Remarks by John C. Bogle, Founder, The Vanguard
Before the New England Pension Consultants' Client Conference
April 6, 2000
In these extraordinary and volatile markets we are facing today,
it’s difficult for me to imagine more appropriate subjects than
"Risk" and "Risk Control" to sound the keynote for an "Agenda for
the Future"—the perennial theme, as I understand it, for this conference.
It has been "Reward," of course, that has been the keynote of the
past 18 years, and most particularly for the past six years, during
which the longest and strongest bull market in the history of the
world has taken a new lease on life. Even as "it is always darkest
before the dawn," however, it may well always be brightest just
before evening begins to fall. When reward is at its pinnacle,
risk is near at hand.
Risk has been with us, well, forever. At the dawn of civilization
in Rome during the second century B.C., for example, some of the
characteristics of modern capitalism, financial markets, and speculation
were already in place. Indeed, the term speculator—one who
looks out for trouble—comes from ancient Rome. As Cato himself told
"There must certainly be a vast Fund of Stupidity in Human Nature,
else Men would not be caught as they are, a thousand times over,
by the same Snare, and while they yet remember their past Misfortunes,
go on to court and encourage the Causes to which they were owing,
and which will again produce them."
Although we cannot be certain whether our stock market today is
the epitome of the same kind of speculative snare that has caught
men a thousand times over, no investor today should forget those
words. My point is not that we are now caught in one of those
periodic snares set by the limitless supply of stupidity in human
nature. Rather, my point is that we might be. Professional
investors who ignore today’s rife signs of market madness—of a bubble,
if you will—are abrogating their fiduciary duty, and dishonoring
their responsibility for the stewardship of their clients’ assets.
Four Key Elements of Investing: Reward, Risk, Time, and Cost
How should that responsibility be honored? By recognizing that,
for all of the projections and assumptions we make (and almost take
for granted), there is one element of investing we cannot control:
Reward. For future stock market returns are completely unpredictable
in the short-run and—unless we know more about the world 25-years
from now then we do about the world today—may prove even less predictable
over the long-run. But we can control the other three primary
determinants of investing: Risk, time, and cost, and we should focus
Risk, and risk control, will be my main theme today, but
first just a few words on the roles that Time and Cost
play in investing. We can control time in two ways: First, by focusing
on how much time will elapse from the date an individual investor
or a corporate pension plan begins the accumulation of investment
assets during the years of productivity and thrift until the investors
will require the distribution of income, and even the drawdown of
capital—essentially the liability on the balance sheet when retirement
begins. We can control, after all, how many working years will pass
before we retire, and we had best get as much time as we can on
our side. Second, we can control the very time horizon over which
we hold stocks. With our own free will, we have the power to choose
whether we will be long-term investors or short-term speculators.
With its 90% portfolio turnover, the fund industry has chosen short.
My own chips are on long.
And, lest we forget, we can also control Cost. In my remarks
today, I’m not going to place my customary emphasis on the costs
of investing, for my sense is that you money managers, clients,
and consultants here assembled have already done your best to hold
your investment costs to the reasonable minimum. In the industry
in which I’ve plied by trade for a half-century, however, "money
is no object." Alas, it is the shareholders’ money which is no object,
and mutual fund costs are completely out of control. Over the past
15 years, for example, mutual fund fees and operating expenses,
sales charges and transaction costs, opportunity costs, and the
horrendous tax costs—generated, in turn, by grossly excessive portfolio
turnover—have consumed nearly six percentage points—one-third—of
the stock market’s return of 18% per year. (It would take a truly
remarkable money manager to leap that six-point hurdle for 15 years
in a row!) In the last year alone, all-industry costs absorbed an
estimated $120 billion of the returns earned by mutual fund shareholders—an
Four Key Elements of Investing
Reward: Out of Our Control
But what none of us can control is Reward. With few exceptions,
generous investment rewards have been generated in the financial
markets over the long-run. But we have the ability to predict neither
when the rewards will occur, nor when they will depart from past
norms. Our markets are remarkable arbitrageurs that reconcile past
realities with future expectations. The problem is that future expectations
often lose touch with future reality. Sometimes hope rides in the
saddle, sometimes greed, sometimes fear. No, there is no "new paradigm."
