Efficient Frontier
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William J. Bernstein

Deeper Causes

Efficient Frontier ordinarily does not comment on market fluctuations, moral philosophy, or the Knicks’ playoff prospects. But these are not ordinary times. Most broad market indexes are 30%-40% off their 2000 peaks, techs and the Nasdaq (which are not, repeat, not, asset classes) are off by almost 75%. Finally, the most widely followed Internet index has fallen 90%—about what befell the Dow during the 1929-1932 Götterdämmerung. Trillions have been lost, hopes shattered, and futures ruined.

As always happens with market catastrophes, anger is widespread and blame is assigned; the process is just beginning. Bland, white male executives, who in normal times would retire wealthy and faceless after dull but profitable careers, have become the villains of a latter-day morality play. Worse, they have become household names—Blodget, Skilling, Ebbers, Fastow, Lay, and the Dickensianly monikered Grubman.

Large-scale criminal activity is always more complex than we would like to admit. The narcotics industry is a scourge, but it could not exist without demand for drugs; the user shares guilt with the supplier and the dealer. The producer and consumer of child pornography bear joint responsibility. And so it goes; without demand, there are far fewer criminals.

Little effort is needed to identify the driving force behind the widespread corporate shenanigans slowly emerging from under every rock. When realized stock returns are low, no one gets terribly excited about silky smooth earnings growth or large but unsustainable increases in revenue. Quite the contrary; in normal times, good news in corporate bottom lines receives the same credence as sweepstakes promotional mail. But when returns rise, so does credulity, and so too do the rewards to the bearers of glad fiscal tidings. Jack Welch is transformed from a competent but unexciting bean counter into the second coming of Thomas Edison; men and women with limited talent and ethical vision find that, with only minor lapses, they can become rich as Croesus.

Who ultimately directed this charade? Human nature dictates that it is far more satisfying to castigate the most visible miscreants than examine the visage in the mirror: an investing public ignorant of the risk-return nexus, clueless about how to estimate expected returns, and unaware of how awful market losses could be and how bad those losses would hurt. In short, plungers who were putty in the hands of executives and analysts who simply could not resist the easy pickings. Finally, credit with assists folks like Dent, Markman, Glassman, Hassett, and the Gardner brothers, who fed and deepened the delusion that everyone should be rich.

Was it foolish to buy and hold stocks? Of course not. The long-term returns of most stock asset classes have been more than acceptable; it’s just that they’re joined at the hip with the certainty of serious intermittent declines. Today’s victims forgot or, more likely, were never aware of Keynes’ famous dictum that from time to time it was the duty of shareholders to suffer losses with equanimity.

Aviation provides a rich source of investment metaphor. In just a few hours, the average person can learn to safely operate a simple aircraft—as long as the sun is shining and the air is smooth. Unfortunately, when the sky turns foul, difficulties arise. In the late 1990s, John Q. Investor hopped into an F-15, lit the burner, and went vertical. He wasn’t strapped in, and he hadn’t taken any lessons.

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