The Fiduciary’s Six Commandments

In a recent issue of Financial Analysts Journal, Robert Shiller comments on the recent deflation of the U.S. stock market bubble. It is understandable, he implies, that many foolish people were taken in. What puzzles, he notes, is that college endowments, presumably run by the best and brightest in academia, were joyous participants in the orgy, maintaining a mean portfolio exposure of 54.7% to U.S. equity and an additional 10.5% exposure to foreign equity.

Certainly, Shiller posits, these people were not fools, at least in the conventional sense. Rather, what occurred was an " . . . error that afflicts some of Shakespeare’s tragic figures—in the sense of having subtle weaknesses of a partial blindness to reality."

Taking the analogy one step further, I suggest that even Shakespearean proportions have been exceeded: we are in the midst of a catastrophe of Biblical magnitude. It is likely that investors will be forced to wander in a desert of low asset-class returns for many years, until a new generation is born . . . who will joyfully commit the same sins as their parents.

But don’t despair. Coming down off the mountain I see Charlton Heston. Since he’s been moonlighting for the National Rifle Association, he has only had time to copy six commandments. But if you have fiduciary responsibilities, ignore them at peril of your immortal soul:

Thy investment policy statement is thy God; thou shalt not have other policies before thee. First and foremost, you should clearly record the goals, allocation policy, and portfolio mechanics of your operation. Aside from the legal benefits of an airtight investment policy statement (IPS), it will force you to think clearly about the above issues. If you’re confused about how to go about this, I cannot recommend highly enough the bible of investment management fiduciary responsibility: Trone, Allbright, and Taylor’s The Management of Investment Decisions. Your IPS should be detailed yet clear. It should be simple enough to understand so that a monkey could implement it, because someday, one will.

Thou shalt not covet thy neighbor’s conventional wisdom, thy neighbor’s investment return, nor thy neighbor’s muse. As Charles Kindleberger famously said, there is nothing so corrosive to good judgment as watching your neighbor become rich.

Thou shalt estimate asset-class returns by objective criteria, not historical fairy tales. One of the prime movers of the late bubble was the uncritical acceptance of historical returns data. There’s no need to name names here; most of us know the cast of characters. At the height of the madness in early 2000, who did not know that equity returns since 1926 compounded out to 11.3%—that a dollar invested during the prior 74 years had now grown to $2,192? Or that in the past century, there were no 30-year periods when stocks did not beat bills and bonds?

How many said, "Hey, wait a cotton pickin’ minute! Half of that return came from non-recurring factors like an average 4.5% dividend yield and a tripling of multiples"? How many took the next step and noted that the "low risk" of long-term stock investing in fact rested on those self-same high historical returns? In other words, if stocks beat bonds by an average of 6% per year, and if the annual standard deviation of those returns is in the 15%-20% range, then the "low risk" is merely a function of the high returns. If returns going forward are low, then hello risk.

Finally, how many noted what a felicitous date 1926 was—what Dimson, Marsh, and Staunton call the "visibility" problem: the benefits of stock investing did not become visible to the public before 1926. Begin the analysis at a more neutral date, say 1900, and the picture of stock returns, particularly in inflation-adjusted returns is not quite as pretty. In their wonderful book, The Triumph of the Optimists, this trio examines the tepid nature of stock returns in 16 developed nations over the entire 20th century, and the even more uninspiring record of real dividend growth, which was negative in a majority of nations.

One series worth studying is that of real GDP in the United States over the past two centuries:

Since 1789, real U.S. GDP has grown at 3.85% per year; but with slowing population growth, this rate fell to 3.31% over the past century, and to 3.11% over the past 50 years. Those of you who see a technology-driven acceleration of economic activity at the right margin of this graph better stop buying your eyeglasses from the Glassman-Hassett-Dent-Gilder optician shop and change the lens tint from rose to clear.

Worse, as we’ve already seen, about 2% of this GDP leaks out the new-issues drain before it reaches the per-share framework of investors. So figure 1% of real earnings and dividend growth. If we’re lucky.

Are there other asset classes with higher returns? Probably. But you’re going to have to think for yourself and do your own math. No one ever said this was going to be easy.

Thou shalt abjure expenses. Now that you’ve been whacked upside the head by the Old Testament Expected Returns God (and his good buddy, the Recent Realized Returns Avenging Angel), consider your expenses. While you were worshiping the false idols of double-digit returns, a percent per year to your pension consultant’s favorite hot manager seemed like a pretty good bargain. But remove the scales from your eyes and behold: you are paying one-third of your expected real return to these sinners. Is it worth it? Repent, be saved, and save, all at the same time.

Thou shalt relieve thy participant’s burden. It is likely that your participants are up the 401(k) creek, or one of its tributaries, without a paddle. Yes, you have saved a few dollars, but the cost to your participants is beyond calculation: they have been left to deal with expensive, poorly diversified fund choices without any tools or preparation. You may think that in switching from the defined-benefit to defined-contribution format, you have shed liability. If so, think again. It will not escape notice that you were asleep at the switch in establishing your plan, avoiding record-keeping responsibility so that you might send the fund salesman’s children to private school. Meanwhile, it is slowly dawning upon a new generation of trial lawyers that the 401(k) quagmire may make tobacco litigation look like an evening stroll. Repent, I say: be a mensch and provide your employees with a default choice of a low-cost, passively managed fixed allocation. Better yet, switch back to your old defined-benefit plan.

Thou shalt do constant battle with thy board. Now for the hard part. Once per quarter, you will have to sit down with about a dozen silverbacks who do not know the first thing about finance. They will believe in The Returns Fairy (that there are superior managers and it is your job to find them), they will berate you for not foreseeing market downturns, and they will religiously believe in the wisdom of investing in the last decade’s hottest asset class. When you enter the boardroom, you are not only an administrator; you are also an educator. You must spend five or ten minutes each meeting teaching them the basics of modern finance. Since new committee members will constantly be rotating through, this is a never-ending chore.

Keep your chin up, always do the right thing for the participants, and remember: a good deed never goes unpunished.

Copyright © 2002, William J. Bernstein. All rights reserved.

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