Here is the full transcript:
CONSUELO MACK: This week on WealthTrack- how you can win in what one of our guests calls a losers’ game- the stock market- and how can you protect yourself from financial peril? These two wise men of Wall Street have skillfully navigated many financial storms. We revisit the late, great Peter Bernstein, a renowned expert on risk, and Charles Ellis on timeless investment strategies, next on WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Sometimes, to understand the present, you have to revisit the past. That is what we are doing this week. We are re-broadcasting a WealthTrack classic, interviews we did with two of Wall Street’s wisest men: one sadly no longer with us, the other very much alive and contributing.
The year was 2006, two years before the financial crisis hit full force. But storm clouds were gathering for those experienced and attuned enough to notice. One of those was Peter Bernstein, universally considered to be the authority on risk. He was an economist, money manager, seminal financial thinker, historian and author of many books, including the bestseller, Against the Gods: The Remarkable Story of Risk
. His twice monthly analysis of the economy and the capital markets, Economics and Portfolio Strategy, was read by investors around the world. Even back in 2006, Bernstein expected relatively low returns from the financial markets in the years ahead. I asked him how we should invest?
PETER BERNSTEIN: As you know, I believe passionately in diversification, so you have a little bit of everything. The United States is kind of a very well worked over as an investment opportunity. So I think one goes abroad. Not only are securities abroad, both bonds and stocks, valued more cheaply than in the U.S. They're no bargains, but more cheaply in the U.S. But in the emerging market world, in the developing world, exciting things are happening. Countries that were once in the doghouse are on a roll now, largely because they're selling to us in such huge amounts. But even in Europe, which has been kind of laggard, things are stirring, governments are changing. Nobody notices this, but productivity growth in Europe is as good or better than in the United States. They're giving it away in the social safety net rather than in growing their businesses. But this is beginning to change. And I think if something happens there, there's huge opportunities. We see Japan finally coming up out of the doldrums.
So I think the opportunities are outside the U.S. Somebody once said to me, you're not diversified if you're comfortable with everything that you own. And we're always comfortable with what we know. We buy, we live in New York, we buy Con Edison. If we live in California, we buy the California utility. But that means going outside the U.S. is very important. And it's a big part of the world now. It's not a little peripheral thing. It's a major part of the world.
CONSUELO MACK: Now, let me ask you about that, Peter, because I know one of the things that you have advised clients, and you and I have talked about before as well, is the importance of being well diversified, and having a little bit of everything. And as kind of the least risky way to go, and also the best way again, to get the kind of returns that we expect more, that we want from our investments. But, so how should we diversify, though? Because the average U.S. investor has probably, you know, 60, 70, 80% in stocks. We've been fed this mantra that stocks provide long term growth, that's where we should be. You disagree with that. About U.S. stocks at this point. But how do we diversify then? What should we be investing? I mean do so asset allocation for us.
PETER BERNSTEIN: I mean I guess, today I would have no more than half my assets in the U.S. if I was starting fresh.
CONSUELO MACK: In U.S. stocks.
PETER BERNSTEIN: Well, the U.S. stocks, maybe even U.S. stocks and bonds. One can do this quite easily. There are exchange traded funds- all kinds of, almost anything that you want. And exchange traded funds that will offer a whole big piece. For instance you can buy all the stocks in the world outside the U.S., and similarly, you can buy bonds outside the United States. And there's one for gold. If you do, just go to iShares on the Internet. They have a very easy, easy site to work with, and to look. So I do not think that individuals say, I wonder what French stock I should buy, or what German stock. I wouldn't dare do that myself. So it should be done in funds. And these are the best ways to do it. It's worth looking at.
CONSUELO MACK: And talk a little bit about one of the things, again, one of your major themes has been in investing is that dividends matter.
PETER BERNSTEIN: Yes.
CONSUELO MACK: So dividends have mattered historically.
PETER BERNSTEIN: Yes.
CONSUELO MACK: I think the returns, the stock returns from reinvested dividends is, I don't know, 50%.
PETER BERNSTEIN: Yes, that's right. That's right.
CONSUELO MACK: But in this day and age, with stock payouts low, and dividend yields low, do they matter as much, and will they matter as much in the future?
PETER BERNSTEIN: Yes. I think they matter, first, because it is cash in your pocket. And at a time when, who knows what earnings are, there's been so much hanky panky all the way. Now they're going to start expensing options, so that it gets a little more complicated. This, at least, you know what it is. And you can make more of a judgment about a stock, the growth rate dividends. But dividends at this point, I think, have two positive features that deserve attention. One is the tax rate is the same as on capital gains, 15%. Not a big number. I mean it's 85% is yours.
CONSUELO MACK: Right.
