B A R R I E D U N S T A N

T H E W O R L D ’ S G R E A T E S T M O N E Y M A N A G E R S . . .

WARREN BUFFETT & CHARLIE MUNGER • DAVID FISHER • BILL GROSS • MARC FABER • SIR RON BRIERLEY

MARTIN LEIBOWITZ • ABBY JOSEPH COHEN • JACK BOGLE • LEW SANDERS • ANTHONY BOLTON

GARY BRINSON • RAY DALIO • JEREMY GRANTHAM • BARTON BIGGS • PETER BERNSTEIN

. . . H O W T H E Y D I D I T , W H A T T H E Y B E L I E V E .

Foreword by US investment great , Char les E l l i s

The wisdom that leads to

wealth

With over half a century of experience to draw upon, no other journalist can boast

the range and depth of analysis of fi nancial markets. As the elder statesman

of Australian fi nancial journalism, Barrie brings to his interviews a depth of

understanding that allows him to probe the thinking of some of the best fi nancial

minds in a manner that puts his subjects at ease and that delivers rare insights.

—Richard Gilbert, CEO, Investment and Financial Services Association

Barrie Dunstan brings both great experience and insight to his writings on the

investment industry. Over the years he has sat down with some of the true legends

of the investment world and this book offers a unique insight into how some of the

best minds in the world approach investing. —Jeremy Duffi eld, Managing Director, Vanguard Asia-Pacifi c

Dunstan has produced a book that is as insightful as it is readable. His dissection

of these investment veterans’ different ways of thinking is testament to his

journalistic prowess ...

—David Marvin, Chairman, Marvin & Palmer

Part-business strategy and part-biography, Investment Legends provides a rare insight into the world’s most infl uential and successful investors. In this collection of candid, perceptive and engaging profi les, respected fi nancial journalist Barrie Dunstan reveals the people behind the legends and the personal qualities that have seen them dominate the world of investment. Discover what shaped these pioneers during their lives and their education, what brought them into the industry, the people who infl uenced them during their career and who among their peers they admire.

Barrie Dunstan is one of Australia’s most experienced and widely read investment writers, with 52 years of stock market involvement underpinning his craft. He has worked at The

Age and The Herald, and since 1987 has been writing for The Australian Financial Review, where he is currently an associate editor.

DU

NS

TA

N

AU$34.95 NZ$38.99

Invest legends-cover.indd 1-3Invest legends-cover.indd 1-3 9/7/08 3:27:41 PM9/7/08 3:27:41 PM

Barrie Dunstan

The wisdom that leads to

wealth

First published 2008 by Wrightbooks,

an imprint of John Wiley & Sons Australia, Ltd

42 McDougall Street, Milton Qld 4064

Offi ce also in Melbourne

Typeset in Palatino LT 10.5/15pt

© Barrie Dunstan 2008

The moral rights of the author have been asserted.

National Library of Australia Cataloguing-in-Publication Data:

Dunstan, Barrie.

Investment legends : the wisdom that leads to wealth / Barrie Dunstan.

9780731408375 (pbk.)

Includes index.

Wealth. Investments. Finance.

332.6

All rights reserved. Except as permitted under the Australian Copyright Act 1968 (for example, a fair

dealing for the purposes of study, research, criticism or review), no part of this book may be reproduced,

stored in a retrieval system, communicated or transmitted in any form or by any means without prior

written permission. All inquiries should be made to the publisher at the address above.

Cover design by Rob Cowpe

Printed in Australia by McPherson’s Printing Group

10 9 8 7 6 5 4 3 2 1

Disclaimer

The material in this publication is of the nature of general comment only, and neither purports nor

intends to be advice. Readers should not act on the basis of any matter in this publication without

considering (and if appropriate, taking) professional advice with due regard to their own particular

circumstances. The author and publisher expressly disclaim all and any liability to any person,

whether a purchaser of this publication or not, in respect of anything and of the consequences of

anything done or omitted to be done by any such person in reliance, whether whole or partial, upon

the whole or any part of the contents of this publication.

