Peter L. Bernstein on risk

Insight: The flight of the long run

If the long-run expected return on bonds in the future were higher than the expected return on equities, the capitalist system would grind to a halt, because the reward system would be completely out of whack with the risks involved. After all, from the end of 1949 to the end of 2000, the S&P 500 provided a total annual return of 13.1 per cent, while long Treasuries could grind out only 5.8 per cent a year.

But does this history really tell us anything about what lies ahead? Neither the awesome historical track record of equities nor the theoretical case is a promise of a realised equity risk premium. John Maynard Keynes, in an immortal observation about the future, expressed the matter in simple but obvious terms: “We simply do not know.”

Will our economy and society emerge so risk-averse after these experiences that years will have to pass before we return to a system naturally generating vibrant economic growth and a renewed willingness to both borrow and lend? Or will we head in the opposite direction, where faith in ultimate bail-outs will justify the wildest kind of risk-taking? Or will the entire structure collapse from government debts and deficits that turn out to be so unmanageable that chaos is the ultimate result?

We can neither answer those questions nor can we claim they are a complete list of the possibilities. The unknown today seems more than usually unknown. Then my whole point remains the same. The long run is an impenetrable mystery. It always has been.

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One Guy Who Has Seen It All Doesn't Like What He Sees Now

Peter Bernstein has witnessed just about every financial crisis of the past century.

As a boy, he watched his father, a money manager, navigate the Depression. As a financial manager, consultant and financial historian, he personally dealt with the recession of 1958, the bear markets of the 1970s, the 1987 crash, the savings-and-loan crisis of the late 1980s and the 2000-2002 bear market that followed the tech-stock bubble.

Today's trouble, the 89-year-old Mr. Bernstein says, is worse than he has seen since the Depression and threatens to roil markets into 2009 and beyond -- longer than many people expect.

Mr. Bernstein, whose books include "Against the Gods: The Remarkable Story of Risk," sees two culprits. One is the abuse of securitization -- the trend for banks to hold fewer loans on their books and instead turn them into securities that were sold to other investors. The other is simply years of overborrowing by financial institutions and consumers alike.

Mr. Bernstein is hopeful that Federal Reserve intervention will prevent deflation and depression, but he says there is no guarantee.

Excerpts of a recent interview

Interview with Peter Bernstein

He says the current credit crisis is a unique historical event, in which too many people took high risks in a low-risk environment, and as a result changed the environment. He believes risks appeared low, not least because so many securities carried triple-A credit ratings. "They[ratings agencies] became part of the delusion instead of being a monitor of the delusion", he says.

He also says central banks do not have the tools to fix the financial crisis: "This is a problem of a seizing up of the whole credit system around the world and rupture of trust." The fix is going to take a long time, he says, and the compressison of credit availability is squeezing the real economy.

...gold's price rise reflects people running from uncertainty, in America and the rest of the world: "You can't eat it, can't live in it, can't do anything with it. But it's a hedge. And this is a hedgy kind of time."

Link to the video

The Shape Of The Future

The central message of our analysis is not that the origin of today's difficulties is uniquely in the household sector or that the residue of these difficulties has scrambled the whole credit structure in the financial markets. Everybody knows about these troubles.

On the other hand, too few observes have noted how the consequences of these developments are going to require an extended period of time before the blockages they impose have been eliminated. But that is not all they have missed. This extended period of difficulty is going to bring about a new economic régime, different in many aspects from the experience of most people alive today. Along the way, we will have to pass through a transition period that harks back to an unfamiliar past in both the financial system and in the household sector.

But this, too, shall pass. Yes, glassy-eyed bankers, prudent consumers, and a reformulated globalization can keep a lid on economic activity around the world for quite a while. What develops from that transition, however, should resemble what took place over the course of the 1980s. Without anyone realizing it, the errors of the past, drip by drip by drip, were buried and a new and better system took their place.

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