Has this crisis shaken your belief in diversification and the modern portfolio theory you developed?
First, we want to distinguish between portfolio theory and some of these financially engineered products. Portfolio theory, as used by most financial planners, recommends that you diversify, with a balance of stocks and bonds and cash that’s suitable to your risk tolerance. Contrast this with Australian municipalities that put all their money into credit-default swaps. They’re bankrupt. That’s why we need to be diversified.
What do you say to those who’ve lost the faith?
I think of each year of the S&P 500 as a random draw from a bushel basket that has the same probability as we’ve seen since 1926 or so. The chief problem with the individual investor: He or she typically buys when the market is high and thinks it’s going to go up, and sells when the market is low and thinks it’s going to go down. You have to be in the market and prepared when the recovery begins.
But a lot of asset classes now seem to move in lockstep.
Corporate bonds have a much smaller beta than big-cap U.S. equities, which have a smaller beta than emerging markets. [Beta is a measure of an asset’s risk compared with the broad market.] If you look at 2008, emerging markets did worse than U.S. big caps, and those big caps did a lot worse than corporate bonds or U.S. government bonds. So if you were entirely in, say, emerging markets, your portfolio was hit a lot harder than if you were diversified. Simple as that.
If you owned just government bonds and cash, you’d be in pretty good shape. So why not market time?
I have to confess to having done quite a bit of market timing recently myself. When Bear Stearns collapsed in 2008, I decided to move partly out of equities. When the Federal Reserve cut the interest rate by 50 basis points last year, I moved into commodities. By sheer luck, I hit the commodities boom. I’m embarrassed to say I’ve done some market timing. But as a rule, you cannot do it. I don’t know anyone who’s done it regularly and gotten rich by market timing.
Should the average investor stick to mutual funds?
If the investor doesn’t have enough time and skill to investigate individual stocks or enough money to diversify a portfolio, the right thing to do is to invest in exchange-traded funds that give you exposure to asset classes. It does make sense for the individual investor to think in terms of holding individual asset classes. The typical mistake for small investors is to pull out of the market.
Should investors be scooping up stocks on the cheap?
My unofficial position is that next year is going to be really bad or really great, and I’m leaning toward really great. But that’s just a feeling. And even with that feeling, I wouldn’t shift very much. It’s kind of like driving a car: You don’t pull your wheel too far to the left or too far to the right. I would never be 100 percent in stocks or 100 percent in bonds or cash. If you’re cautious, maybe 40 percent or 50 percent in stocks. And if you’re optimistic, maybe 60 percent or 70 percent in stocks. The rest should be in fixed income and maybe a little cash.
Do you think Bank Bailout 2.0 will fix the financial system?
I don’t think the bailout will work. Nobody knows what these pieces of mortgage-related paper are worth. Suppose that a bank had invested a lot of money in the Irish sweepstakes and now has losing tickets. Should the U.S. now buy that bank? It makes no sense. President Obama says we do not want to reward failures. Well, the way the capitalist system works is, failures go bankrupt. Some say you can’t let Citigroup go bankrupt. But suppose it did? We would have saved some money, the company would have been split apart, and management would have been thrown out. Those things are all likely to happen anyway, but now with the government spending a lot of money. It’s a waste.
Will investors change their approach to risk-taking?
New players will always come in and say it’s now a different ballgame. In five years, 10 years, there will be another bubble and some people will say once again that this time is different. Then it will burst.
