Fifty Years from Now

What will the best-practice portfolios of our children and grandchildren look like? What rules will they operate under? Put another way, which of our beliefs and intermediations will they retain, and which will they look back on as quaint and outmoded?

Only a few things are certain: First, human nature will not change. There will always be bubbles and panics; valuations will go to extremes in both directions. Second, risk and return will continue to be joined at the hip.

But our models and vehicles will likely not look anything like those we have today. If the evolution of financial intermediation occurs at even half the pace of the past fifty years, open-end mutual funds and ETFs will occupy only a small and musty corner of the financial landscape, much as closed-end funds do now.

Financial theory will also evolve. The three- and four-factor models will likely give way to better ones. And yet the gap between theory and practice will remain as wide as ever. This is largely a function of the personalities of finance’s best and brightest, whose primary skill set is abstract, and thus is directed at models, away from the human-induced complexity of the markets that will still defy successful modeling for a long time to come. During a recent CFA Institute conference, the brilliant Robert Merton, at the conclusion of a talk on the use of quantitative risk-management techniques and derivatives, was asked if his experience at Long Term Capital Management had taught him any lessons. He sniffed:

I have not spoken about it publicly. If there were some new theory of finance that was discovered because of the LTCM event, however, I surely would have relayed it to everyone a long time ago.

Were we able to resurrect Karl Marx, he might just as well have responded that the events of 1986-1991 had not changed political theory. So, one more eternal verity: investing has always been, and will remain, an operation in which wealth is transferred from those without a working knowledge of financial history to those who have one. No matter how elegant the theory, no matter how rigorous the analysis, from time to time things will go totally off the rails. Further, most of the time this will happen in a novel way. Those who take history seriously will need no fancy models to survive; those who rely instead on black boxes should at least factor in a very, very fat tail.

Equity should continue to offer higher returns than debt, for the simple reason that stocks, because they own only the residual claim on revenues, are inherently riskier. This is not to say that from time to time their valuations will fail to reflect this, as occurred in the late 1990s.

Diversification will become even more important than it is now. Diversification’s value is the result of three countervailing forces. First, as markets grow ever more integrated, asset-class behavior tends to become ever more correlated. Although this lessens the value of diversification, it is overwhelmed by two factors that favor it: a steady supply of new non-correlated assets into the investment universe and, even more importantly, the compression of asset-class valuations. Think about it: in a world with only a few asset classes that vary widely in valuation, it just might make sense to place a bet on those with particularly juicy expected returns and stay away from those with poor ones (as occurred, for example, in the 1930s, with its very low bond yields and very high equity payouts). But in a world with dozens of very noisy equity asset classes with nearly identical ex-ante expected returns, most of the time you’re crazy not to own all of them.

Finally, there are the imponderables. Will, for example, small U.S. investors become ever more involved in the capital markets? This is largely a political question, dependent on whether the electorate ever wakes up to the mess of IRA/defined contribution pottage sold to them by the libertarian right. Over the past few decades, it has become apparent to even the most enthusiastic proponents of private accounts that most plan participants are about as qualified to manage their retirement portfolios as they are to do brain surgery or play left wing for the Rangers. Some autonomy needs to be stripped from them by mandating default opt-ins, lifecycle funds, annuitization, and so forth. Would it not be better simply to throw in the towel, throw out Wall Street, and establish a national pension system? Most Europeans, when they gaze upon our retirement system (and our health care system as well), laugh themselves silly.

Will the inevitable economic rise of China and India mean that these dynamic markets will produce outsized returns for those brave enough to brave their markets? A very good question, but I’m betting no. Remember, equity prices are based on per-share metrics, and in nations with inadequate shareholder protection, outstanding equity gets diluted faster than iced tea on a hot day. Despite China’s ten percent annual economic growth and the recent torrid performance of its stock market, its real long-term returns over the past fifteen years have been negative. (And forget Russia: its ascent is linked directly to the buoyancy of the commodities markets. Not only is this unlikely to persist, but natural resources are a well-known developmental curse.)

Into the time capsule this goes. Too bad I won’t be there in fifty years when my great-grandkids open it and chuckle about how short-sighted, parochial, and naïve great-grandpa was.

 

Copyright © 2008, William J. Bernstein. All rights reserved.

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