Sunday, October 18, 2009

Efficient Frontier and William Bernstein

Last week we had polymath William Bernstein (finance thinker, author, portfolio manager, former neurologist and Berkeley PhD in chemistry) on campus for a seminar. I'd been a reader of his site Efficient Frontier for many years, and when I learned by chance that he lives in Oregon, invited him to visit.

Here is an Amazon link to Bernstein's books -- ranging from practical investing advice to histories of global trade and of the birth of prosperity in the modern world.

Below is an excerpt from the preface of his new book.

... I have come to the sad conclusion that only a tiny minority will ever succeed in managing their money even tolerably well.

Successful investors need four abilities. First, they must possess an interest in the process. It is no different from carpentry, gardening, or parenting. If money management is not enjoyable, then a lousy job inevitably results, and, unfortunately, most people enjoy finance about as much as they do root canal work.

Second, investors need more than a bit of math horsepower, far beyond simple arithmetic and algebra, or even the ability to manipulate a spreadsheet. Mastering the basics of investment theory requires an understanding of the laws of probability and a working knowledge of statistics. Sadly, as one financial columnist explained to me more than a decade ago, fractions are a stretch for 90 percent of the population.

Third, investors need a firm grasp of financial history, from the South Sea Bubble to the Great Depression. Alas, as we shall soon see, this is something that even professionals have real trouble with.

Even if investors possess all three of these abilities, it will all be for naught if they do not have a fourth one: the emotional discipline to execute their planned strategy faithfully, come hell, high water, or the apparent end of capitalism as we know it. “ Stay the course ” : It sounds so easy when uttered at high tide. Unfortunately, when the water recedes, it is not. I expect no more than 10 percent of the population passes muster on each of the above counts. This suggests that as few as one person in ten thousand (10 percent to the fourth power) has the full skill set. Perhaps I am being overly pessimistic. After all, these four abilities may not be entirely independent: if someone is smart enough, it is also more likely he or she will be interested in finance and be driven to delve into financial history.

But even the most optimistic assumptions — increase the odds at any of the four steps to 30 percent and link them -- suggests that no more than a few percent of the population is qualified to manage their own money. And even with the requisite skill set, more than a little moxie is involved. This last requirement — the ability to deploy what legendary investor Charley Ellis calls “ the emotional game ” — is completely independent of the other three; Wall Street is littered with the bones of those who knew just what to do, but could not bring themselves to do it.

It's a sobering thought that so few people make competent money managers, given that most Americans now manage their own retirement accounts. During dinner, we refined his estimate (taking into account correlation) of the fraction of competent investors to about 1 in 1000.

Although I had thought about this question in the past, and even identified the various factors, it hadn't occurred to me until dinner with Bernstein that this was a good reason to suggest finance as a career to someone who has the right interests (history, finance theory, markets -- relatively easily acquired, as these subjects are fascinating), personality factors (discipline, controlled risk taking, decisiveness -- not so easily acquired, but can be improved over time) and intelligence (not easily acquired, but perhaps the threshold isn't that high at 90th percentile). No one factor is particularly rare, but the combination certainly is. As long as the signal to noise ratio in a financial career is reasonable, a person with all these qualities can be confident of success. While only a few people will ever run a hedge fund, it would seem that almost everyone could benefit from help managing their money -- if the advisor has all the qualities listed above.


rps said...

For the average person who knows that he doesn't know, can't he just follow John Bogle's advice and expect to do alright?

Unknown said...

ummm, he made those numbers up. like, he totally just pulled the whole 1/1000 thing out of his ass. and i am supposed to take someone seriously who wont even do the footwork to find statistics that defend his line of thought? please.

Anonymous said...

It's hard to tell who is a "good investor" because for most of us "investing" is really "total net worth management."

I'm not going to tell you mine, and I don't expect you to tell me yours. You might tell me a trade or two, and I might tell you how I've faired in this or that "mental account."

Neither would I expect data mining in brokerage or mutual fund account to tell us anything useful.

We only hear small parts of the picture.

That said, I think I'm a bit of a pessimist. I think a long bull market can raise all boats, but outside of that happy circumstance, I'm not sure most investors do all that well.

Steve Hsu said...

I think there are many academic studies (I seem to recall one using ETrade data) showing that small investors do very poorly (have negative alpha).

This is certainly reinforced by situations where I actually know the trades conducted by people close to me (my wife, mother, in-laws, etc.).

It's true, the average person could follow Bogle's advice and do well, but *how many actually do*? (How many people are still overpaying for crappy active management?)

The 1 in 1000 figure is for someone who would be advising others on investments, or running large sums of money, and may have to tailor the strategy to different risk profiles, situations, etc.

Anonymous said...

Strangely enough, if you only looked at my eTrade account, I did crazy-good. That was the account that received my dot-com options.

Who knows though, since I sold down the back side of the dot-com boom, maybe I made $$$ while having negative alpha.

I've more or less held my own since then (telling you very little), depending on which inflation metric I choose.

Going forward I lean towards the Bogle plan, but recognize that it is sensitive to entry points and bad decades thereafter.

Ian Smith said...

I really do satisfy all Berstein's criteria (and have done well) so I know he did "pull those numbers out of his ass".

But, it's all irrelevant, because though I have the GMAT, I don't have the resume to get into a good B-school, and therefore it will take decades to get rich.

My "strategy" is simple: Buffet + hedge shorts + leverage. That is, I zero out the beta in the portfolio and leverage the residual (alpha). Knowing how to do this doesn't require mathematical brilliance, but it may still be that only 10% can do it.

DaveinHackensack said...

Benjamin Graham disagreed with #2. From p.570 of the revised edition (edited by Zweig) of The Intelligent Investor:

"In forty-four years of Wall Street experience and study I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra".

I disagree for an additional reason: the problem with adding probability into the mix (e.g., the Kelly Criterion) is that it depends on subjective inputs anyway.

The rest of the abilities Bernstein mentions ring true, and except for the last one, they aren't especially rare or difficult. The last one can be aided by holding a cash cushion and not running a long-only, unhedged portfolio. An investor who has some hedges and short positions will have options when the world looks like it's about to end.

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