Hope, greed and fear make up the market’s eternal paradigm.
The conventional wisdom is wrapped up in what we call "Efficient
Market Theory," which holds that since the financial markets incorporate
all knowledge of all investors about all things,
they are by definition efficient, eternally priced to perfection.
But I wonder, and no one has ever been able to explain to me why
the market was perfectly priced on August 31, 1987, or January 2,
1973, or September 8, 1929, each of which was followed by a catastrophic
market decline, ranging from 35% to 85%.
In this age of statistical abundance, to be sure, we see table
after table of data showing annual returns in the U.S. stock and
bond markets encompassing two full centuries. We quickly learn that
stocks outpace bonds in 60% of all one-year periods—well
short of a sure thing. But the odds rise to 73% when we go
out five years and 82% when we go out ten years.
And over 25-year periods, stocks outpace bonds more than
99% of the time, about as close to zero risk as is imaginable
here on earth. (I’ve deliberately committed the sin of using outpace.
The correct phrase is: have in the past outpaced. Please
join me expressing the idea correctly!)
Because we can never be certain of the order in which the
annual returns will come, those kinds of cumulative data are period-dependent
and therefore inevitably misleading. So, we try to rectify the problem
by throwing each year’s return into a sort of Waring blender, turn
the dial to "puree," and pour out a fine potage. (Or is that a "mess
of pottage," for which Esau traded his birthright?) At first glance
this approach seems to provide more meaningful data. But the devil
is in the details. So don’t forget that this methodology goes under
the title of a "Monte Carlo Simulation."
All of these statistics leave me apprehensive. Why? Because the
future is not only unknown but unknowable. Yet with the acceptance
of Modern Portfolio Theory; the ease of massaging data with the
computer; and our existence (at least in the U.S.) in today’s era
of remarkable political stability combined with powerful economic
growth, investors seem to have developed growing confidence that
they can forecast future returns in the stock market. If you fall
into that category, I send you this categorical warning: The
stock market is not an actuarial table.
To which I add: When everyone assumes, at least implicitly, that
the market is an actuarial table, that the past is inevitably
prologue, and that common stocks, held over an extended period,
will always produce higher returns than bonds—and at lower
risk—then stocks inevitably will be priced to reflect that certainty.
At that point, however, the certainty becomes that stocks will produce
lower future returns, and at higher risk at that. It is impossible
to escape the suspicion that such an actuarial mindset, if you will,
is extraordinarily prevalent today among investment advisers, consultants,
and economists—and, for that matter, the individual and institutional
investors themselves. Forewarned is forearmed.
Risk in Today’s Market
With all of the lip-service we pay to the notions of risk and risk
control, how do we explain that by almost any conventional measure
of stock valuation, stocks have never been riskier than they
are today. Looking back 70 years, major market highs were almost
invariably signaled when the dividend yield on stocks fell below
3%, or the price-earnings ratio rose much above 20 times earnings,
or when the aggregate market value of U.S. equities reached 80%
of our nation’s gross domestic product (GDP). Yet today, dividend
yields have fallen to just over 1%, so far from the old "risk" threshold
as to render it seemingly meaningless. What is more, stocks are
now selling at something like 32 times last year’s earnings. And,
with our $9.4 trillion GDP and our $17 trillion stock market, that
ratio has not quite reached 200%. (Just be patient!) Clearly, if
past data mean anything, risk is the, well, forgotten man of this
Great Bull Market.
Even as we talk about the stock market, furthermore, let’s be clear
that today, more than any time I can recall, there are really two
U.S. stock markets. One exists on the New York Stock Exchange,
along with a few smaller markets for listed stocks. The other exists
on the NASDAQ (the "over-the-counter" market). The relationship
between the market capitalizations of the two has changed radically.
