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Peter Bernstein is the financial market's leading philosopher of risk. The octogenarian Bernstein, long an adviser to institutional investors, is known to a wider audience through his books explaining how modern financial theory operates in today's capital markets and how we can use it to shape our own investments. Among his best-known are 1992's Capital Ideas, an examination of how concepts developed in academia transformed Wall Street, and Against the Gods, a sweeping history of risk and return in the financial markets, published in 1996. Capital Ideas Evolving, a follow-up to the 1992 work, is due out this month. Contributing Editor Christopher Farrell recently caught up with Bernstein. The following are excerpts from their chat:How do you define risk?The definition is not mine, but I like it. It's from Elroy Dimson at the London Business School: Risk means more things can happen than will happen.
That means you don't know the limits of what can happen, but you still have to make decisions. So you manage risks by comparing them to potential returns, and through diversification.
Remember, just because more things can happen than will happen doesn't mean bad things will happen. The outcome can be better than you expect. Maybe a stock I own will triple.Does that perspective on risk affect how you look at today's market?It affects how I look at the markets anytime. It's difficult to assess the range of possible outcomes. I used to do scenario forecasts—four or five possible outcomes. I'd put probabilities on the forecasts, and they would add up to 100%. But that's not true because there is always something you didn't think of. When you're gambling, you do have the range of outcomes. In the markets, you don't.How worried are you about the subprime mortgage market?I'm worried, but I don't think the subprime market will upend the apple cart. The problems are too well-known.In late February a 9% drop in the Chinese stock market sent equity prices sharply lower around the world. Why?History is full of things like that, but usually there is more of a buildup. There was a week of significant decline before the 1987 market crash. There were declines before the 1929 crash. This time the market wasn't doing much—and then bang. Then again, investors seemed far more complacent about market risk this time around.How so?I have a sense that people have rationalized this as a period of low interest rates, low returns, and low risk. Investors are seeking higher returns and not worrying about it because we're in a low-risk environment. But we could also be in a low-return environment because we have overvaluation of assets.
I think what happened to the Chinese market, although peripheral in world markets, was a wake-up call that investors have been underestimating market risk everywhere.Where did the idea come from that we are living in a world of low returns?It started after the crash of 2000-2001, when we entered a period in which the rate of inflation seemed to be low and under control and likely to remain so because central bankers everywhere are hawks on inflation. A low-inflation environment relieves some uncertainty about the future, and less uncertainty encourages investors to make longer-term bets. In an environment where risks are low, the returns should be low, too.
In search of higher returns, a lot of investment pros went into alternative investments where expected returns are higher, and so are the risks. You see it in emerging-market returns. Now, some of this is justified by the fundamentals. These are no longer just emerging economies. They are part of the global markets. That said, the enthusiasm for these markets was overdone.What role are financial derivatives playing in all of this?The fall in 2000-2001 was a big one, but the financial system didn't blow up. The typical failure of institutions did not occur. I kept waiting for it to happen. It may be that the derivatives business did spread the risk. I don't know whether that will be the case the next time.So the derivatives are a big plus?Derivatives have become quite complicated, and there are a lot of inexperienced players using them. Here I worry.You recently wrote that over the long term, stocks are fundamentally less risky than bonds. Doesn't that fly in the face of conventional wisdom?Stocks are less risky in this sense: So long as a capitalist system persists and the financial markets hold together, equities do have a built-in long-term rate of return. That rate of return is a nominal measure of the economy. In other words, if the economy continues to grow, there is in the long run a positive return to equities. Bonds, on the other hand, are victims of inflation surprises. And you can't say there won't be an inflation surprise.Why don't investors expect a higher return from bonds than from equities?The reason is that a bond is a contract. It specifies a moment when the issuer has to repay the money. If a bond gets into trouble, the terms of the contract give bondholders some power and choice, since bondholders get paid back first. In sharp contrast, there is infinite uncertainty with equities. Equities are a claim on uncertain future earnings.Tell us more about Capital Ideas Evolving.The big story in the original book was how the guys in the Ivory Tower figured out what markets and investing are about. Ideas like the trade-off between risk and return, the efficient-market hypothesis, and diversification. But implementation was limited when I wrote the book. Now everyone is doing it—people like Nobel laureates Robert Merton and Bill Sharpe, Andrew Lo at MIT, Bob Shiller at Yale, all the big finance thinkers are making money from their ideas.But what about the idea that markets are efficient and can't be beaten?The efficient market is the benchmark. All these guys say how difficult it is to beat the market and that it's getting more difficult. David Swensen [chief investment officer for Yale University's endowment fund] went the unconventional route into alternative investments because he thinks conventional markets are too efficient. They're all aware of the limits of active management. They're trying to beat the market, and the ones I write about did it. By Chris Farrell