Bernstein And Bogle On The Search For The Perfect Portfolio

Recently, one of my Seeking Alpha readers turned me on to an article written by Peter L. Bernstein entitled The 60/40 Solution. You can read more about Mr. Bernstein here. For purposes of this article, suffice it to say that not only was he an extremely successful money manager in his own right, but he is known for his educational work.

Having lived through–and lost a lot of money during–the market crash of 2007-2009, I’ve learned a couple of lessons on the topic the hard way. Since that time, I have made great progress in becoming a more disciplined investor. Despite that, I feel I have benefited greatly from the material I am about to share here from two investing legends, Mr. Bernstein himself as well as John C. Bogle.

The Future – Surviving the Element of Surprise

In his article, Mr. Bernstein argues for a return to the classic portfolio allocation of 60% stocks and 40% fixed-income investments. He notes, wryly, that in the midst of a raging bull market this “stodgy” allocation doesn’t tend to make for lively cocktail-party conversation. However, for the truly long-term investor, survival becomes the key component in any equation. Mr. Bernstein summarizes it this way.

Many aspects of investing are fun, but your future wealth isn’t a game. You should manage it in the most cold-blooded fashion.

Did you catch the key phrase? Your future wealth. And in that word “future” lies the crux of the challenge. Because the simple fact is; no one knows the future with 100% certainty. Bernstein argues that “the constant lesson of history is the dominant role played by surprise.” Because of this, unexpected events defy the forecasts of even the keenest investors. And it is this steady stream of surprises that contributes to the volatility of stocks, particularly in the short run.

As Bernstein observes, “you can make a killing in one year and give it all back and more in another.”

The Role of Stocks and Bonds

Before we go further in our analysis of a 60/40 portfolio, it may be good to briefly feature the key differences between bonds and stocks.

In short, a bond is a contract. Put another way, think of a bond as a loan. In its most typical form, the borrower, be that a government agency or a corporation, contractually obligates itself to repay the face value of the bond at some future point, while providing income in the form of coupons according to designated terms along the way. At the same time, the bondholder is not an owner, and therefore does not participate in any other benefits accruing from the potential growth of the business. If you’re interested in reading more about bonds, see here and here.

In contrast, a purchaser of a stock is not contractually promised anything. Even if a certain stock pays a dividend, that dividend can be cut or even eliminated. However, the stockholder is an owner in the business. If the business prospers, the stockholder will prosper as well. In theory, there is no limit to the gains that can be realized.

The Perfect Portfolio – More Conservative Than You Think

Back to that 60/40 portfolio. Why did Bernstein argue for this particular allocation? It’s because of how markets work. In the previous section, we discussed why stocks involve a greater level of risk than bonds. In general, rational investors will only buy stocks when they believe they will be compensated for that extra risk. And that is why, over the long term, stocks tend to outperform bonds. The idea behind weighting stocks a little more heavily than bonds is to benefit from that long term outperformance.

But how does a 60/40 portfolio work out compared to a portfolio comprised of 100% stocks? Here is a picture developed using the Portfolio Visualizer website. This graphic covers the period of January, 1987 through January, 2019, or some 32 years. As will be seen, Portfolio 1 is comprised of 100% U.S. stocks, Portfolio 2 of 60% U.S. stocks and 40% U.S. bonds.

2019-02-14_1723
$10,000 Initial Investment – 60/40 Allocation vs. 100% Stocks (1987 – 2019)

If you look first at the CAGR figure, you will see that the 60/40 portfolio held up quite well, “only” underperforming the all-stock portfolio by about 1.3% per year. However, you will also notice that over 32 years that 1.3% difference, when compounded, added up to almost $70,000. Why, then, would one looking out to the future today not simply hold a portfolio comprised of 100% stocks? Bernstein answers this question brilliantly.

Many people pride themselves on being “long-term investors,” but acting deliberately when prices are bouncing around is not so easy. When stocks are blasting skyward, even the most steadfast can be sucked into the updraft. When they are cascading downward, keeping one’s cool is almost impossible. Volatility provokes the constant dread that some investors know more than we do, making us fearful of ignoring such powerful price movements. (Italics mine)

Remembering that my graphic covers the period 1987-2019, think about those words for a minute.

  • Think about what happened on October 19, 1987. On that day, known as “Black Monday,” the Dow plunged 22.6% in a single day, the biggest one-day percentage loss in history. I’d like to share a personal note about that day. At the time, I worked in downtown San Francisco, in the corporate headquarters of a Fortune 500 company. I was too young, and too new in my working career, to have much money in the market so I was not affected greatly. However, I can vividly recall an officer of the company who was an active trader, and whose office was directly across from me, sitting at his desk vacantly starting into space, numb with disbelief at what had just transpired.
  • Or what about September 11, 2001? Was there ever a day, at least in the U.S., where Bernstein’s words, “the constant lesson of history is the dominant role played by surprise,” were brought home with more dramatic impact? In the week following the horrific attacks on the World Trade Center, the Dow lost some 14% and the S&P 500 dropped 11.3%.
  • Or what about the bear market of 2007-2009, during which all the major U.S. averages experienced declines of over 50%? As alluded to in the introduction to this article, with too many risky stocks in my personal portfolio, I was personally affected by that event, suffering an even worse decline.

In summary, then, an investor who managed to achieve the results displayed for Portfolio 1 in my graphic would have needed the self-control to ride out all of those episodes without giving in to fear and selling any of his holdings.

Related to this, in his article, Bernstein offers the cogent observation that, in his real-world experience, investors with a smaller allocation to stocks have often been the ones most likely to be winners over the long haul. Specifically, that the “muting” effect of the bonds allowed them to suppress a feeling of full-scale panic and make more rational decisions when it came to the stocks they held.

Yes, the perfect portfolio may be more conservative than you think.

Enter John C. Bogle and the 50/50 Allocation

While his words feel very contemporary and relevant in the current environment, Peter L. Bernstein wrote his seminal article all the way back in 2002. Might there be another point of view, again from a legendary investor, that might be even more up-to-date?

As it turns out, there is. I strongly suggest you take the time to consider the following video. Really, the entire thing is “gold,” and certainly worthy of your time. However, if your time is limited, start at the 48:45 mark. (NOTE: You will need to follow the link and watch the video on the YouTube site itself, as the licenseholder has not authorized it to play natively on other websites).

 

No doubt, you were struck by the stunning similarity to Bernstein’s words. In his advice to a young man, Bogle lists some of the potential risks out there; including potential nuclear war, the reality of global warming, racial division, threats to world trade, and income inequality. He then concludes with these powerful words:

You don’t know, and I don’t know, what’s going to happen in any of them, the market doesn’t know, nobody knows . . . so what you want to think about is how much risk you can afford. (Italics mine)

Bogle then goes on to reveal what he is doing with his own money. He offers the view that stocks are certainly at the upper end of historical valuation ranges and therefore, at the present time, he is holding an allocation of 50% stocks and 50% bonds.

In Search Of The Perfect Portfolio For The Next 10 Years

Based on all of the information presented in this article, I decided to write a follow-up article for Seeking Alpha. Therein, I offer my take on what I believe could be as close as anything to the perfect portfolio for the next 10 years. I hope you will take a few minutes to look it over.

In the meantime, as always, I wish you . . .

Happy investing!

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