PETER BERNSTEIN: And the other is that because the payouts are so low, and because of the tax thing and so forth now, there is pressure for companies to increase their payouts. I think dividends are going to increase faster than earnings. So if you're in something where you think the earnings growth is there, and the dividends, that it is important. It is an important consideration. Even Microsoft is paying a dividend.
CONSUELO MACK: Yes, they are. They paid a big one as a matter of fact. Let me ask you about that point. Because a lot of analysts, or strategists that one talks to, will tell you that the companies that keep earnings, and don't pay them out in dividends, you know, they can grow faster, and you know, they'll give you better growth over the long term. You have found through your research absolutely the opposite.
PETER BERNSTEIN: That's correct. That the lower the payout, and the bigger the reinvestment, the lower the future earnings growth. There's nothing like having management a little starved for money. Because then they will only choose the best investments. Best things to do, if they've got lots of it. If they're plowing back most of their earnings, oh, boy, that's like, in a ... I forgot the metaphor. But they can just pick anything. So they will be making less than optimal investments, because they have so much money. That's how it works. Managements like to have money. They like to be expansive. They like to add the power. And there's more discipline when there isn't as much. This is a lot about the whole buyout business of the 1980s was about- corporations accumulating too much cash, and not using it properly. The companies that have to go into debt in order to expand will be much more careful about what they do. Much more selective in what they invest in. That's very important.
CONSUELO MACK: A couple of more questions. You wrote a book about the history of risk. What you know, when you and I have talked, you were actually, it strikes me that you're an optimist.
PETER BERNSTEIN: Yeah, I really...
CONSUELO MACK: And why, given the risks that all of us toss and turn about every night, why are you essentially an optimist?
PETER BERNSTEIN: I'm an optimist about the U.S. But I'm an optimist because problems do get solved. Maybe not one day you wake up, and everything is back in order. But it takes an awful lot to crush a system as vital, in many ways as flexible, as the U.S. economy. We went through, in 2000, when the bubble burst. I mean the bottom really dropped out of NASDAQ, and a big drop in the U.S. market, too. And word about bankruptcies, and people were saying that the derivatives were going to pull the whole... nothing bad happened, really. I mean, Enron, all of the scandals, those companies disappeared. We kept right on going. Now this Revco, an enormous, really terrible failure, though it's a ripple. So there's a lot of resilience. There's a lot of youth in this country; a lot of new people coming in, who want to be part of it. Sure I'm an optimist.
CONSUELO MACK: So, one last question. And what is the ... for individual investors, for successful, long term investing, what should our philosophy be? I mean what should our mantra be? What should our approach be, to really take advantage of the vitality that you see in the capital markets?
PETER BERNSTEIN: Well, the vitality, I mean vitality you get in the equity markets. I mean there's no question about it. You must be there. All the scare stories about what might happen and so forth, you should still have some money in the equity markets. This is essential. As I say, I think big things outside the U.S. also. I am- since I don't like stock picking, and I'm not very good at it- a big believer in funds, rather than in trying to do it yourself. And although- this occurred to me the other day- the mutual fund industry has been criticized, because their returns aren't good enough, and so on. How much worse, the people who were in mutual funds, may be disappointed with what happened. But if they'd managed that money themselves, I know they would have done worse. So this may not be divine and perfect. But it's better than doing it yourself. It's worth the cost.
CONSUELO MACK: Peter Bernstein, thank you so much for your time and your just, brilliance. Thanks for sharing it with us.
PETER BERNSTEIN: Thank you.
CONSUELO MACK: Our second wise man of Wall Street is Charles Ellis. Charley is the founder and former managing partner of the international consulting firm, Greenwich Associates, from which he advised the world’s leading financial firms on strategy for decades. He’s found time to author 15 books, including Winning the Loser's Game, Fifth Edition: Timeless Strategies for Successful Investing. And he’s also taught at Harvard and Yale’s business schools. He has chaired Yale’s investment committee, which oversees one of the best performing endowments of all time. I talked to Charley about why he thinks Wall Street is a loser’s game for most individuals.
CHARLES ELLIS: Active investing is the Loser's Game, and the reason I call it Loser's Game is the outcome is determined not by the winner but by the loser. And I like to use the analogy of tennis. The way some people play tennis. The winners with 120-mile-an-hour serves and brilliant shots at net and terrific placement, they win points. Game I play, we lose points. And who will come out ahead is determined by the person who loses the most points makes the other person the winner. And if you're in a Loser's Game, it's important to know the right ways to play that game.