The value of NASDAQ ran about 6% of the value of listed U.S. common
stocks in 1977, rose to 25% by 1995, to 32% by 1998, to 57% in 1999,
and then to an astounding 78% in mid-March 2000. Since 1999 began,
the capitalization of the listed market has remained roughly unchanged
at $9 trillion, while the capitalization of the NASDAQ has soared
from $2.9 trillion to $7.1 trillion, or by 145%. (Note: Since mid-March,
the value of the NASDAQ has fallen to $5.8 trillion—$1.3 trillion
of, well, water over the dam—and is now valued at 64% of the listed
Old Economy, New Economy?
We can examine the nature of this dichotomy by comparing the stocks
in the so-called Old Economy, which have been stagnant, with
the stocks of the New Economy, which have been following
a near-parabolic arc into the stratosphere. In a recent study of
this dichotomy, Bernstein Research divided the market into two categories:
The New, consisting of technology, telecommunications, and Internet
commerce; the Old consisting of everything else. Their analysis
reflects an Old Economy valued at $10.6 trillion as 2000 began,
and a New Economy valued at $6.7 trillion, respective totals that
are remarkably close to the NYSE/NASDAQ split, though not with precisely
the same stocks in each.
The past earnings growth of each Economy has been virtually identical.
During the expansion of earnings that Corporate America has enjoyed
since 1995, earnings in the New Economy have grown at 8% annually,
compared to 7% annual growth for Old Economy companies, meaning
that the New Economy has provided no more than a remarkably steady
share of about 16% of total corporate profits during the period.
But, despite this similarity—and I do know that markets are
valued less on the realities of past earnings than on the hopes
and expectations of future earnings—the stocks in the New Economy
were valued at 101.6 times earnings as 2000 began—compared to 25.6
times for the stocks in the Old Economy. Yes, the stock market is
a wonderful arbitrage mechanism, but when it begins to discount
not just the future, but the hereafter, watch out!
New Economy versus Old Economy*
Bernstein & Co. Inc.
The Ultimate Test: Future Cash Flows
Why this note of caution? Because the theory you were taught in
your finance classes is not only correct, but eternal. Sooner or
later, the rewards of investing must be based on future cash
flows. The purpose of any stock market, after all, is simply to
provide liquidity for stocks in return for the promise of future
cash flows, enabling investors to realize the present value of a
future stream of income at any time. With current price-earnings
ratios averaging more than 100 times, investors today clearly believe
that the future streams of income in the New Economy will be enormous.
How big must these cash flows be? Well, for the purpose of argument,
let’s assume that the investors who own the $6.7 trillion New Economy
today expect these companies to provide a 15% after-tax return a
decade hence. That’s almost $1 trillion dollars . . .and that’s
a lot of money! Especially considering that these stocks earned
just $66 billion last year. But who among us can be certain that,
in this New Era in the economy, earnings won’t grow at the
31% annual rate required to reach that total?
The Buffett Analysis
I, for one, don’t believe these optimistic expectations will be
realized. But don’t mistake my word for the truth. If we use the
kind of methodology that Warren Buffett uses to measure corporate
value, we can at least put some sort of rule of reason on that kind
of earning power. Mr. Buffett tells us that corporate profits after
taxes have generally been slightly below 6% of the nation’s gross
domestic product (GDP), and presents good reasons to expect that
a much higher ratio is unlikely to prevail over the long term. If
we assume that our nation’s economy grows at a 6% nominal rate,
the GDP in 2010 would be about $16.5 trillion. If after-tax earnings
in the Old Economy grow at that rate, they would rise from $412
billion to $740 billion. With the New Economy’s $980 billion, we
have total corporate profits of $1.7 trillion in 2010. At that level,
projected corporate profits would be more than 10% of GDP, far above
any share in history, and nearly double the fairly steady 5 ½% norm
of the past. Nonetheless, that enormous share arguably represents
the earnings expectations of today’s investors. Their expectations
are priced into the market, so the market, having discounted them
once, will not discount them again. Put another way, unless that
robust scenario comes true, market risk today is extremely high.
These historically high financial ratios and this crude economic
analysis do not reflect my only concerns. Another is that the sheer
mathematics of the market—even assuming the continuation of box-car
growth rates that are by no means assured—seem to defy reason.
A recent analysis by Professor Jeremy Siegel (author of "Stocks
for the Long-Run," the source of virtually all of the data we use
for long-term returns on financial assets) considered the nine large-cap
companies that are currently priced at over 100 times 1999 earnings.
