Peter Bernstein’s Legacy

It is so many years ago now that I cannot exactly recall when it was that I started receiving Peter Bernstein’s Economics and Portfolio Strategy newsletter. At some point I guess his wife Barbara must have switched from using a typewriter to a word processor, but the format – four to eight pages or so of elegant prose, a couple of graphs, the distinctive coloured paper – has barely changed.

Now with Peter’s death, at the grand old age of 90, another distinctive voice in the investment world has been silenced. As some of his obituaries have noted, one of the remarkable things about Bernstein was that most of his intellectual output – the newsletter, the Journal of Portfolio Management, his many books on investment themes – only began at an age when most people were already contemplating retirement.

There is an irony in the fact that he should die at a point when financial markets are once again under attack for having failed the societies they are meant to serve, for few people have done more to promote an understanding of the way that financial markets work. His whole career was dedicated to advancing the idea that investment is a professional business to which rigorous thinking and standards could (and should) be applied.

He was a willing and enthusiastic exponent of the many ideas that, for good and ill, have come out of academia to reshape our attitudes to finance. The Journal of Portfolio Management, which he founded in 1974, was created precisely so as to provide a forum in which the new ideas could be presented and challenged.

In his wonderfully readable history of modern financial theory, Capital Ideas, he recalled how in his days working for a family-oriented bank in the 1950s, “clients would come to us and say ‘Here is my capital. Take care of me’. As long as their losses were limited when the market fell, and as long as their portfolios rose as the market was rising, they had few complaints. They came to use and stayed with us because we understood their problems and the myriad kinds of contingent liabilities that all individuals must face”.

“We joked that we were nothing more than social workers to the rich – but skilled social workers to the rich, confident that our performance was being measured in human satisfaction rather than in comparative rates of return. We knew no more about the clients of other investment managers than they knew about ours”. That world, still dominated by the private investor, is far removed from the faster, harsher, more institutionalised world we inhabit today.

And yet of course the changes that the intellectual advances and innovation of the last 35 years have unleashed – in performance measurement, in traded options, in asset allocation, in our understanding of risk and so on – have been far from an unalloyed success. Those who believed in efficient markets and rational expectations have been forced to accept the inexorable evidence that such ideas are badly flawed – and indeed, wrongly applied, have the power to do harm as well as good.

Bernstein never believed however that the course of financial innovation would run smoothly. In Capital Ideas, which appeared son after the 1987 stock market crash and the jailing of Michael Milliken, he was already defending the role of the stock market in capitalism. By making diversification easy and inexpensive, he argued, the stock market increases liquidity and enhances the overall level of risk-taking in society.

And risk-taking, with all its ups and downs, is essential to economic progress.”Institutions that encourage risk-taking are essential if a society is to grow and raise its living standards. Granted, risk-taking involves social costs. But the capitalist nations have no monopoly on pollution, maldistribution of income, inadequate education, poverty, speculation, crime or corruption”.

Nonetheless he ended his book by quoting Harry Markowitz, the father of modern portfolio theory: “Granted that the invisible hand is clumsy, heartless and unfair, it is ever so much more deft and impartial than a central planning committee”. Amidst the wreckage of the shadow banking system, such faith in the power of financial innovation to do good over time is inevitably once again under challenge.

The irony is that, in Bernstein’s view, the greatest contribution that financial theory has made over the last three decades is in providing the tools that allow us to understand and measure risk more accurately. Yet those tools, some of which are embedded in the Basel 2 regulatory regime, for example, have proved wholly inadequate to prevent a banking crisis of unprecedented proportions.

There is plenty of work therefore still to be done in understanding the way that unfettered markets work and the limits that should rightly be placed on them. It is a shame that Bernstein himself will no longer be around to chronicle the next stages of the ongoing financial revolution of which he was both champion and critic. His own view, elegantly expressed in his newsletter on many occasions, was that investment risk is far more complex and multi-faceted than most investors assume.

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