Give you another illustration. Teenage driving is a Loser's Game. The kids all think if they're really good with their steering, if they really take off when the light changes, if they're clever about finding ways to bob and weave in and around traffic, that's great. But as the father of a teenage driver, or the mother of a teenage driver, what do you really care about? Only one thing. No serious accidents. No serious accidents, your kid is a great driver. And if it's my kid that's driving your daughter, and my kid has no accidents, you're very glad to have your daughter in my car. Same thing with investing. Active investing is, the outcome is driven by the behavior of the person that winds up, while they're trying to get it right, trying to win, trying to get ahead, they wind up doing themselves more harm than good, and the net result is they lose relative to the market.
CONSUELO MACK: Why is that? What is it that individual investors do in trying to manage their portfolios that puts them in the Loser's category? And you know, who are the winners, number one? And define what you mean by winning in the market.
CHARLES ELLIS: Well, to me, winning in the market is truly getting the results you really, really want, that are right for you over the long, long, long term. And I think of investing much more like marriages and most people who are active investors are doing more dating. And I have nothing against dating. But great relationships will be developed only by having a marital commitment and working together to have something of real importance take place. And I think anybody's been married understands. This is a real difference, and none of us who are married want to go back to dating. Same way of investing. If you will think carefully about what are your real, long-term objectives and find a way to articulate those objectives, you can then find investments that match with what you're trying to accomplish. And you'll be relatively happy all the time and over the long term you'll be very happy.
CONSUELO MACK: So, when I think about objectives, you're talking about more than just, "I want to make money in the market." You're talking about really establishing an investment philosophy and discipline is key and then going out and seeking out the investments that will fulfill those goals.
CHARLES ELLIS: True.
CONSUELO MACK: Is that right?
CHARLES ELLIS: Yes. Most of us, most of us, our first objective is to not lose.
CONSUELO MACK: Actually...
CHARLES ELLIS: What Mark Twain used to call return of the money and then return on the money is the secondary thing.
CONSUELO MACK: So, that should be our first objective, is not to lose, as opposed to win?
CHARLES ELLIS: Yes.
CONSUELO MACK: Which is the way most people go about it. All right.
CHARLES ELLIS: Because we're human beings, we do a whole bunch of stuff that there's now in the field of economics being described as behavioral economics, we do crazy things that are not in our best interests. But that's who we are. So might as well accept that that's who we are and find a way to live with who we are. Those of us who get nervous when prices are coming down ought to study. You know, when prices are coming down, they're less costly. You can buy more value for less money. This is actually, although you're uncomfortable, it's good news, and those of us who get excited about, "Look, my stock is going up, it's really going up." Well, yes, that's right. But, Charlie, in the long run, if it's gone way up, what's the destiny? The destiny is, it's going to come back to its average, long-term value to price relationship. It probably will come down. So it's not necessarily good news for you that the stock has gone way up in price if you're a long-term investor, and I'm only interested in being a long-term investor.
CONSUELO MACK: So, for long-term investors, you are a big proponent of index funds versus actively managed funds.
CHARLES ELLIS: I am.
CONSUELO MACK: Why? Why index funds; why not just go with the market?
CHARLES ELLIS: The data shows over and over and over again that most all active managed funds underperform the index, a sensible index. Now, if you're a small-cap value manager, active, the right index to compare against is a small-cap value index. Not high-growth, high-priced index. You have to choose your index. But if you choose the right and fair index, 75 to 80% of the active managers over every ten year period underperform, plus- and this is worth keeping in mind- you have higher taxes because the turnover is pretty rapid, and so, you're getting short-term taxes as well as more frequent long-term taxes. Index funds don't do much. So they don't have much taxes, and the combination of low fees, low taxes, and low errors, index funds keep coming up with a better result.
CONSUELO MACK: There are tons of index funds being created as we speak. The exchange-traded funds, which are index funds that trade like stocks, you know, I feel like there's one being created every day practically. How do you pick the best index fund, number one, and what kind of diversification should you have in your index fund portfolio? Again, thinking as a long-term investor?
CHARLES ELLIS: Well, you're asking several different questions at the same time. So, I'll try to--
CONSUELO MACK: Yes. I am. Sorry.
CHARLES ELLIS: --pick it up. Now, first thing in index funds, you want to be with a highly-reputable index fund manager who has specialized in this field, has become proficient at it, because if you're really good at doing index fund management in your trading activities, you'll be a little bit less costly than anybody else. Secondly...
CONSUELO MACK: So, names- Vanguard, for instance.
CHARLES ELLIS: Vanguard, with whom I'm associated because I'm a director. I became a director because I so admire the work that they do. It's not the other way around. But they do a great job. Second would be that the fees are low. It's really upsetting to me, again, I'm back to Vanguard, they've got a low-fee strategy towards life, and their concept of value-delivered service to investors. Low fee of ten basis points. You get to some index funds .Exactly same index fund. Now, ten basis point but 100 basis points. And you'll never get that money back. And you're not getting anything for it. You're just paying up for nothing.