Dr. Siegel accepted, for argument’s sake, that the earnings of these
companies would grow at their estimated average rate of 33% per
year(!) over the coming decade—an even higher rate than I assumed
earlier. Even so, for investors to earn a 15% annual return, they
would have to sell at an average of 95 times their earnings five
years from now, and 46½ times their earnings a decade hence. Based
on his analysis of the nifty-50 era of the early 1970s, he reports
"no stock that sold above a 50 p/e was able to match the S&P
500 over the next quarter-century." His conclusion: "Big-Cap Tech
Stocks Are a Sucker Bet."
Are Big-Cap Tech Stocks a "Sucker Bet?"
9 Large Tech Stocks versus S&P 500
|Estimated Growth in EPS
*Required P/E assuming return
of 15% for tech stocks and 10% for S&P 500.
Source: Professor Jeremy J. Siegel.
As a veteran of the Go-Go Era in the market during the mid-to-late
1960s, I observe disquieting similarities with today’s tech-driven
markets. During 1963-1968, based on their over-heated records of
past performance, the Go-Go funds drew ever larger portions of mutual
fund cash flows. Five major funds turned in a total return of +344%,
almost 3½ times the 99% gain of the S&P 500, and their
assets promptly leaped 17 times over, from $200 million to $3.4
billion. Alas, retribution quickly came, and they posted negative
returns averaging –45% through 1974, a period when the S&P was
off just -19%. None of those Go-Go funds has prospered, and few
have even survived.
Technology funds today are generating relative returns that are
remarkably similar to those of the Go-Go era. Five of today’s most
successful funds have earned an average return of 403% during just
the past three years, four times the 92% gain in the S&P 500.
Their assets have soared seven times over, from $5.6 billion to
$40 billion. And in another disquieting similarity, the records
of both groups of funds are not without suspicion. In the Go-Go
era, it was "letter stocks," private placements that funds bought
from company insiders at large discounts and promptly marked-up
to current value, that inflated fund returns. And in this era, it
is hardly unreasonable to assume that hot IPOs may have inflated
the records of the technology funds. Absent clear disclosure of
the facts, investors would be foolish to consider such returns as
a harbinger of the future. In any event, just as the Go-Go era of
35 years ago proved just another extraordinary popular delusion,
so the Tech-Boom era of the turn of the millennium may prove just
one more madness of crowds.
Comparison of Go-Go Era to Tech-Boom Era
||5 Large Go-Go Funds
||5 Large Tech Funds
Yet another concern I have is today’s high level of speculation.
One of the best measures is, for me, a bittersweet one: the fascination
of investors with market index funds that can be—and are—traded
like individual stocks: Spiders, Webs (Cute! Just a fun game, or
so it seems), Qubes, and eShares. A quarter-century ago, when I
started the first index mutual fund, I viewed it as the ultimate
in long-term investing—diversified, buy and hold, low-cost, and
high tax efficiency—and it has worked marvelously. Ironically, these
new index proxies are the ultimate in short-term speculation, and
I cannot imagine that such speculation will serve investors well.
Investors are now trading S&P-500-like Spiders at an annual
turnover rate of nearly 2000%, and NASDAQ-like Qubes at a turnover
rate of nearly 13,000%—average holding periods of just 18 days and
2.8 days respectively. Their combined volume is staggering; if present
volumes hold, some $1.5 trillion(!) of these shares will be traded
this year. In the hectic market of April 4, 2000 alone, trading
in these two listings totaled $10 billion! Welcome to the new millennium.
So, let me be clear: You can place me firmly in the camp of those
who are deeply concerned that the stock market is all too likely
to be riding for a painful fall—indeed a fall that may well have
begun as I began to write this speech ten days ago. From Milton
Friedman to Robert Schiller (author of the newly-published "Irrational
Exuberance"), to John Cassidy of The New Yorker, and Steven
Leuthold, Jeremy Grantham, Jeremy Siegel, Julian Robertson (who
just threw in the towel), Gary Brinson (whose convictions may have
cost him his job), and Alan Greenspan (whose conviction’s haven’t).
