Continuing my in-depth examination of "The Investor's Manifesto," we'll examine Chapter 1.
A Brief History of Financial Time
Bernstein talked at length in his various prefaces about his desire to keep his books readable. This is the third paragraph of his first chapter:
“What I cannot figure out,” my friend began, “is whether investors are really smart or really stupid.” Seeing my puzzled expression, he continued, “Maybe the equity risk premium is still high, in which case prices will mean revert, which means that stock investors are really stupid. Alternatively, the equity risk premium has gotten a lot lower in the past 10 years, in which case prices will not mean revert, which means stock investors are really smart.” Just what did he mean, and why was his question so important?
I think Bernstein needs to get out more. I've been studying quite a few financial texts in the past few months, and yet I couldn't parse this at first glance. Bernstein recognizes that it isn't very clear, and helpfully translates this "into plain English:"
“In the past, stocks have had high returns because they have been really risky. But stocks are now so expensive that there are only two possibilities: either they are going to fall dramatically in price and then have higher returns after that (in which case investors are stupid for paying such high prices now), or there will be no big fall in price and little risk, but returns will hereafter be permanently low (in which case investors are smart).
Even this "plain English" version, I think, needs a little help. I had to read it a few times to get the nuances. The first sentence of the "plain English" explanation is clear. Risk goes along with reward. In fact, the only reason reward is there at all is to compensate investors for risk. Nobody would buy a stock (or a bond, or any other investment vehicle) if the reward was low and the risk high. This is exactly why people with poor credit have to pay a higher interest rate on their credit cards.
So stocks are expensive now (at the time of this anecdote). They can either get much cheaper, stay the same, or get more expensive. Because stocks are expensive at the time of the anecdote, there's little room for upward growth.
If stocks drop in value in the future, then present investors will lose money (are stupid), but future investors will have the opportunity to invest at a low price and get a higher return on their investment.
If they go higher or stay the same in the future, investors who buy now are smart, but future investors will get little return on their investment.
In the Beginning
All investment (whether it's you purchasing stock, you loaning a bank money by depositing it in a savings account, you loaning a company money by buying a bond, or a bank loaning you money by issuing you a credit card) is about a provider of capital, a consumer of capital, and the rate of return the consumer must give the provider to convince the provider of capital to do so.
There are two main types of deals in which capital is provided: debt financing and equity financing. In debt financing, you are loaning money to some entity at a specified rate of return. The risk you assume is the risk that the debtor will be unable to repay your loan. (Bonds are debt financing.)
In equity financing, you are buying a share of a company. (This is investing in a stock.) You get a share of the assets and of the future profits of the venture. Here your risk is that the company will do more poorly than you expect (giving you less return) or go out of business (leaving you nothing).
In modern investing, owners of bonds are paid back before owners of equities -- if a company is short of cash, the equity investors will be the last to receive any. This, of course, greatly increases the risk.
One other significant difference between debt and equity investing is that in debt investing, the return is defined. You will get a certain interest rate. In equity investing, you're guessing what the return will be based on your opinion of the company and of the economy in general.
For these three reasons—the increased possibility of loss, the difficulty of estimating future profits, and the residual nature of equity ownership—a substantial return premium should be demanded by equity owners.
This is why we mix bonds into our portfolios -- they give a lower risk than stocks, with a correspondingly lower return.
We now come upon a key term in the text -- equity risk premium. We
have stocks (equity) and bonds (debt). Stocks have a higher risk than
bonds, and thus a higher return. This difference in return should
exactly mirror the difference in risk between the two types of
Near Death in Venice
Here Bernstein examines the course of bonds issued by the city-state of Venice, Italy, over two hundred years. The lessons he takes from this apply very well to today's markets. When times were good, these bonds were expensive, and investors in them made little money. When times were bad (generally due to fear of losing various wars) the bonds lost much of their value, and investors who bought in good times lost a great deal of money.
Investors who purchased bonds while times were bad, however, were able to purchase their bonds at a great discount. This meant that they made a huge profit when times got better and bonds grew more expensive, but also means they would have lost everything had Venice lost one of these wars. The discount on the bonds was the investors' risk premium.
Bernstein points out that, "Among developed nations, recovery from military and economic travail is the rule, and very high returns are usually made by those brave enough to invest when the sky is blackest."
While this is true, Bernstein also points out that the risk is real:
Markets, however, do not always recover. Until World War I shut down the St. Petersburg exchange in 1914, the Russian stock and bond markets were among the world’s most respected and active. They never reopened. During the twentieth century alone, military and political upheaval rendered not just St. Petersburg’s bourse, but also many other once-vigorous securities markets, defunct, or at least moribund: Cairo, Bombay, Buenos Aires, and Shanghai, to name a few.
Is the US economy right now a version of Venice? Or is it a version of St. Petersburg? Bernstein thinks Venice, although he admits nobody will know until it happens.