“The fact that something so unthinkable could occur has had a lasting impact on my view of life and on investing in particular” – Peter Bernstein
I’m extremely proud of the event we put on this week, the Evidence-Based Investing conference. There were a lot of like-minded investors in the room and on the stage, so we ended the day with a panel called “The Limitations of Evidence.” This was a great way to end the day because a lot of financial evidence is subjective. It’s not exactly like studying a crime scene and finding a bloody boot print or DNA on a knife.
Peter Bernstein absolutely nailed this concept in Against the Gods, when he wrote about things that used to be true that no longer are.
In 1930, when President Hoover declared that “prosperity is just around the corner,” he was not trying to fool the public with a soundbite or a spin. He meant what he said. After all, history had always supported that view. Depressions had come, but they had always gone. Except for the period of the First World War, business activity had fallen in only seven years from 1869 until 1929. The single two-year setback during those years was 1907-1908, from a very high point; the average annual decline in real GDP was a modest 1.6%, and that included one decline of 5.5%.
But production fell in 1930 by 9.3% and in 1931 by 8.6%.At the very bottom, in June 1932, GDP was 55% below its 1929 peak, even lower than it had been at the low point of the short-lived depression of 1920. Sixty years of history had suddenly become irrelevant.
Today we take for granted that bonds have higher yields than stocks, but this was not always the case.
In 1959, exactly thirty years after the Great Crash, an event took place that made absolutely no sense in the light of history. Up to the late 1950s, investors had received a higher income from owning stocks than from owning bonds. Every time the yields got close, the dividend yield on common stocks moved back up over the bond yield. Stock prices fell, so that a dollar invested in stocks brought more income than it had brought previously…Until 1959, that is. At that point, stock prices were soaring and bond prices were falling…The old relationship between bonds and stocks vanished, opening up a gap so huge that ultimately bonds were yielding more thank stocks by an even greater margin than when stocks had yielded more than bonds.
The cause of this reversal could not have been trivial. Inflation was the main factor that distinguished the present from the past. From 800 to 1940, the cost of living had risen an average of only 0.2% a year and had actually declined on 69 occasions. In 1940 the cost-of-living index was only 28% higher than it had been 140 years earlier. Under such conditions, owning assets valued at a fixed number of dollars was a delight; owning assets with no fixed dollar value was highly risky.
The Second World War and its aftermath changed all that. From 1941 to 1959, inflation averaged 4.0% a year, with the cost-of-living index rising every year but one. The relentlessly rising price level transformed bonds from a financial instrument that had appeared inviolate into an extremely risky investment….No longer did investors perceive stocks as a risky asset whose price and income moved unpredictably. The price paid for today’s dividend appeared increasingly irrelevant. What mattered was the rising stream of dividends that the future would bring.
It pays to never say never, especially in investing, but there are some things I’m 99.9% sure of. I don’t know what could ever cause the following three things to be invalidated.
- Costs matter. The reason active managers fail to beat their benchmark is because their fees are often ten times higher than the index.
- Timing the market is a fools errand, at least for 99% of us. Sure you can make a few good calls, but over your lifetime you need to make hundreds if not thousands of good calls. Good luck with that.
- Picking stocks is really difficult. Two out of three stocks underperform the index and most of the overall gains of the index are in the top 25% of performers.
For most other things, I try to be humble and keep an open mind because what looks like evidence today may appear laughable in the future.