Viewed a decade hence, today’s stock market may just be one more
chapter in "Extraordinary Popular Delusions and the Madness of Crowds."
All of us who serve as stewards of other people’s money have a
special responsibility, not only to consider the level of risk in
the stock market today, but to control the risks to which our clients
are exposed. There are three principal approaches to risk and risk
control that I’ll now discuss. 1) Ignoring equity risk; 2) Reducing
risk by broadening diversification among sectors of the equity market;
and 3) Reducing risk by reducing equity exposure.
Dealing with Risk-Part I
Ignoring Equity Risk
1. Assume Present Ratio is Appropriate
A. Time Horizon
B. Liability Structure
C. Need for Income
2. Best Advice: "Stay the Course"
The first approach, simply ignoring equity risk, is not as stupid
as it may sound. Indeed, if the equity exposure of the portfolio
is deemed appropriate to the client’s time horizon and need for
income (dividend yields and interest coupons, not capital
gains), there are far worse strategies than simply "staying the
course," a phrase which I have described as the single best piece
of investment wisdom ever spoken. Such a solution implicitly assumes
that the steward has already controlled the risk in the account,
gradually reducing equities as, for example, the time for drawing
down income or capital at retirement approaches, and probably having
reduced equity exposure to (or at least toward) the account’s norm
as the Great Bull Market has carried the equity ratio ever upward.
For example, a 60% equity position when the market rise began in
mid-1982, untouched, would today have increased to 85%. (It should
not go without saying that, taking no action whatsoever and letting
the profits ride would have been a far more profitable strategy,
so far at least. And continuing to bet the house’s money is, after
all, the conventional strategy of the gambler.)
Ignoring equity risk, to be sure, assumes that the client—or the
client’s investment committee—has both the financial resources and
the emotional stability, indeed the courage (the guts, if you will),
to stay the course. But make no mistake about it, even the best
of intentions have a profound tendency to vanish when the stock
market drops 50% (as in 1973-74) or even 35% (as in 1987). Panic
is at best not a pretty emotion, and when panic is in the streets
investors can turn ugly and act in ways that directly counter their
own best interests. The counterproductive emotions of investing
have had a way of eroding—and in some cases even destroying—the
assets that have been created over the years by the productive economics
of investing. Holding tight, moreover, means not engaging in market
timing, which any intelligent investor must recognize is a two-decision
process that requires not only selling right, but knowing
when the day comes to reverse engines and buying right. It
is not easy.
For me, staying the course implies owning a broad cross-section
of the U.S. markets: growth stocks and value, large stocks and small,
Old Economy stocks and New, listed stocks and NASDAQ. It’s always
tempting to make heavy sector bets, but betting is, well gambling,
nowhere more obvious than in the (temporary to be sure) devastation
wrought upon value investment strategies during the past five years
(S&P Growth Index up 304%, Value Index up 157%). While the reversion
to the mean that has been the eternal rule among market sectors
strongly suggests that value’s day is now in prospect, timing is
hazardous duty, so my own view is that the optimal long-term strategy
is to own a broad cross-section of the U.S. market. It will hardly
surprise you that I’d realize that goal by owning the broadest-possible
cross-section—a total stock market index fund. But for you who believe
you can beat the market, be my guest. And good luck. (I really
Ignoring equity risk, of course, in effect assumes that the economics
of investing in U.S. stocks—the core portfolio for nearly all investors—will
remain productive over the years ahead. I, for one, see no reason
that this should not be the case. The powerful growth in our economy,
our capacity for technological innovation, our global hegemony,
the work ethic of our labor force, our rising productivity, all
should be positive signals of future progress. And yet one can never
be certain. Just a decade ago, each of those five factors—growth,
innovation, global power, work ethic, productivity—defined the Japanese
economy. (Remember "The Rising Sun"?) But for the better part of
a full decade now, the Japanese economy has been a pallid shadow
of its former self and the Tokyo market a near-perennial bear. (The
Nikkei Index fell from a high of almost 40,000 in 1989 to a low
of around 13,000 in 1998. It is now at about 20,000. Would most
of today’s U.S. investors have stayed the course through such rough
seas? Not unless they were prepared to assume such risks.) So, we
must never forget that "it can happen here." However far-removed
that prospect may seem today, a lot can happen in a decade.
