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.