4 'Deep Risks' That Could Decimate Your Portfolio | William Bernstein

Young investors who have never experienced a bear market should maintain a 50/50 stock/bond allocation as a test; if they buy more stocks during the bear market, they have the temperament for higher equity allocation; if they panic and sell, they should reduce equity allocation.

“I counsel young investors who've never encountered a bare Market to keep about a 5050 portfolio and when that first bare Market hits see how they respond okay if they buy more stocks uh they've got The Moxy to do that then God bless they should have a higher overall stock allocation for the rest of their life uh but on the other hand if they panic and sell maybe they should be 2575”

A key difference between professional/successful traders and rookies is the ability to separate risky assets from riskless assets in separate accounts, so that if risky assets decline they still have enough reserves to meet living expenses and avoid panic selling.

“there's a certain intellectual framework that you have to have as well in order to be a successful uh Trader uh or or successful investor for that matter uh which is that you have to be able to separate out your risky assets and your riskless assets you have to be able be able to maintain separate accounts so that if your risky assets go down the tubes you have enough riskless assets that you can say you know I can still buy groceries okay I can still pay my rent I can still pay my mortgage and I'm not going to panic”

Economic growth is fundamentally driven by four factors: rule of law and strong property rights, scientific rationalism, efficient capital markets, and efficient transportation and communication systems.

“well there's four of them uh I wrote the book 25 years ago so let's see if we can remember all of them f f first of all is is rule of law and strong institutions and and and property rights okay second is scientific rational and having a scientific way of looking at the world the third is is capital uh markets okay uh having efficient Capital Market so that uh projects can get uh funded and Investments uh can get funded and then the fourth is an efficient Transportation uh system and communication system”

Ed Chancellor and Claudio Borio (at the BIS) have done rigorous research showing that low real interest rates and low hurdle rates directly contribute to sluggish economic growth in developed economies.

“there are some who suggest Ed Chancellor is is certainly one of them there's a fellow at the bis I think it's name is claudio bario who's done fairly rigorous research that basically ascribes our low economic growth to this low hurdle rate”

Despite becoming much richer, China has not become more democratic as political scientists might have predicted, suggesting that the relationship between wealth and democracy is more complex than initially theorized.

“one would predict that China would have become a much more democratic country because as people become richer they are more demanding of civil liberties and a economy and one would have predicted 15 20 years ago that China would would had a good chance of evolving into a democratic system that appears not to be happening uh which which basically uh goes against the prediction I think of most political scientists that what that they would have made”

Economic growth began accelerating rapidly around 1820, marking an inflection point where per capita GDP growth exploded from nearly flat growth to rapid growth; this date corresponds to the introduction of railroads and telegraphs in England, completing all four growth factors.

“the traditional uh date that chometric like to identify is 1820 that appears to be about where the where the inflection point was before that there was almost no growth uh on a on a on a per cap on a per capita GDP basis from year to year maybe very slow growth in Holland and in England for about 200 years before that and then all of a sudden in 1820 uh things explode”

Inflation is the most important of four major long-term financial risks, as it is ubiquitous throughout financial history and very few nations have escaped either serious inflation or hyperinflation.

“first and foremost more important than any of the other three is inflation it's everywhere and always in Financial history there are very few Nations that have that have escaped hyperinflation let alone serious uh inflation”

Devastation—existential risks including nuclear war—is the fourth major financial risk; the world came close to nuclear exchange during the Cuban Missile Crisis in October 1962 and on several other occasions in the past 50 years.

“then last is Devastation which is something you don't want to Discount uh on several occasions in the past 50 years we almost blew up the planet uh I lived through October of 1962 uh when you know there were probably a couple of Soviet subcommanders who saved the world from getting blown up”

The fractional reserve banking system creates inherent instability because banks create money when times are good and expand leverage, but when confidence erodes people withdraw deposits and deleveraging becomes a painful process, creating cycles of instability.

