William J. Bernstein - "The Investor's Manifesto" - Chapter II

November 28 2017

Wer nicht wagt, der nicht gewinnt! (Nothing ventured, nothing gained.) ~ Johann Karl August Musäus

This chapter is all about failure and how to avoid it (maybe) and a reminder that the whole point of investing (and deferring present consumption) is to have the ability to consume in the future.

CH. II - The Nature of the Beast

Bernstein starts out with recent scares. The infamous dot.com bubble collapsed the stock market in late nineties and early 2000s. Every stock class that was not a dot.com business suffered.

Both real estate investment trusts (“REITs”) and small stock bloomed post-crash.

We thus learn of bear markets. A bear market is a pessimistic market, such as a recession. The two recent examples are the 2000-2001 dot.com bubble, in which tech companies turned broke and the 2007-2008 global financial crisis in which, contrary to the dot.com bubble, consumers turned broke and all stock classes were affected.

Bernstein warns that those examples must alert us to the necessity of diversification. One never knows what the market might do, so one must focus on the long-term instead of short-term gambles.

Next, we get a useful lesson on how to estimate future returns.

  • Don’t rely on past returns to estimate future ones. Knowing history will prevent making known mistakes; it does not predict future successes.

  • To estimate future returns, one must use ones best guess of what realized returns will be. Some maths to do so (known as the Gordon Equation):

For Bonds =

Expected Return = Interest Coupon - Failure Rate

For Stocks =

Expected Return = Dividend Yield + Growth Rate (of dividends)

One is to always consider return in real terms, that is in after-inflation terms.

Many people assume that by buying a house, they have made an investment. Bernstein begs to differ. Property is an item of consumption. If you must buy, he says, do not pay more than 15 years of fair rental value for a home.

I thought this was a neat little pointer, so I conducted some very brief research into the area I live in (surburban South Australia) and check what 15 years of fair rental value would get me.

(I’m aware that Bernstein writes with the US in mind, so this is just a fun little diversion.)

I started out by using the most popular real estate site in Australia: www.realestate.com.au

Upon entering my suburb, the only filter applied was “2 bedrooms”. The area does not commonly have flats, so most results will be for houses or units.

Firstly, there was all but one place with two bedrooms, all others came up as three bedrooms. Of the eight options, the cheapest was AU$295 per week and the most expensive AU$415. This averages to approx. AU$310 per week.

A year has approx. 52 weeks, so we are looking at AU$16.120 per year.

It follows that our house should not cost more than AU$241.800.

I’ve checked if this would be possible in my area and was surprised to see that yes, you can buy a place in this price range. You just have to be quick (and willing to live on a main road).

It seems that perhaps the difference in house prices is too large between the US and Australia to really apply the 15 year-reasonable rent value rule but it isn’t too far off, either.

Back to business and a somber consideration:

The efficient market hypothesis (“EMH”) states that all information about security has already been factored into its price. Consequently, stock picking is futile because stock prices only move in response to new information.

Lessons: Diversify, for bears are always a-coming. Gordon helps with returns and old news is useless.