The friendly ghost of Peter Bernstein
When the great author, economist and market historian Peter Bernstein passed away in June 2009, the investment world lost a national treasure. To me, he was like the Julia Child or Jacques Pepin of the investment industry. For decades, Peter studied, practiced and researched economics and investment strategies, so that others could benefit from his work.
I still do. Often I find myself referring to his books, articles and interviews in my attempts to soak up his timeless wisdom. And with all the volatility in the markets the last month, I’ve been thinking about Peter Bernstein, probability and risk quite a bit.
Risk can be good or bad.
What is the role of risk in our lives and our society today? To hear Peter tell it, risk is a very broad, yet very simple concept. He didn’t define it the way many investors do as the permanent loss of capital. Risk to him essentially meant that we simply don’t know what is going to happen in the future. It could be good or bad. But the bottom line is that the future is unknowable. It always was and always will be. It’s worth mentioning that a lot of people in the investment world seem to forget this (the talking heads on CNBC, for example).
Another fact that many overlook is the long road to acceptance that Modern Portfolio Theory has traveled. The foundation for modern risk management came about in 1952 when Harry Markowitz floated the idea of a systematic method for portfolio selection that would begin to measure the trade-offs between a risk and return.1
Although it wasn’t immediately accepted, Markowitz’s Modern Portfolio Theory framework has been guiding institutional investors for decades. Of course, Peter Bernstein took Markowitz’s work into account and wove it together with that of many other mathematicians, economists and big thinkers over the centuries. His seminal book Against the Gods: The Remarkable Story of Risk explored many ideas, but it began with the belief that modern thinking started when humans let go of the idea that our fate was left to the gods. Yes, human beings actually did have some control over the outcomes in their lives.
Calming words on volatility.
And so it was that the idea of risk management and probability began to take shape as we know it today. Of course, behavioral economics has a part to play as we attempt to untangle our feelings toward risk and the markets and how we eventually act (or react) to the day-to-day movements we encounter. I have always found that the concept of volatility is far less scary in the presence of Peter Bernstein’s words.
Peter reminds us that risk is always out there. Some of us may have forgotten this after 6 plus years of relatively calm waters. From time to time, things are going to play out differently from how we expect them to. What are the consequences if you are wrong? How well will you and your clients be prepared to handle such an outcome?
As Frank Pape wrote in the most recent issue of Consider this, making sure your clients have a written financial plan can certainly help. And, as Peter Bernstein used to say, a well diversified portfolio should include some holdings that make you feel a little uncomfortable.2 How else would we know if we’re diversified?
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