Peter Bernstein: 'Always Ask: What If I'm Wrong?'

Last Updated Jun 17, 2009 5:39 PM EDT

Economist Peter Bernstein


Born in 1919, economist, author, and investment adviser Peter
Bernstein recalls the challenges of jump-starting the economy during the Great
Depression. Unfortunately, he says, that crisis has little to teach us about
the current one.

"With bubbles, there is always greed, and risk is
always dismissed, at least temporarily," says Bernstein, who has
written nine books on economics and finance, including Against the Gods.
In the 1970s, he was the first editor of the influential Journal of
Portfolio Management
.

Now this legendary financial historian believes all the market
theories of the past deserve a vigorous reexamination. "We've
moved into a dysfunctional financial structure, so you can't say
anything is working right," he says. "And I'm not
sure how we instill faith again in that system."

Editors' note: Peter Bernstein passed away in early June 2009. CBS MoneyWatch.com mourns his loss.

Okay, Peter, so how’d we get here?


There
are so many ways of saying the same thing. Of course, the word “greed”
comes to the top of the list. Greed has always been there.

In this case, it was
so easy to borrow, and people tend to follow the leader. There was a period of
time where we had no recessions and there was great confidence that the Fed had
inflation under control. We also believed there was this kind of understanding —
with Asia, and China, in particular — that we would buy their stuff
and they’d buy our bonds.

We had a low-risk environment. If so, it
was perfectly rational for someone to take a high risk — to issue or
buy a subprime mortgage, for example, a risky piece of paper. The appetite for
risk was high. In time, environments changed. With more and more people taking
higher risks, it’s no longer a low-risk environment. Now’s
it’s high-risk. The bubble burst.

Do you think Wall Street will radically change?


Yes.
And this concerns me, because even if we stop going down, getting out of the
hole will be difficult. Securitization — taking a bunch of loans and
bundling [them] as collateral as a bond and then selling that bond —
had a lot of rotten stuff in it this time. But it was a wonderful way of
expanding the capacity of the system to grant credit.

Didn't securitization cause the crisis?


Well,
saying that is like condemning the messenger because he brings bad news. It’s
true, but the system itself — the idea of securitization —
enormously increased the capacity to give credit. And rebuilding a banking
system that goes beyond taking deposits and lending money to people down the
street is going to take a long time. Economic growth needs credit.

What modern market theories need reexamining?


They all
deserve a reexamination. Everything has fallen apart in the crash. None of
those theorists ever said the market was macro-efficient, that the market as a
whole was perfectly valued. They said that stock A was perfectly valued
relative to stock B or the market. In this case, when the whole structure
crumbles, nothing is valued correctly. Capital ideas and all of portfolio
theory
dealt with markets that were much calmer; they weren’t totally
rational, but they weren’t macro-irrational to the degree it is now.
They depend on a financial structure that’s functional. Now we’ve
moved into a dysfunctional financial structure, so you can’t say
anything is working right.

What are the lessons for an individual investor?


The one thing
that was missing in the bubble, and is characteristic of bubbles, was asking
the questions, "What are the consequences if I’m wrong?" "What if home
prices stop going up?" These were never asked. Now investors need to ask
themselves, "If I sit on my cash for the next five years and I’m
wrong, what are the consequences?" I’m very gloomy, and I don’t
see a way out of this, but I’ll never be all cash.

Have you made big changes to your own portfolio?


We’ve
jiggered some things, but we still own stocks. We own some corporate bonds. We
own some municipal bonds. We’ve changed the proportion, but we’re
still exposed as broadly as we can be for our risk tolerance.

Is diversification still useful?


It’s
uncomfortable, because diversification ain’t what it used to be. A
lot of things are now moving in sync. The only things that went up were
government bonds; everything else went down. There was no place to hide
recently.

Should most investors own index funds?


Yes. That hasn’t changed. [ href="http://moneywatch.bnet.com/investing/blog/fund-watch/indexings-most-overlooked-benefit-consistent-returns/100/">MoneyWatch columnist Patrick McDevitt agrees.] The average investor doesn’t have the expertise or the time
[to manage individual investments], and it’s very expensive. There
are mutual funds that charge too much, too, and trade too much. That’s
why most of the mutual funds I hold are indexes. Places to look are where
diversification is broad and turnover is low. I don’t play any games.

So many experts steered us wrong. Who can we trust?


I sure as hell
don’t know. This is an experience that has no precedent, so nobody is
very smart on this occasion. I’m old enough to have lived through the
Depression. The Depression was caused by and magnified by things entirely
different. The Depression has very little to teach us. We’re really
flying blind.

So, is it time to buy stocks?


If
it’s an L recovery and not a V recovery, people are going to get very
impatient with the equity market. I’m just diversified across the
board and holding on.

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