Review of "Rational Expectations: Asset Allocation for Investing Adults" by William J Bernstein

I bought this book after seeing it mentioned in “Investors Chronicle”, a weekly magazine which I have subscribed to for over 20 years and which I recommend to anybody living in the UK who is interested in investments.

Overview of the book

The book is quite short, just under 200 pages and I found it immensely readable. It deals with essentially just one problem: asset allocation for somebody saving for retirement. Below I have selected some snippets which give a flavour of the book.

Introduction

After quoting Rabbi Hillel, who summarised the entire Torah in one sentence, the author says:

“Investing is… simple: there are risky assets, there are riskless assets, and there is an exchange rate between them. When times are good, that exchange rate is low, and when blood flows in the streets, it is high.

Oh, yes, and one more thing. Make sure, absolutely sure, that you have enough riskless assets to tide you over during the bad times, when you are the most likely to see your income fall or even lose your job. Preferably, you should have yet more than this, so as to take advantage of that high exchange rate when it shows up, as it inevitably does.

Even more simply: you must have patience, cash, and courage – and in that order. All else, as Hillel said, is commentary.”

Chapter 1: Asset-class models, asset classes for real

The author begins by considering a simplified situation where the investor has only two alternative assets.

1. “Bonds” which are risk-free and guarantee a return of 3% per year.
2. “Stocks” represented here by a single investment where each year the outturn is either +30% or -10% depending upon the toss of a coin.

The first useful insight the author gives is that the expected return R of the hypothetical "stocks" is not 10%, (the arithmetical average of +30% and -10%) but rather 8.17% being the geometrical average.

The author goes on to consider the risk of the coin toss "stocks" portfolio underperforming the "bonds" portfolio over particular periods of time. For example with 30 coin tosses in total, there is a 5% chance of your "stocks" outcome being worse than holding the "bonds" for 30 periods.

He then goes on to look at the returns from real US stocks from 1926 to 2012.

In passing, as the author is an American writing for Americans, most of the examples relate to the US stock market. However anyone who reads this book will readily be able to apply the same methodology to the UK stock market.

The author considers that there are three kinds of investor in practice:

“Group 1: the average small investor, who does not have a coherent asset-allocation strategy and who owns a chaotic mix of mutual funds and/or individual securities, often recommended to him or her by a broker or adviser. He or she tends to buy near bull market peaks and sell near bear market troughs.

Group 2: the more sophisticated investor, who does have a reasonable-seeming asset-allocation strategy and who will buy when prices fall a bit (“buying the dips”), but who falls victim to the aircraft simulator / actual crash paradigm [earlier the author points out that coping with aircraft crashes is much easier in a simulator], loses his or her nerve, and bails when real trouble roils the markets. You may not think you belong in this group, but unless you’ve tested yourself and passed during the 2008-2009 bear market, you really can’t tell. And even if you kept your discipline in 2008-2009, if the global stock markets experience another decline on the order of 1929-1932, you still don’t know for sure.

Group 3: those who do have a coherent strategy and can stick to it. Three things separate this group from group 2: first, a realistic appraisal of their true, under-fire risk tolerance; second, an allocation to risky assets low enough, or a savings rate high enough, to allow them to financially and emotionally weather a severe downturn; and third, an appreciation of market history, particularly the carnage inflicted by the 1929-1932 bear market. In other words, this elite group possesses not only patience, cash, and courage, but also the historical knowledge informing them that at several points in their investing career, all three will prove necessary. Finally, they have the foresight to plan for these eventualities. The last point is perhaps the most important: always ask yourself, will I really continue buying equities all the way to the bottom of a 90% market price decline?”

Chapter 2: Diversify me! Portfolio models: simple and not so simple

In this chapter the author looks at how diversification can reduce risk and sometimes even increase return at the same time.

He emphasises the importance of calculating your basic living expenses over the rest of your lifetime. For simplicity, he suggests setting this amount as equal to 25 years of "residual living expenses" – the amount you need to live on after the receipt of state pensions, other pensions and any other periodic benefits. Once you are retired, and no longer earning, the author considers that if you do not have this amount in low risk assets whose cash payments match your retirement expenditure, you have zero capacity for taking on risk. Otherwise, if your portfolio under performs, you will find yourself with insufficient income on which to live.

He describes a portfolio meeting the above requirements as a “liability matching portfolio” and regards it as essential to achieve this by time one retires.

Chapter 3: The evil nexus: market history, your portfolio, and your brain

The author mentions a research experiment conducted by Baba Shiv and colleagues. They took 15 subjects who had brain lesions that disconnected their fear-sensing neural structures, as well as looking at a control group of people without brain lesions.

In the experiment, participants received $2.50 or nothing depending upon the outcome of a coin toss. Alternatively they could choose not to participate in the coin toss; in that case they would receive a definite $1. There were 20 coin tosses for each individual in the experiment.

Tossing the coin had an expected return of $1.25 which is greater than $1 from opting out of the toss. Accordingly the rational choice is to select a coin flip for every one of the 20 choices in the experiment.

The actual finding was that the control subjects (with normal brains) only bet 61% of the time. Conversely, the brain-damaged patients bet 84% of the time.

An even more important statistic is the behaviour after a losing coin toss. After a losing coin toss, members of the control group bet only 37% of the time on the next available coin toss, while brain-damaged patients bet 85% of the time, essentially the same as their overall average decision on betting.

The author points out that in his experience the most emotionally intelligent and empathetic people tend to be the worst investors. Conversely individuals who show some of the characteristics of Asperger’s syndrome behave in the same way as the brain-damaged patients in the experiment, not letting emotions affect their investment behaviour.

Chapter 4: When to hold ‘em, when to fold ‘em: a lifetime asset-allocation trajectory

In this chapter, the author looks at three hypothetical individuals of assumed ages and assumed income profiles and then considers how market circumstances can impact upon them.

1. A 45 year old mid-career executive who has decided he has saved enough, and proceeds to stop saving and spend his annual employment earnings each year.
2. A 65 year old who has just retired.
3. A 25 year old junior executive who is saving 20% of his salary.

For educational purposes, the author assumes that the starting date is January 1929, so that all three of the individuals above are about to encounter the greatest stock market calamity ever. The discussion of what happens to these hypothetical individuals is extremely instructive.

The two final chapters, “Loose Ends” and “Walking the Walk: Nuts and Bolts for Investing Adults” look at some of the implementation issues.

Concluding comments

This book tackles one task, and tackles it extremely well. I recommend it to anyone who is interested in the subject, with only one caveat.

The author is serious when he states that he is writing for “investing adults.” I found the book straightforward to read, but I have been reading about investments since my early 20s. If you are completely unfamiliar with investments, you may find the book challenging. I recommend giving it a try.