Risk Is A Choice Rather Than A Fate Common sense, a wise man once declared, isn’t all that common. Wisdom is even less common, as it is an uncommon accumulation of common sense. Wisdom does exist, however, and it is an unalloyed pleasure to be in its midst. No, I’m not talking about Bill Gross, even though he is most definitely a wise man, and I enjoy being in his midst. He does not suffer fools gladly, and suffers foolish puckering even less gladly.

Rather, I’m talking about Peter Bernstein, a veritable fountain of wisdom in our business, known most famously for his 1996 book, Against the Gods: The Remarkable Story of Risk . Peter doesn’t suffer gratuitous groveling any more than Bill, I’m sure. But since Peter’s not my boss, there can be no suspicions surrounding my calling him wise. It is simply the truth. Peter is also my friend, a remarkable story of its own, at least to the two of us: Peter and I are, you see, huge fans of rabbits.

I confessed my own fondness for the furry little creatures in this space in February 2000, in a tract titled “Me and Morgan le Fay. 1My essential thesis was that Ms. Morgan, my (son’s) beautiful Netherland Dwarf bunny, and the equity market shared many characteristics: boundless exuberance and a passion for mischief. Ms. Morgan and Mr. Market were different , however, in that my family openly acknowledged and embraced Ms. Morgan’s frivolity, while the public openly denied that Mr. Market was blowing bubbles.

A couple of weeks after publishing that missive, I got a most fascinating letter from Peter, regaling me with a wonderful narrative as to his own happy experiences as the proud owner of rabbits, starting with his very first, Prospero, so named in honor of his first book, Price of Prosperity , in 1962. Indeed, Prospero becoming a Bernstein was literally a matter of celebrating the book, as Peter spied her in a pet store on the walk home from a celebratory Sunday brunch. Fortified with a nip or two, as was the unapologetic New York convention thirty years ago, Peter took her home and has been a rabbit fancier ever since.

In that first letter, Peter never mentioned economics or markets at all, but simply introduced himself in a remarkably warm and personal way. Peter is from the school of thought that a personal letter is not just a phone call on paper, but a literary work, an act of essential giving from the writer. We’ve been pen pals ever since, and I treasure our correspondence. That first letter is framed on my office wall, opposite a one-sentence note of kindness from Alan Greenspan in 1993.

The Ten-Year Trailing Risk/Reward Quotient For Stocks
Looked Much Better At The End Of Last Year Than It Does Now

Figure 1 is a line graph mapping the risk versus return for asset classes for 10-year trailing periods for three categories: the S&P 500, 7-10 year U.S. Treasury notes, and 3-month Treasury bills. Four 10-year periods are shown, marking the risk/reward for each asset class, plotted on the graph, with each plot connected by a line. Return, expressed as the average of rolling 12-month returns, is scaled on the Y-axis, and risk, expressed as a standard deviation of rolling 12-month returns, is scaled on the X-axis. The plots for a line representing September 1991 to September 2001 show a lower line than that of the period for December 1990 to December 2000. The big difference is the S&P plot: for the period ending in 2001, it has a return of about 14%, and risk of 14%. But the plot for the period ending in 2000 is better: a return around 16% with risk around 11.5%.

  Figure 1
Source: Bloomberg 

Beyond that, Peter and his lovely wife, Barbara, graciously invited my family to visit them this summer at their home in Vermont, near where Morgan le Fay’s notional owner, my son Jonathan, goes to summer school. It was a delightful time with Peter, listening to an intellectual giant speak plainly, yet elegantly, about life as a journey to be enjoyed, rather than a problem to be solved. Barbara’s warmth and joy punctuated their obvious love of each other, underscoring the wisdom of Peter’s affection for life.

While musing about rabbits more than two grown men probably should, Peter and I actually mostly banter about economics and markets. And we usually start with the essential macroeconomics of Keynes, as revealed in the General Theory , published in 1936. We chuckle as to the great difference in moods of the economics profession between the time we each first read it.

Peter had the privilege of doing so in 1937, just one year after it was published, and as his professors at Harvard – including the greats Joseph Schumpeter and Alvin Hansen — were struggling to figure it out. By the time Peter graduated, the economics profession, led by Hansen, had embraced the essence of Keynes: If and when the private sector loses the will and wallet to invest, driving the economy into an enduring state of underutilization of human and tangible resources, it is the duty of the public sector to put its wallet into deficit, so as to support aggregate demand.

In contrast, I read the General Theory for the first time in 1977, when the economics profession was rejecting Keynesian thought as a surefired path to stagflationary ruin. Monetarism was all the rage, and Supply Side economics, whatever it is, was percolating in the still. What a difference forty years makes!

But Peter is still a card-carrying Keynesian, and so am I. And while our joint affection (or affliction!) for Keynesian macroeconomic thought holds in a general way, it holds in a specific way in top-down, macro-driven investment strategies. And the starting point for discussion is inevitably Chapter 12 of the General Theory, “The State of Long-Term Expectation.”

While most of the book is as thick as a Guinness to a Coors Lite man, imponderable and unappetizing to anybody but a connoisseur of economics, Chapter 12 is an explicit detour into the psychology, rather than the arithmetic, of investment and investing. In Keynes’ words, Chapter 12 is “a digression on a different level of abstraction” than most of the book.

Keynes, you see, wasn’t just an economist, but an investor and speculator. He defined investing as “forecasting the prospective yield of assets over their whole life,” and speculating as “forecasting the psychology of the market.” And, he declared, analyzing the intersection between two “should not lie beyond the purview of the economist.”