“well you have a system where Banks make literally make money they create money and when times are good uh and people are feeling good they create a lot of money and then when people uh start to worry about the financial system uh and they pull in their horns that leverage uh disappears and deleveraging as we found out in 2008 and 2009 is a very painful process”

A core principle of psychology is that humans are overconfident about three things: ability to pick stocks, ability to time the market, and most dangerously, ability to handle risk when the market crashes.

“one of the primary neuros pychological characteristics of human beings is that we're overconfident so we're overconfident about our ability to pick stocks we're overconfident about our ability to time the market but the overconfidence that is the most dangerous is our overconfidence about our ability to handle risk uh when the ottoman hits the fan uh we think that we're risk tolerant we can look at it in a spreadsheet and convince oursel we're going to buy when prices are low but in the actual event the world is so scary that we wind up not being able to do that”

Baumol's law explains why highly mechanized/technologized sectors show high growth while sectors without technological advance show low growth, and gives the example that education costs rise because the price of everything else has fallen.

“there's a phenomenon um called boms law which is that the things that are the most mechanized and are most subject to technology the ones where you see the highest growth uh and that you see the least productivity growth uh in fields that don't see a lot of technological advance so for example in teaching the cost of Education increases because the price of everything else has has fallen”

Brain-computer interface technology has significant dual-use potential (good or evil) and must be carefully controlled to prevent authoritarian governments from weaponizing it.

“all Technologies are can be a force for good or for good or evil uh God Only Knows uh once again you don't want that technology in the hands of an authoritarian government uh well yes that that is a good point”

A 25-year-old actively saving for retirement should hope for decades-long brutal bear markets so they can accumulate stocks at cheap prices, because sequence-of-return risk means that returns early in accumulation are less important than returns late in the accumulation phase.

“well what I mean by this quote is is there's something called sequence of return risk which is a much larger phenomenon so we all know that someone who retires uh wants to see the good returns first and the bad returns last all right uh whereas if someone so that that person will do very well the Rey who does the worst is the one who retires in the equivalent let's say of 1966 when you have 18 years or 20 years of poor stock returns which depletes the portfolio before the the the bull market comes back”

During the hyperinflation of the Weimar Republic (1920-1924), when the German mark devalued by a factor of one trillion, stocks actually achieved positive real returns over the entire period.

“one of the things that people didn't don't realize about the viar inflation of the early 1920s is that over that long fouryear cycle from 1920 to 1924 when the rich Mark devalued by a factor of one trillion that's trillion with a t the real return of stocks was actually positive over that uh whole period”

People sorting themselves into geographically separated communities based on political ideology is described by the 'Big Sort' concept from a book by Bill Bishop, written 15-20 years before Michael Lewis's 'The Big Short.'

“Mr doio is tapping into something called the big sort not the big short but the big sort which was a book that was written by a guy by the name of Bill Bishop uh 15 or 20 years ago before the Big Short was written uh and it's about how we're sorting ourselves in the United States and in other places into communities that fit our culture and our political beliefs”

Empathy encourages people to take more risk when markets are booming, and this tendency to take on excess risk during good times turns out to bite them when crisis arrives.

“is empathy basically encourages you to take more risk when the sun is shining and that turns out to turns around to bite you when the storm clouds gather”

When the price of money approaches zero, the price of everything else becomes volatile and unpredictable, creating economic distortion.

“okay when the price of everything uh goes when the price of money goes to zero then the price of everything else goes Haywire”

Deflation is a second major financial risk that typically occurs during financial panics and is usually short-lived but very damaging; in the era of vigorous central banks and fiat currency, it is relatively easy to address.

“then the next is deflation which is something that you see during Financial panics it's usually very short-lived and in the era of vigorous central banks and fiat currency it's pretty easy thing to take care of”

Bernstein acknowledges that civil polarization and geographic self-sorting (the 'Big Sort') is occurring in the US, with voters increasingly concentrated in communities aligned with their political beliefs, evidenced by rising margins of victory in presidential elections.

“we are sorting ourselves uh into separate uh Bubbles and you can see that very very vividly uh in presidential uh elections by the margins uh that that presidential candidates win it used to be unusual to see a candidate win a state by more than 20 uh per. well now it's the rule in hardcore blue and red States”

Prosperous countries predominantly have English common law systems, which evolved from English folk culture's view of what is 'fair and right', and this legal tradition is one of the primary reasons for prosperity in English-speaking nations (Canada, US, New Zealand, UK, South Africa).