Dealing with Risk-Part II
Broadening Equity Diversification
A. Growth and Value
B. Large and Small
E. Alternative Investments
2. Effect on Risk: Less portfolio
volatility, but more risk in individual holdings.
The second approach to risk control is broadening the conventional
focus of an equity portfolio in marketable U.S. equities to encompass
other equities that have reliably different correlations
with the U.S. market, dominated as it is by large cap growth and
value stocks. I emphasize the word "reliably." While the returns
on large-cap and small-cap stocks, and on growth and value stocks,
have often had different correlations, they have been, and I assume
will continue to be, spasmodic and mean-reverting. This brings us
right to "Modern Portfolio Theory" (MPT), the cardinal principle
of which is portfolio diversification: The broader the diversification,
the lower the specific risk. In the ideal portfolio (the all-market
index fund) all specific security risk is diversified away.
The classic example of broadened diversification, of course, is
the addition of foreign stocks to U.S. equity portfolios. The record
is crystal clear that, if we accept standard deviation as our
risk measure, the use of foreign equities reduces risk. The
problem is that I’m not at all sure that it is proper to use standard
deviation as a proxy for risk, and even less sure that we should
use risk-adjusted return as a proxy for investment success. After
all, over-simplifying ever so slightly, the Sharpe ratio for calculating
risk-adjusted return equates an extra percentage point of return
with an extra percentage point of risk. But this much must be clear:
An extra percentage point of long-term return is priceless, and
an extra percentage point of short-term standard deviation is meaningless.
So what investment purpose is served by dividing the meaningless
into the priceless, weighting both equally? I’ll leave it to you
to answer that question, even as I applaud the Sharpe Ratio for
serving a useful academic purpose in objectively weighing
returns earned against risks assumed.
The "Efficient Frontier"
When we consider the impact of international diversification on
U.S. portfolios, we are led quickly to the famous "Efficient Frontier"
of the financial academy. Clearly, the ultimate diversification
would be to own the entire World portfolio, now about 50% U.S.,
25% Europe, 15% Japan and Pacific, 10% emerging markets. But a decade
ago, it was 50% Japan and Pacific, 30% U.S., 15% Europe, and 5%
emerging markets. But I’m not at all convinced that a U.S. investor
should have had 70% of assets outside the U.S then, or even 50%
of assets outside the U.S. now.
Most of the academic community rejects the full market-weight strategy
but endorses a more sophisticated form of analysis to set the structure
of the global portfolio. The analysis involves the calculation of
an efficient frontier, which is designed to determine the
precise allocation of assets between U.S. and foreign holdings.
The goal is a combination that promises the highest return at the
lowest level of risk (i.e., the lowest volatility of return acceptable
to the investor). I am skeptical of this approach as well, for the
efficient frontier is based almost entirely on past returns
and past risk patterns. That bias may be unavoidable—after
all, history is our only source of hard data—but past relative returns
of stock portfolios and (to a lesser degree) past relative volatility
are hardly reliable harbingers of the future, and may even be counterproductive.
Consider how the global efficient frontier has shifted over time.
Ten years ago, the highest returns (+23%) had come from a 100% foreign
EAFE portfolio, the lowest from 100% in the U.S. (+17%). Yet in
the ensuing decade, precisely the reverse was the case—U.S. +18%,
EAFE +7%. Slavish reliance on history seems particularly flawed
in markets where currency fluctuations create substantial extra
risk—a special risk that no investor is obliged to assume. Further,
the idea that foreign stock markets do not have high correlations
with the U.S. stock market has in itself come into doubt. The fact
is that, while the correlation was indeed at low levels (about 0.20)
during the two decades ending in 1992, the correlation has since
leaped up to 0.60. Who is to say that, in an ever more global economy,
it won’t continue its rise to 0.70 or even to 0.80 or more in the
years ahead. So, as in all things, treat history with the respect
it deserves…no more, no less.
