Bill Bernstein on Bargains, Rebalancing, and Brains

There are no screaming bargains among asset classes in the market right now, but there aren't any obvious sells, either.

That's what author, investment advisor, and former neurologist William Bernstein said at Morningstar's Investment Conference Thursday. It's worth paying attention to his opinion because eight or so years ago in his book, The Intelligent Asset Allocator, he crunched a lot of data and concluded that REITs, TIPs, junk bonds, and small-value stocks would have higher future expected returns than the large-growth stocks that were dominating the headlines and investors' portfolios at the time.

Currently Bernstein sees most stocks as modestly overvalued, and REIT yields as not that attractive. He's also worried about what effect currency fluctuations could possibly have on foreign equities, which have benefited tremendously recently from a weak dollar. He didn't include commodities in his overall assessment, though, because he doesn't use them (he doesn't like the futures markets and doesn't trust the retail funds and ETFs that offer commodity exposure). But he does think commodities are in a bubble.

Bernstein thinks about relative valuations among asset classes, but the author of the Efficient Frontier Web site is really a buy-and-hold investor who uses mostly passive funds from DFA and Vanguard. He spent a lot of time talking about the right way to rebalance a long-term portfolio. Bernstein has done considerable research into the best ways to rebalance--whether to do so at preset times on the calendar or when asset classes meet certain thresholds. He prefers the threshold method because he said he thinks it can result in better returns, though he admits that he has had trouble coming up with hard data to back that up. The difference between really good rebalancing and average rebalancing is about 10 or 20 basis points, or hundredths of a percent, in portfolio return, he said. No matter which form of rebalancing you choose, Bernstein has concluded that you can go two or three years without resetting your asset allocation.

The former neurologist said he doesn't pay as much attention to behavioral finance as you would expect for someone with a medical background, but he said it can help you understand what emotional responses to expect when tough investing decisions arise. Like a pilot who has to overcome his fear of pushing down on the plane's stick when losing speed (doing so helps gain airspeed), investors have to steel themselves to make the hard choice. Bernstein, a former pilot, noted that some of the best trades are made when you have a nauseous feeling in your stomach.

The biggest mistakes most experienced investors make, Bernstein said, are not knowing enough economic and market history and conflating economic growth with equity returns. The current credit crisis, the burst of the technology stock bubble, and the collapse of hedge fund Long-Term Capital Management have all been called 100-year storms in finance, but they've all happened in the last decade. China's economic growth has been astronomical in the past 15 years, but its equity market returned just over 1% from 1993 through December 2007.

Do you agree few asset classes look cheap? Are commodities a bubble? What's the best way to rebalance? And do you know your economic history?

Dan Culloton
Senior Mutual Fund Analyst