“the sort of basic the basic structure of rule of law uh in northern Europe is English common law and in the English speaking line in the english-speaking world as well you look at the most prosperous countries and also the most successful um uh uh stock markets in the world they're in englishspeaking Nations Canada the US New Zealand uh the UK South Africa yeah uh it's not Shakespeare it's not that they're speaking the language of Shakespeare it's they inherit the English common law and English common law evolved simply from English FK culture it's what people thought was fair uh and right”

The United States is unlikely to be surpassed as the dominant economic power because bright young people with good ideas preferentially move to the US due to the rewards and superior technological/scientific infrastructure, even compared to other developed nations like Sweden and France.

“do you see another Nation uh surpassing the US in uh technological growth and ultimately economic growth because if you're a bright young person with a good idea you want to come to the United States uh you know you might have a pretty good shake at doing it and Sweden or in France uh but if I'm a bright young person with with a brilliant idea um I want to come to the United States because of the money or for some other reason no because of the because of the rewards you're most likely to get rewarded uh in the United States and the infrastructure the technological the scientific infrastructure in the United States is so fantastic”

Short-term high-quality fixed income and inflation-indexed bonds are classic hedges against inflation, while commodity producer stocks (but not commodity futures due to contango) and long-term stocks also provide inflation protection.

“well I guess deflation is pretty straightforward you just hold cash and presumably in a deflationary environment your cash increases purchasing power over time but what about inflation have you done research on on assets that have consistently outperformed the CPI on a on a longer term basis perhaps not outperform it but at least not lose your shirt so the classic one again is short-term uh high quality fixed income assets or the primary uh hedge inflation index bonds particularly now that they're selling relatively cheaply are not a bad way to do it Commodities producers uh also do that I'm not a big fan of Commodities Futures because they're subject to contango you get a negative rooll return uh over the past 10 or 20 years because everybody in their dog is trying to protect against it so you wind up in in with the opposite of uh uh of of normal Keynesian back ration in other words Kango uh so I like the producers the stocks of The Producers better than I like the the futures”

Europe (particularly England) embraced scientific rationalism and developed sophisticated capital markets (Italian and Dutch markets 400-500 years before 1820) before other regions, explaining why the Industrial Revolution occurred in Europe rather than elsewhere.

“they were the ones who embraced scientific rationalism they were the ones who had the first developed well-developed Capital Market starting with the uh Italian and Dutch markets 500 years ago 400 years ago uh so that's where all four of those uh came together”

Tail risks like nuclear war are not something investors can reasonably hedge against; the portfolio is irrelevant if nuclear war occurs, so inflation is the one risk worth really focusing hedge efforts on.

“really inflation is the one you should really really worry about because that's the most likely and it's the one you can do the most about the others are less likely and you know to to one extent or another there's a whole lot less you can do about them so that's the one you should focus on that's the one where the real the money is in terms of risk management is is Hing against inflation”

The United States faces a 10-20% probability of a debt-spiral hyperinflation over the next several years to decades, driven by unsustainable government deficits that neither political party is willing to address through spending cuts or tax increases.

“I think we're in paranoia in the United States and in fact much of the developed World we're at a risk of getting into a uh credit cycle uh where the um uh liabilities of the government the national uh that increases to the point where the servicing costs actually start to uh raise the cost of of that Capital uh tend to jack up interest uh rates”

The most empathetic people are the worst investors because empathy means feeling others' emotions, so when other people are greedy or fearful, empathetic investors channel into those emotions and suffer losses.

“I've observed in my investing career and especially among friends uh and acquaintances that the most empathetic people are the worst investors all right uh and the reason for that is simple the definition of empathy is feeling others emotions so if other people are greedy or fearful and you channel into that uh that's going to hurt you in the financial world”

Economic productivity and growth acceleration fundamentally depend on technological change—the ability to increase the productive work a worker can accomplish per hour.

