Has this crisis shaken your belief in diversification and the modern
portfolio theory you developed?
First, we want to distinguish between
portfolio theory and some of these financially engineered products. Portfolio
theory, as used by most financial planners, recommends that you diversify, with
a balance of stocks and bonds and cash that’s suitable to your risk
tolerance. Contrast this with Australian municipalities that put all their
money into credit-default swaps. They’re bankrupt. That’s
why we need to be diversified.
What do you say to those who’ve lost the faith?
I think of each year of the S&P
500 as a random draw from a bushel basket that has the same probability as we’ve
seen since 1926 or so. The chief problem with the individual investor: He or
she typically buys when the market is high and thinks it’s going to go
up, and sells when the market is low and thinks it’s going to go
down. You have to be in the market and prepared when the recovery begins.
But a lot of asset classes now seem to move in lockstep.
Corporate bonds have a much smaller beta
than big-cap U.S. equities, which have a smaller beta than emerging markets.
[Beta is a measure of an asset’s risk compared with the broad
market.] If you look at 2008, emerging markets did worse than U.S. big caps,
and those big caps did a lot worse than corporate bonds or U.S. government
bonds. So if you were entirely in, say, emerging markets, your portfolio was
hit a lot harder than if you were diversified. Simple as that.
If you owned just government bonds and cash, you’d be in
pretty good shape. So why not market time?
I have to confess to having done quite a
bit of market timing recently myself. When Bear Stearns collapsed in 2008, I
decided to move partly out of equities. When the Federal Reserve cut the
interest rate by 50 basis points last year, I moved into commodities. By sheer
luck, I hit the commodities boom. I’m embarrassed to say I’ve
done some market timing. But as a rule, you cannot do it. I don’t
know anyone who’s done it regularly and gotten rich by market timing.
Should the average investor stick to mutual funds?
If the investor doesn’t have
enough time and skill to investigate individual stocks or enough money to
diversify a portfolio, the right thing to do is to invest in exchange-traded
funds that give you exposure to asset classes. It does make sense for the
individual investor to think in terms of holding individual asset classes. The
typical mistake for small investors is to pull out of the market.
Should investors be scooping up stocks on the cheap?
My unofficial
position is that next year is going to be really bad or really great, and I’m
leaning toward really great. But that’s just a feeling. And even with
that feeling, I wouldn’t shift very much. It’s kind of like
driving a car: You don’t pull your wheel too far to the left or too
far to the right. I would never be 100 percent in stocks or 100 percent in
bonds or cash. If you’re cautious, maybe 40 percent or 50 percent in
stocks. And if you’re optimistic, maybe 60 percent or 70 percent in
stocks. The rest should be in fixed income and maybe a little cash.
Do you think Bank Bailout 2.0 will fix the financial system?
I don’t think the bailout will
work. Nobody knows what these pieces of mortgage-related paper are worth.
Suppose that a bank had invested a lot of money in the Irish sweepstakes and
now has losing tickets. Should the U.S. now buy that bank? It makes no sense.
President Obama says we do not want to reward failures. Well, the way the
capitalist system works is, failures go bankrupt. Some say you can’t
let Citigroup go bankrupt. But suppose it did? We would have saved some money,
the company would have been split apart, and management would have been thrown
out. Those things are all likely to happen anyway, but now with the government
spending a lot of money. It’s a waste.
Will investors change their approach to risk-taking?
New players will always come in and say it’s
now a different ballgame. In five years, 10 years, there will be another bubble
and some people will say once again that this time is different. Then it will
burst.