Further, extremely small variations in risk often separates the
optimal portfolio from those deemed less efficient. For example,
in the decade ended in 1989, the lowest standard deviation (60/40
U.S./foreign) was 14.4 percent, compared to 15.0 percent for both
a 30/70 mix and an 80/20 mix (purportedly the most efficient).
Conversely, in the 1999 decade, the 12.8 percent deviation for the
lowest risk (70/30 U.S./foreign) portfolio compared with the 13.4
percent figure both for a portfolio holding 100 percent U.S. equities,
and one holding 50 percent U.S.—allocations that are, well, worlds
apart. These tiny differences in volatility—in both cases, only
a half percentage point—are so small as to be almost invisible to
any real-world investor, particularly one who is not willing or
able to engage in the arcane methodology required for calculating
the standard deviation of monthly returns, even assuming that such
deviation is a valid proxy for risk. With all these weaknesses,
such analysis seems a wholly unwarranted triumph of process over
Did He Say "Gold"? Or "Alternative Investments"?
If the idea is truly to reduce risk (or to be clear, standard deviation)
by the introduction into the portfolio of asset classes with low
correlation to the U.S. market, what about gold? I may be the first
serious investor in decades to bring up the subject of gold as a
useful portfolio diversifier, but surely it fills the bill! (Others,
such as James Grant, discuss gold as an investment opportunity,
but I’m just not so sure.) Gold stocks have had a correlation of
about 0.05 with the U.S. market, doubtless the smallest figure for
any discrete sector of our market. A few decades ago, gold was considered
the diversifier, just as foreign stocks are in this more
recent era. So I emphasize that while diversifiers may serve a useful
purpose, investors are unwise to diversify their equities
ever more broadly merely for diversification’s sake. Rather,
we must consider the tangential relationship between standard deviation
and risk, the implications for long-term returns when we reduce
short-term risks, and the amount of real risk we are assuming.
In this context, I’d like to touch briefly on one more diversifier,
made especially popular in recent years by the well-publicized investment
strategies of some of the nation’s largest college endowment funds.
I am referring to alternative investments, including hedge
funds, venture capital, private equity, and real estate, all of
which appear to have low correlations with marketable stocks. These
endowment funds (also heavy users of foreign stocks) have undertaken
these alternative investments at the expense of their traditional
U.S. equity holdings. However, the record is not at all clear that
this more diversified bundle of equities has enhanced returns over
what a conventional 65/35 stock/bond portfolio, benchmarked to the
accepted market indexes, has provided.
What is more, many alternative investments have characteristics
that make them considerably riskier than U.S. stocks as a
group: the business risk of new enterprises, the financial risk
of real estate, the leverage risk of hedge funds. And foreign stocks,
too, carry larger risks, for the emerging markets, economic risk;
for many nations, severe political risk; for all such markets,
currency risk. I urge you to consider the wisdom of reducing short-term
volatility risk by assuming the substantially higher financial
risk in owning alternative investments in the portfolio. Let’s never
substitute the precise analysis of past data for the wisdom God
gave us to make sound judgments.
Dealing with Risk-Part III
Controlling Equity Exposure
A. Most reliable method of risk reduction
B. Deals with consequences, not probabilities
2. Risk Control
A. Benchmark Risk ("Style Drift")
B. Real Risk ("Losing a lot of Money")
So far, I’ve given you two strategies for dealing with risk in
today’s heady markets: (1) Getting your asset allocation right,
maintaining a long-term time horizon, and staying the course; and
(2) diversifying some risk away by introducing equities with reliably
different correlations with the U.S. market. But what if you can’t
afford to ignore risk, either because your clients are not prepared
to "tough it out" in the difficult markets we may face, or because
your client portfolios are not properly structured? And what if
you share my misgivings about the real protection available by diversifying
into what may be riskier asset classes in the paradoxical quest
to reduce the volatility risk of the equity portfolio? One major
option remains: Controlling risk by reducing equity exposure.