“it's basically a function of technological Advance all right uh uh when you when you when you look at what has improved the the quality of life and wealth it's it's obviously uh technology it's it's the ability the amount of work the amount of productive work that a given worker can do in an hour it's just about economic productivity and productivity is driven by technological change”

Gold is a good hedge against deflation (not inflation) because it hedges against loss of faith in the banking system, which is what causes deflation.

“I believe you're roting correct people wrong but I believe you wrote that gold is good hedge against deflation but not so much inflation is that correct that's that's correct and that simply falls out of the work that's been done by uh Dimson Marsh and ston uh this was in one of their yearbooks their credit s yearbooks I think about uh 10 years ago uh and what they saw was that gold was at best a so so hedge against inflation but it was a spectacularly good hedge against deflation well it wasn't that you're hedging against deflation you're hedging against the thing that causes deflation which is a loss of faith in the uh loss of faith in the banking system and gold does very well under those circumstances”

The last three drivers of growth (capital markets, transportation, communication) are now of only historical importance because all modern countries have access to them; what now separates rich from poor nations is rule of law and property rights.

“now the last three are really of only historical importance because in today's modern world every country in the world has access to Capital markets they have access to transportation and communication and they have scientific they have access to Scientific rationalism even if they don't have a great University system uh in there in the country that they're that uh that you're in question they can always send their kids abroad to get an education what cleaves the rich from the poor nations of the world today is rule of law okay and property rights”

Value stocks perform well during inflation because their liabilities are denominated in nominal currency, so when that currency depreciates, the real value of their debt decreases, benefiting the bottom line.

“and finally there's a class of stocks that does do very well with inflation or relatively well with inflation besides Commodities producers and that's value stocks in general because their um liabilities are denominated in real excuse me in nominal currency uh and when that nominal currency uh deflates that decreases the amount of their real liabilities which goes to their bottom line”

Confiscation—when governments take away assets—is a third major financial risk, with catastrophic historical examples in China and the Soviet Union over the past 150 years.

“there's confiscation which is when your government takes away your your assets uh we've seen some pretty catastrophic examples of that in the past 150 years particularly in China and in the Soviet Union”

An investor who accumulated their portfolio from 1966 to 1986 (a period of poor returns) and then retired in 1990-1995 did spectacularly well because they accumulated cheaply and then retired into a bull market, whereas someone accumulating over the past decade will not do as well because they accumulated at high prices.

“the person who accumulated their portfolio from 1966 to 1986 uh and then went to went on to retire in 1990 or 1995 did spectacularly well all right uh whereas the person who acquired their portfolio uh over the past decade probably isn't going to be doing that well because they will have acquired their equities at very high prices”

The satellite photograph of the Korean peninsula showing South Korea brightly lit and North Korea dark (except for Pyongyang) is a spectacular visual example of how rule of law and property rights determine prosperity versus poverty.

“you have to see a spectacular example of that is to look at um uh the a night satellite photograph of the Korean Peninsula okay the South the South part we've all seen this this this famous photograph which is the South South Korea is lit up like a Christmas tree uh and there's only one little spot of light in North Korea uh in pongyang which I like to joke is King jongin's uh flat screen TV”

Predicting specific applications of emerging technologies like brain-computer interfaces is impossible; asking 30 years ago what the internet would be used for would have yielded only 5% of current uses, illustrating that technological impact is fundamentally unpredictable.

“what what are we going to be using the internet for you asked that question 30 years ago you wouldn't have come up with even 5% of the things that we're doing now uh and I I really I wouldn't want to predict what the outflow of what the downstream outflow of that is going to be but it could be very significant I I wouldn't even want to predict specific instances”

Young people drive economic growth while old people do not; high costs of social welfare systems supporting elderly populations will sap capital structure and drive debt accumulation in developed countries.

“for the simple reason that young people are the ones who in and old people are the ones who don't the cost of the social welfare systems meant to that is needed to support an elderly population are going to sap our capital structure as as well uh it's one of the things that is major thing in fact that's driving uh the increase in debt around the developed uh world”