VOI CES

1 The ideal asset allocation for today’s

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market and for the future is
4 more conservative than you thought
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7 PETER L. BERNSTEIN
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The 60/40 Solution

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18 t h e d e r i vat i o n o f t h e Before I get into those matters, however, let’s stop to con-
19 word “risk” reaches back to the early Italian risicare, which sider why the 60/40 formula was so popular in the era before
20 translates as “to dare.” Risk looked at from this viewpoint is the bull market of the ’90s. Stocks, after all, are riskier than
21 a choice rather than a fate. For a true long-term investor, the bonds, which are contracts to pay interest and to redeem the
22 choice, by definition, must be survival, or you can forget that principal when it falls due, while stocks have no maturity
23 long-term stuff. Survival as an investment objective has been date and often yield less income to their owners. Then why
24 proven essential over the past 21 months, as the dangers of not 50/50, or even 40/60? The answer is in how markets work.
25 seeking maximum return have been demonstrated once again. Rational investors buy stocks only when they can expect to
26 Once upon a time—that is, for many years before the great make enough extra in the stock market to compensate for the
27 bull market of the ’90s—the most popular benchmark for greater risks involved in owning stocks. This dynamic process
28 portfolio asset allocation aimed at this goal was about 60 per- of pricing stocks relative to less risky assets explains why,
29 cent in stocks and 40 percent in fixed-income investments. over the long run, stocks have returned more than bonds and
30 After 1990, this seemingly stodgy arrangement largely went why, therefore, more stocks than bonds makes good sense.
31 by the boards as stocks roared ahead, encouraging institu- As experience teaches, however, reading the future is never
32 tional and individual investors to become increasingly aggres- easy. Unexpected events often defy the forecasts of even the
33 sive in their search for higher returns. But now the high-tech keenest investors. As investors search for the appropriate
34 bubble has burst, the economy has weakened, and the war on price for equities, a steady stream of surprises makes stocks
35 terrorism has landed at our front door. highly volatile in the short run. You can make a killing in one
36 Does this fundamental transformation in the environment year and give it all back and more in another. Bonds have also
37 mandate a return to 60/40? In a more general sense, should had their moments of high volatility, based in large part on
38 investors consider shifting—on a permanent basis—to a con- fluctuating expectations about the outlook for inflation, but
39 servative stance, where the allocation to stocks is smaller those moments have been relatively brief and less intense
40 than it might have been in the recent past? than the swings in equity markets. In many instances, fur-
41 The short answer to this question is “Yes!”—but not for the thermore, bond prices have offset equity volatility by moving
42 reasons you might imagine. I don’t recommend cutting back in the opposite direction from stock prices. Hence, 60/40
43 because the bad economic news and the war on terrorism are seemed like a good compromise for the long-run average bal-
44 promoting a bearish view of the market. I’d say the same thing ance between maximizing return and minimizing risk.
45 whether I were bearish or bullish. This is not a question of mar- The arithmetic is interesting. Over the long 75-year span
46 ket timing. If it were, you could stop reading now, because mar- from the end of 1925 to the end of 2000, a portfolio of $100
47 ket timing recommendations have an impressive track record fully invested in stocks would have generated a compound
48 of being harmful to an investor’s financial health. The issues return of 11 percent a year compared with 9.3 percent a year
49 involved are more basic, even philosophical, and quite unre- for a 60/40 portfolio—assuming no taxes and full reinvest-
50 lated to where I happen to think the equity market is headed. ment of dividends. This spread of less than 2 percentage
51 points looks modest, but it is far from chicken feed when
52 PHOTOGRAPHS BY LEN IRISH compounded over 75 years: The $100 in the 100 percent stock