I conclude that the single most effective way to control risk
is by controlling equity exposure. For risk, as America’s risk
guru Peter Bernstein tells us in Against the Gods, "is about
mystery. It focuses on the unknown, for there would be no such thing
as risk if everything were known." Mr. Bernstein quotes Pascal:
"Which way should we incline? Reason cannot answer." In short, we
simply do not know, and probabilities—that darned "actuarial table"
again—do not give us the answer. He then notes, "outcomes are uncertain,
but we have some control over the consequences of what does happen.
And that is what risk management is all about." Put another way,
we must base our asset allocation not on the probabilities
of choosing the right allocation, but on the consequences
of choosing the wrong allocation.
Since I agree with that analysis, I am deeply troubled about how
the investment profession has come to define risk management today.
As Jeremy Grantham recently noted, "when money moves from the hands
of amateur investors to the hands of professional investors, the
concept of real risk is replaced by the concept of benchmark
risk." And so we have the eleventh commandment of investment management:
"Thou shall not permit style drift." The order of the day for investment
managers seems to be to limit variations from their benchmark style
so that their judgments won’t cost them their jobs. As a result,
risk control has come to mean, not controlling the client’s principal
risk, but controlling the manager’s career risk.
"Style drift" means that growth managers can’t buy value stocks,
nor can small stock managers buy large stocks. If the time horizon
is long, the variations moderate, and the principle of mean reversion
holds, avoiding style drift may not cause irreparable harm to a
portfolio’s investment returns. (However, I reiterate my own stock
preference for the "style" set by the total U.S. stock market.)
But when style drift comes to mean, as Mr. Grantham says, "above
all, that equity managers can’t buy bonds," there is an obvious
flaw in our system of capital formation. For bonds—diversified portfolios
of U.S. Treasuries and A or better corporates with little credit
risk—are, finally, the investor’s only real protection against the
most dire consequences of the inevitable uncertainty of equity ownership.
Consideration of bonds as an important asset class implicitly requires
us to recognize, as I quoted in Common Sense on Mutual Funds,
that "risk is not short-term volatility, for the long term
investor can afford to ignore that. Rather, because there is not
a predestined rate of return, only an expected one that may not
be realized, the risk is the possibility that, in the long-run,
stock returns will be terrible." Put another way, the risk is that
the investment portfolio might not provide its owner—individual
or institution—with adequate cash to meet future requirements for
essential outlays. In short, that the investor will lose a ton of
money, just when it is needed the most.
No one knows whether or not bonds will provide higher total returns
than stocks over the next decade or quarter century. But we do know
this: that bonds will produce far higher income. I don’t
mean to be a Luddite, but income remains important, and a bond portfolio
today, without compromising on quality, can produce a yield of 7
1/2%, $75,000 of income per million dollars of capital. An all-market
stock portfolio can provide a yield of only about 1%—a bit more
than $10,000. Even if its dividends grow at 6% per year, it won’t
be until 2036 until the stock portfolio pays $75,000, and until
2057 until the cumulative dividend payments aggregate to
the cumulative bond interest payments. In these days when it is
so easy to spend principal, it is easy to ignore income.
But I believe that this situation will prove transitory, not eternal.
Nonetheless, fixed-income investments are not only our only real
means of controlling risk, they are now our only real means of generating
income. In a world of box-car total returns on stocks, risk is often
ignored, bonds deemed irrelevant, and income old-fashioned. But
when the going gets tough, all three—risk, bonds, and income—will
come into their own again.
A Final Thought
And so ends this long journey through the thicket of risk and risk
control in an era of confidence, and perhaps even greed. I’ve spent
much time telling you why I think stocks are facing outsized risks
today, and the recent surge of market volatility may be the harbinger,
that after all these years, risk is again coming home to roost.
I’ve also presented three distinct means of dealing with equity
risk, from ignoring it, to reducing short-term volatility, to dealing
with real protection against losing capital when capital is most
needed. While I cannot give any investor a neat formula for risk
control, I am comforted to share that inadequacy with the likes
of Paul Samuelson, who tells us, "there is no way any professor
of economics or any minister of the church can tell you what your
risk tolerance must be."
No, nor can any Wall Street seer, nor any money manager, nor any
indexing advocate, nor even any grizzled veteran of 50 years in
this wonderful business.
to Speeches in the Bogle Research Center.