Peter and I are spending our careers trying to prove Keynes right on that score! The economist need not be, and should not be, a potted plant on the windowsill of market psychology, as if the sentiment of the market was but noise generated by the machinery of commerce. Quite to the contrary, Keynes argued, the “state of long-term expectation” is actually a short-term variable that dominates the course of long-term investment:


“The daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investment between one individual and another, inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; while there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit.”

As I’ve noted before2 , that one passage from Keynes is the essence of Nobel Laureate James Tobin’s famous “Q” – the market value of a company versus the replacement value of its assets, acting as a determinant of whether entrepreneurs buy or build. Pondering that concept before Tobin gave it a letter, Keynes asked:


“How are these highly significant, even hourly revaluations of existing assets carried out? In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth a convention (Keynes’ emphasis). The essence of this convention lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reason to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely.  The actual results of an investment over a long term of years very seldom agree with the initial expectations. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance, errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equiprobablities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities.

We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct (Keynes’ emphasis) in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct , since our existing knowledge does not provide a sufficient basis of a calculated mathematical expectation.

In point of fact, all sort of considerations enter into the market valuation, which are in no way relevant to the prospective yield. Nevertheless, the conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affair, so long as we can rely on the maintenance of the convention (again, Keynes’ emphasis).

For if there exists organized investment markets and if we can rely on the maintenance of convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near term, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For, assuming the convention holds good, it is only these changes, which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence.

Thus investment becomes reasonably ‘safe’ for the individual over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments, which are ‘fixed’ for the community, are thus made ‘liquid’ for the individual. It has been, I am sure, on the basis of some such procedure as this, that our leading investment markets have been developed. But it is not surprising that a convention, in a absolute view of things so arbitrary, should have its weak points.”

Peter Bernstein has spent an illustrious career, which is still going strong, studying precisely the “weak points” embodied in investment paradigms founded on the consensus presumption that what has been is, and what is will forever more be. Indeed, Peter’s driving motive in writing Against the Gods: The Remarkable Story of Risk was the existence of:


“…a persistent tension between those who assert that the best decisions are based on quantification and numbers, determined by the patterns of the past, and those who base their decisions on more subjective degrees of belief about the uncertain future.”

Peter finds a comfortable eclectic home between those two camps, as we do here at PIMCO, through the study of not just the facts, but the whys of history. Or in Peter’s own wise words:


“We must know why people of past times did – or did not – try to tame risk, how they approach the task, what modes of thinking and language emerged from their experience, and how their activities interacted with other events, large and small, to change the course of culture. Such a perspective will bring us to a deeper understanding of where we stand, and where we may be heading.”

Which brings us to the here and now. Peter, like Bill and I (or, is that Bill and I, like Peter?), writes a monthly essay on evolving economic and financial themes. I consider his Economics and Portfolio Strategy must reading3 . His October 2001 missive, “The Promises Men Live By: An Update,” is a case in point, in which Peter takes up the sensitive subject of required returns as “a central element in investment strategies and planning.” In fact, Peter is actually re-visiting this subject, having explored it in detail in his December 1998 epistle, “The Promises Men Live By.”

In that earlier tract, Peter traced the evolution over the last thirty years of fiduciaries promising not just to act fiduciarily, but promising to generate a “required rate of return.” The passage of ERISA in 1971 formalized the concept in defined-benefit pension land, as did legislation shortly thereafter requiring foundations to distribute annually at least 5% of either their income or their assets, whichever was greater, subsequently relaxed to at least 5% of assets. Operating in a similar fashion, many educational endowments ventured down the same path, establishing explicit investment rules and objectives and rules for transferring funds from endowments to university budgets.

The whole process, as Peter poignantly observed, was about “making promises” – promises of absolute, not relative investment returns! And in doing so, Peter observed in 1998, institutional investors had collectively become their own enemy:


“…the soaring asset values that investors are inflecting upon themselves are complicating the task of meeting required return objectives for the future. Now, the only w ay to meet required returns – to keep those promises – is to take on even more risk.”

The game had, Peter observed, become, “self-feeding, with so many believers convinced through thick and thin that only the stock market can make their promises come true.” And the game would continue, he mused, until there was “somewhere, a shock massive enough to shake loose this set of beliefs.” And when it did, he opined, the ever-richer valuation of equities – alternatively, the ever-declining equity risk premium! – would be exposed, as would the notion that the stock market is a place for generating “required returns.”

In his update of “Promises,” Peter thinks out loud about the possibility that such a secular  moment of truth — alternatively, the unlearning of the un-truth that the equity market should be viewed as a source of anything “required” — might be upon us. His closing words reveal the uncommon accumulation of a lifetime of common sense, cumulating into wisdom:


“The analysis provided here describes the setting, motivation, and the process leading to the death of the equity cult. There is no reason why its demise has to be abrupt. The cult in its previous incarnation took ten years to die and another ten years or more of bull market to re-flower. But a world where investors sell on rallies is a very different world from one where they buy on dips and where equities are the unchallenged path to the fulfillment of promises.”

Sweet words, Peter. The joy of rabbits is boundless, and Morgan le Fay boundlessly fulfills the promises of her species. She’s requested, however, that I quit referring to the Morgan le Fay stock market, as she’s fearful of guilt by association.

I’m honoring her request. As well as yours, Peter, to give her a daily hug from you!

Paul A. McCulley
Managing Director
October 31, 2001

1 See “Me and Morgan le Fay,” Fed Focus, February 2000.
2 See “Capitalism’s Beast of Burden,” Fed Focus,January 2001.
3 See www.peterlbernsteininc.com


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