are risky assets, and there are riskless ones, and the two play very different roles. Critically, your riskless assets should retain their value in a crisis.

Over the long run, your risk and return are governed mainly by your mix of risky and riskless assets. Beyond that, your allocation among different asset classes of risky assets…matters less than your ability to stick to it through thick and thin. Investing is a game won by the most disciplined…not the smartest.

Your Portfolio and Your Brain

We are not the rational, calculating beings that economists [use] in their models…among other things:

1) We overestimate our risk tolerance.

2) We underestimate uncertainty (often dramatically so).

3) We seek to reduce uncertainty by relying on forecasts. We are most persuaded by eloquent and confident forecasters. Those traits are usually negatively correlated with forecasting ability.

4) We tend to extrapolate from the recent past.

5) We are seduced by narratives.

Better informed and more intelligent observers often make greater forecasting errors. Per Jonathan Haidt, instead of using their ability and knowledge to update prior beliefs, they instead use their gifts to rationalize why, even in the face of overwhelming evidence to the contrary, they’re still correct.

Lifetime Asset Allocation

Say to yourself every day, I cannot predict the future, therefore I diversify.

The purpose of investing is not to simply optimize returns and make yourself rich. The purpose is to not die poor. In other words, once you’ve won the game, the wisest thing is to stop playing.

The primary goal of retirement savings is to completely and safely cover basic living expenses over the rest of the investor’s lifetime.

Young investors…may well have lower tolerance for risk than older investors do. There’s no question that they have a higher risk capacity. But that still won’t stop them from being scarred by a market downturn early in their investing careers that could result in a long-lasting aversion to equities.

Bernstein suggests younger investors start with a 50/50 portfolio and then adjust their equity exposure as they develop a better understanding of their actual risk tolerance (as they experience downturns).

Some level of home-market bias is appropriate since our consumption is in local currency. However, most people tend to overdo this.

All investors will likely benefit from tilting equity portfolios towards the cheapest regions.

Three Kinds of Investors

Be honest with yourself, what group do you belong to? What does your investment portfolio say about you?

1) The average investor, who does not have a coherent asset-allocation strategy and who owns a random mix of mutual funds and/or stocks. He or she often tends to buy high and sell low.

2) The more sophisticated investor, who does have a reasonable-seeming asset allocation strategy but bails when real trouble roils the markets (or when everyone else is seemingly striking it rich).

3) Those who do have a coherent strategy and can stick to it in good times and bad. We all like to think we belong to this group but in reality only 1-2% of investors do.

Odds and Ends

On the efficient market hypothesis, Bernstein references Paul Samuelson’s point that markets are MICROefficient but MACROinefficient. That is, it’s nearly impossible to beat the market by selecting individual stocks and bonds. At the same time, though, large mispricings can arise at the market or asset class level. See U.S. tech in the late 1990’s.

Risk is “bad returns in bad times.”


*There are three, including Rational Expectations. Any guesses on the other two?

**I’ve quoted and paraphrased extensively so eliminated quotations, except when the author is quoting someone else.

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