All dollar amounts cited in this book refer to US dollar, unless otherwise noted.

AcknowledgementsChapter 1: based on interview, 2006, ‘Child of the Depression to US treasure’, AFR, p. 72

Chapter 2: based on interview, 2006, ‘Running ahead of a hedge hogging pack’, AFR, p. 44

Chapter 3: based on interview, 2006, ‘Stay the course key to success’, AFR, p. S4

Chapter 4: based on interview, 2006, ‘Quiet achiever with a stellar track record’, AFR, p. 36-37

Chapter 6: based on interview, 2006, ‘Adding value one day at a time’, AFR, p. 38

Chapter 8: based on interview, 2006, ‘The sunny side of the street’, AFR, p. 41

Chapter 9: based on interview, 2006, ‘The man who wants to understand the world’, AFR, pp. 42–43

Chapter 10: based on interview, 2006, ‘It’s a big kick to swim against the tide’, AFR, p. 24

Chapter 11: based on interview, 2006, ‘People come fi rst for this Fisher of men’, AFR, p. 35

Chapter 12: based on interview, 2006, ‘The boutiques that bring home the bacon’, AFR, pp. 70–71

Chapter 13: based on interview, 2006, ‘Cards continue to fall the right way’, AFR, p. 21

Chapter 14: based on interview, 2006, ‘Alpha hunter’s endless quest’, AFR, p. 69

Chapter 15: based on interview, 2006, ‘Mission possible: have the know and the how’, AFR, pp. 22–23

Foreword v

Introduction vii

1 The Chronicler and Historian

Peter Bernstein1

2 The Literary Investor

Barton Biggs15

3 Staying the Course

John C Bogle29

4 Calm and Balance

Anthony Bolton43

5 The Corporate Raider

Sir Ron Brierley57

6 Analytical Perspicacity

Gary Brinson75

7 The Prodigies

Warren Buffett and Charles Munger 93

8 The Optimist

Abby Joseph Cohen111

Contents

9 The Teacher

Ray Dalio131

10 The Contrarian

Marc Faber149

11 The Admired Manager

David Fisher165

12 The Articulate Pessimist

Jeremy Grantham179

13 The Card Counter

Bill Gross197

14 The Nicest Guy in the Business

Martin Leibowitz213

15 The Early Adopter

Lewis Sanders229

Index 245

Foreword

If you are too busy or don’t have the opportunity to travel out

to meet all the world’s most interesting investment managers,

you have a great alternative: Get a savvy, engaging observer

to station himself in a spot where the best and brightest will

be coming through. Then have him ask all the best questions

of each manager and write up a clear and accurate profi le of

each with an insightful explanation of who they really are,

how they think about investing, and what they believe is most

important, why those beliefs matter, when they might change

their minds, and where they see either risk or opportunity. The

result will be that you, as a thoughtful individual investor,

can make profi table good use of the lessons learned.

Barrie Dunstan’s new book is right on target — lucky us!

An experienced professional journalist, he writes regularly for

the Australian Financial Review on investing and investment

managers. He got engaged in his study of the world’s most

interesting investors many years ago — before most individuals

got involved in investing and well before Australia mandated

that every worker should invest in his or her own retirement

security — so he was there from the beginning and has stayed

vi | Investment Legends

with it for 40 years, establishing an international reputation as

the leading journalist in the nation.

Since almost all the investment greats come, sooner or later,

to Melbourne, if they have any interest in sharing their thoughts

with interested Australians and others, they all come to Barrie

and he has the ‘pick of the litter’.

Good things build their own momentum and Barrie

Dunstan’s profi les are no exception. As he writes more and

more of his superb profi les, more leading investment managers

want to meet him and more individual investors learn that

reading his profi les is next best to being there for all those

conversations Barrie has had with all those managers. And so

the virtuous cycle builds strength and momentum, assuring

that he’ll have even easier access to the very best as they come

to Australia.

