Efficient Frontier
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William J. Bernstein

Of Math and History


Iíll admit that Efficient Frontier isnít for everyone. Most of my friends take a peek, chuckle, and move on, saying something like, "Bill, ole buddy, it looks like youíre having fun, but I donít understand a word of this. Thereís just too much math." Fact is, almost all our readers fall into three broad categories: finance professionals, scientists or engineers, and other professionals who are good with numbers.

Iíll also admit that itís the engineers who most often give me the willies. Human nature mandates that we overvalue those abilities that we possess in greatest abundance. If you were the prom queen, then you tend to overemphasize the importance of physical appearance. If you were the school jock, you tend to judge people by their athletic ability and locker-room behavior.

And of course, if youíre a math whiz, then all of lifeís problems can be solved by spinning proofs and running the numbers. Not a week goes by that I donít get a spreadsheet from someone demonstrating how this allocation or that strategy led to great riches over the past five, twenty-five, or seventy years.

The trouble is, markets are not circuits, airfoils, or bridgesóthey do not react the same way each time to a given input. (To say nothing of the fact that inputs are never even nearly the same.) The market, though, does have a memory, albeit a highly defective kind, as weíll see shortly. Its response to given circumstances tends to be modified by its most recent behavior. An investment strategy based solely on historical data is a prescription for disaster.

The Long Term Capital Management episode is a perfect example. First, find the brightest mathematicians and financial economists you can lay your hands on. Next, put all of them in the same room. After a while, they convince each other that their exceptional quantitative skills are the financial fountain of youth. Finally, supply them with a few supercomputers and several years of highly detailed financial data. Shake well. Result: a financial doomsday machine.

This is not to minimize the importance of mathematical ability in investingóitís certainly necessary for financial success. Itís just not sufficient. Whatís also needed is an historical sense of just how chaotic and random financial markets are.

If youíre going to invest your own money, or other peopleís money, you simply cannot learn enough about financial history. The dullest and most essential part is absorbing the numbers: go to your library and look at Ibbotsonís Stocks, Bonds, Bills, and Inflation until your eyes cross. (It will happen in just a few minutes.) This will give you an idea of how the basic stock and bond classes behave. Log onto Bob Shillerís and Ken Frenchís Web sites; download and internalize their data on U.S. equity returns. Most investors make the mistake of focusing on historical long-term asset class returns. The real utility of the historical record is the vivid picture it paints of the chaotic nature of security volatility.

The descriptive history is the fun part. I used to recommend that folks start with Charles Mackayís Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, but recently itís been superceded by Edward Chancellorís Devil Take the Hindmost: A History of Financial Speculation. Itís much more contemporary and is pure "mind candy." Lastly, I highly recommend Jim Grantís trilogy of vignettes from Grantís Interest Rate Observer: "Money of the Mind," "Minding Mr. Market," and "The Trouble with Prosperity." If you ever have the opportunity to hear this man speak, you should avail yourself. Grant is even more entertaining and educational in person than in print, if thatís possible.

This pleasure was recently mine. Grantís topic, as always, the current state of the bond market. He spun a fascinating story of corporate malfeasance and amnesia in the DuPont-Conoco tango. Anyone who buys or sells capital clearly ignores this saga at his own peril.

Jim transported us in the "Wayback Machine" to 1981. Commodities prices, particularly oil, were sky high. Interest rates were even higher, with long Treasuries near 16% and T-bills briefly in excess of 20%. (And because Mr. Grant generally does not discuss stocks in polite company, he did not note that during the 15 years prior to 1981, stocks had had the same return as T-bills and inflation.) DuPont, fearful of being at the mercy of the petrochemical producers which supplied their raw materials, decided to buy their own: Conoco. It was the biggest corporate takeover to that point in time. Unfortunately, DuPont did not have the requisite cash on hand and went to the debt markets, selling several billion dollars of debentures at coupons averaging 18%.

In retrospect, a truly awful decision: DuPont borrowed at the historical apogee of U.S. interest rates to buy an asset whose value had peaked. But it was actually worse than thatóseventeen years later they then spun Conoco off with bond yields and petroleum prices at historic lows. The punch line was supplied by Mr. Grant, who asked DuPont at the time of the recent spin-off, "Did the company have any comment on their rather ironic sense of timing?" The answer: No comment, since no one currently in their high command was around at the time of the original acquisition.

A spectacular example of institutional amnesia and an excellent object lesson for individual investors. Both Grant and I were around, as they say, at that time, and the memories of an era when commodities were king and stocks and bonds were trash should serve us well in the long term, even if it hasnít over the past decade. If youíre too young (or were too poor) to carry 1981ís scars, you can at least read about them.

The wheels donít come off the wagon the same way each time. Itís unlikely that the next financial catastrophe will be a repeat of the hyperinflationary 1970s¾ it will have a pattern all its own. But read enough about 1981, 1974, 1929, and even the panics of the 19th century, and youíll know that thereís more to investment planning than optimizing spreadsheets or taming a black box.

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