CONSUELO MACK: So, don't pay them basically and those costs can really add up over time?
CHARLES ELLIS: Over the long, long period, they do add up.
CONSUELO MACK: So, second part of that question: Asset allocation. Very important, right, for long-term investment results?
CHARLES ELLIS: Yes. If you think about your children or grandchildren or the people that you love and care about the most, and you said, "Okay, I could give them the ability to pick stocks really well or I could give them the ability to pick managers really well, or I could give them the ability to know which kinds of stocks to be investing in or whether to go international or go emerging markets or go large cap or go small cap, or I could help them get the asset mix right." So, okay, those are five different decisions. I could get only one of them. They're going to get, like, the others will get average experience. Which one would you choose? Absolutely- asset mix. If you get the asset mix right, you'd have to make a major mistake to get anything negative to get a bad result in the whole. Get the asset mix right, most everything else can take care of itself. Get the asset mix wrong. You don’t have a chance.
CONSUELO MACK: How do you get the asset mix right?
CHARLES ELLIS First, understand who you are and understand what the money's purpose is in your life. If you're a very wealthy person, you're probably investing for philanthropic institutions that you're going to give money to or your grandchildren and their children and their children's children. Think about it that way, you'll probably be entirely involved in equity investing. If, on the other hand, you have a modest amount of savings- maybe it's in your 401k plan, maybe it's in your own investment account- and it's probably enough to make it through your life with financial security, then you should be more protective. If, as a human being, you just do like stability, you don't like the ups and downs of the market, accept who you are and behave accordingly.
CONSUELO MACK: Final question. Actively managed funds, which, you know, many investors follow slavishly. How do you handle the actively managed funds? Do you invest in them at all? Under what circumstances? What percentage of your portfolio should you put with an active portfolio manager?
CHARLES ELLIS: The last question about what percentage. That's a matter of personal judgment. The fundamental proposition that I would put to you is if you're going to choose an active manager, choose someone that you'll stay with for at least 20 years. If you're going to stay with a manager for 20 years, you're not going to choose because of their recent performance, you won't choose because of the stocks they own now. Those will all be replaced. You won't choose because of the individual fund manager. He or she will be replaced. You will choose character or culture or the value set of the organization. And as you know, and just slip in, I think there's one such organization. They manage the American Funds. It's called the Capital Group Companies. And I wrote a book about it because I wanted to understand: why were they so able over every long time period to outperform and compete so successfully? And I believe they understand how to manage professionals in such an effective way that they will achieve very substantial results. So, if you wanted to tease me a little bit, my wife owns the American Funds. And I own the Vanguard Index Funds. And we get along fine.
CONSUELO MACK: And the reason the American Funds- and Capital is the name of the book- that they do manage so successfully, why is it? What is it about them that’s enabled them for 75 years to do so well?
CHARLES ELLIS They start with a very strong conviction. Their purpose, and they recruit for it, and they train for it, and they believe it in deeply; they drink the Kool-Aid, as they say. Their purpose is to serve the individual investor- full stop. It is not to make money for the people who are working there, to make money for the owners. That is not their objective. Their objective is to serve the investor, and, as a result, they do some very interesting things. For an example, when money market funds first came out, they would not introduce one. Why not? Because they were afraid that money market funds came out in the early mid ‘70s, and that was the worst time to move out of stocks and into cash. And they didn't want to make it easy for people to make that mistake. So, they wouldn't offer them. Then, as a result, their investors stayed more in equities and get the ride in the best bull market the world has ever seen.
CONSUELO MACK: Charles Ellis, it is a treat and an honor to have you here. Thank you so much.
CHARLES ELLIS Thanks.
CONSUELO MACK: At the conclusion of every WealthTrack, we try to leave you with one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: put the power of dividends to work in your portfolio. Over the last eight decades, dividends have accounted for more than 40% of the total return of the stock market. How do you invest in dividend paying stocks? Obviously you can buy companies that have a history of paying and increasing dividends year after year. Standard & Poor’s publishes a list of what they call their Dividend Aristocrats- stocks with a 25-year history of increasing dividends. If you prefer mutual funds, you can buy an equity income fund or an ETF, such as the Morningstar recommended Vanguard Dividend Appreciation ETF- the symbol is VIG. The key to getting maximum returns from any of these investments is by reinvesting the dividends, thereby unleashing the power of compounding over time.
That concludes this edition of WealthTrack. Next week, we’ll be discussing how to maximize your benefits from social security with retirement income guru, Mary Beth Franklin. It turns out that timing is everything. Thanks for watching and make the week ahead a profitable and a productive one.