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 Many aspects of investing are 1
fun, but your future wealth isn’t a 2
game. You should manage it in the 3
most cold-blooded fashion. Emo- 4
tion, pride, ego, dreams, and night- 5
mares have nothing to do with the 6
process, although some investors 7
rely on little else. It is in this sense 8
that volatility really matters. 9
Many people pride themselves 10
on being “long-term investors,” but 11
acting deliberately when prices are 12
bouncing around is not so easy. 13
When stocks are blasting sky- 14
ward, even the most steadfast can 15
be sucked into the updraft. When 16
they are cascading downward, 17
keeping one’s cool is almost im- 18
possible. Volatility provokes the 19
constant dread that some investors 20
know more than we do, making us 21
fearful of ignoring such powerful 22
price movements. 23
But remember: That $259,000 24
earned since 1925 from a 100 per- 25
cent stock portfolio assumed an 26
investor who bought and held over 27
a period of 75 years and also paid no 28
taxes and fully reinvested the divi- 29
dends. Those are unrealistic as- 30
sumptions, to say the least. Even if 31
portfolio would have blossomed into $259,000, whereas the we could imagine a person blessed with sufficient longevity 32
60/40 portfolio would have grown to only $76,000. to have been active in the market ever since 1925, how likely 33
But consider the following. Equity performance was all would it be that even the most experienced and sophisticated 34
over the place. The annual return on stocks ranged between a investor would have the self-control to stay 100 percent in 35
glorious 54 percent rise and a horrible 43 percent swoon; on stocks, without trading in and out as the market rode up and 36
eight occasions, losses were greater than 10 percent. Although down its roller coaster? I know I could not have been so calm 37
the 60/40 portfolio was inevitably affected by the high stock through depressions, inflations, banking and currency crises, 38
volatility, the 40 percent in bonds helped the balanced port- wars, and political disruptions. 39
folio come through with a more comfortable spread, ranging I emphasize this psychological aspect of the matter, be- 40
from a 40 percent gain to a 9 percent drop. cause those wonderful statistics on long-term returns are 41
These statistics contain important information for decision what the market did, not what any single individual or fund 42
making in any kind of environment, not just today’s. The did, or would do, if history replayed itself. In my real-world 43
results were manufactured by millions of investors making experience, investors with smaller allocations to stocks and 44
bets on the future, financing businesses, and raising cash with some anchors to windward have been the ones most 45
every minute over some 20,000 business days. While some likely to be the winners over the long haul. The crucial ele- 46
were acting each day, a much larger number were reacting and ment of success is the ability to make decisions without freez- 47
making decisions on how to respond to the changing condi- ing up or slamming the panic button. In bear markets, the 48
tions on the next day, or days. How can anyone foresee how muted volatility and the contractual safety of bonds provide 49
something as complex as that is going to work out? That’s the most congenial environment for arriving at rational deci- 50
why this kind of historical analysis is so valuable; it defines sions about stocks. In bull markets, the balanced portfolio 51
the parameters of unpredictability. may not make for lively cocktail-party conversation, but with 52

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 VOICES
PETER L. BERNSTEIN

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2 Your future wealth isn’t a game. Investors
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with smaller allocations to stocks have been winners over the long haul.
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6 60 percent in stocks, your wealth will still be participating Even the most serious efforts to make predictions can end up
7 and growing. so far from the mark as to be more dangerous than useless.
8 I cannot overemphasize the importance of this last point. Consider the following analysis conducted by Jeremy Siegel
9 Few decisions in life motivated by greed ever have happy out- of the Wharton School of the University of Pennsylvania, who
10 comes. Unless you are that rarest of birds, someone who is studied long-range forecasts prepared in 1975 by Roger Ibbot-
11 cool under the rapid-fire, high-pressure decision making re- son and Rex Sinquefield, with strong theoretical support, for
12 quired to maximize your returns, let others take such risks, the quarter century 1976–2000. Siegel describes this work as
13 and allow your portfolio to plug along at a slower speed. In “state of the art...with 50 years of financial returns available”
14 investing, tortoises tend to win far more often than hares over to support the process. Here are the 1975 forecasts for 1976–
15 the turns of the market cycle (and, as we have recently been 2000, in percent per annum, with the actual results in paren-
16 reminded, markets still do have cycles). theses: stocks, 7.6 percent (14.6 percent); bonds, 1.8 percent
17 Here is another way to look at the situation. The constant (9.9 percent); Treasury bills, 0.0 percent (2.9 percent); and
18 lesson of history is the dominant role played by surprise. Just inflation, 12.8 percent (3.3 percent).
19 when we are most comfortable with an environment and All of history and all of life is stuffed full of the unexpected
20 come to believe we finally understand it, the ground shifts and the unthinkable. Survival as an investor over that famous
21 under our feet. Surprise is the rule, not the exception. That’s long course depends from the very first on recognition that
22 a fancy way of saying we don’t know what the future holds. we do not know what is going to happen. We can speculate or
23 calculate or estimate, but we can never be certain.
24 Something very simple but very penetrating stems
25 from this observation. If we never know what the
26 future holds, we can never be right all the time.
27 Being wrong on occasion is inescapable. As the
28 great English economist John Maynard Keynes ex-
29 pressed it some 80 years ago, “A proposition is not
30 probable because we think it so.” The most impor-
31 tant lesson an investor can learn is to be dispas-
32 sionate when confronted by unexpected and un-
33 favorable outcomes.
34 Investment management provides only one de-
35 pendable way to survive through the uncertainty
36 of the future: diversification. Diversification means
37 owning assets that do not move up and down to-
38 gether—a portfolio designed to subdue volatility
39 rather than to maximize returns, while still expos-
40 ing you to the widest possible range of positive op-
41 portunities. (A colleague once suggested you are
42 never adequately diversified unless you have some
43 holdings that make you uncomfortable.) Placing
44 large bets on an unknown future is worse than
45 gambling, because at least in gambling you know
46 the odds. This is why I propose restoring 60/40 to
47 its rightful place as the center of gravity of asset
48 allocation for long-term investors. ∂
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50 Peter L. Bernstein is president of Peter L. Bernstein, Inc., and
51 author of The Power of Gold and Against the Gods
52 (John Wiley). His firm advises institutional investors.

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