As you read these perceptive profi les, you’ll have the

pleasure of meeting some of the world’s most interesting and

capable investors, learning their best ideas, how to invest

successfully, and get the benefi t of having a wise and insightful

guide in Barrie Dunstan.

Charles D Ellis

Introduction

When you write a book called Investment Legends, at some stage

you need to ask: what exactly makes an investment legend?

My original idea in 2006 was simply to see how many really

interesting investment leaders I could interview for a series in

the Australian Financial Review. It was only when the project

progressed towards a book and the working title emerged that

I began to grapple with the term ‘investment legend’.

It certainly wasn’t a title many of the subjects particularly

liked. Indeed, one of the legends suggested that very few

of the people in the book would agree to be described as

‘legends’ — and, he added, that attitude was probably why

they had been successful. My initial criteria was whether the

person was readily recognised in the investment industry and

acknowledged as someone who had made a major contribution

and impact on investing. In Australia, a few of the overseas

legends didn’t necessarily pass that recognition test — but I relied

on other household names to carry the list for the newspaper

series. In the end, however, I found that I had inadvertently

assembled a list of people who were, indeed, signifi cant players

in the investment industry. Luckily — since dull subjects don’t

viii | Investment Legends

work, either for newspaper profi les or books — it also turned

out they were very interesting interviewees.

I found I had selected people whose fame was based on a

variety of achievements. Some people like Warren Buffett and

Charlie Munger, plus Fidelity International’s Anthony Bolton

and Capital Group International’s David Fisher, had stellar

records of consistently above-average investment returns.

Others had taken their ideas and applied them to build or help

fashion major investment houses. Bill Gross at PIMCO, Gary

Brinson at Brinson Partners and Jack Bogle at Vanguard are

well-known examples.

Less well known perhaps, were the stories of Lew Sanders

at AllianceBernstein and Ray Dalio at Bridgewater. Then there

are the genuine bearish or contrarian characters such as GMO’s

Jeremy Grantham and Swiss-born Marc Faber. Apart from the

performers and the builders, there also was a group we can call

the thinkers: the wise old man of the industry, Peter Bernstein,

and Martin Leibowitz with his incredible academic output.

And then there were the strategists, such as Barton Biggs and

Abby Joseph Cohen; the thinkers whose predictions provide a

continual diet for the markets.

Finally there was the question of an Australian legend.

It was a daunting task to fi nd someone who would not be

overshadowed by the overseas legends — and the task proved

too diffi cult for the AFR series, given the deadlines for copy.

However, in 2007 Sir Ron Brierley agreed to represent the

locals, with his New Zealand origins providing a nice, rounded

Australasian representation. He also added to the spread

of investment approaches, as someone who has produced

long-term gains from corporate takeovers. He has done this

with fl air and a certain amount of buccaneering style — and he

has earned his legend status by outlasting his competitors of

the 1960s, 1970s and 1980s.

Much of this rationalisation of what made an investment

legend came later. The initial list was scribbled out on paper

Introduction | ix

in 2006 after the original idea. I had interviewed several of

the subjects in the past and the AFR had published them as

one-off articles. But I thought the occasional articles didn’t

provide full value for the paper or for our readers, considering

what these interesting money managers had to say. So the idea

emerged to do a series of interviews and to present them at

the end of the overseas visit as a series that would provide

more impact than single interviews. Luckily the editor,

Glenn Burge, agreed.

Conceiving the idea was the easiest part. I then had to

make contact with some busy and sometimes reclusive

legends — and try and fi t them into a reasonable time frame

that the AFR’s travel budget could accommodate. The original

wish list ranged far and wide and was very hopeful. It

included Harry Markovitz, and hedge fund maestros Julian

Robertson, George Soros and Mark Holowesko. There were

others I sought unsuccessfully: it was not possible to interview

the elderly Sir John Templeton, founder of the Templeton

Group. Former Fidelity star fund manager Peter Lynch also

wasn’t available and David Swenson, who runs the highly

successful Yale University portfolio, proved elusive. My

fi nal list was a compromise between an original wish list

and what, fi nally, was feasible and manageable. In the end,

it comprised 15 articles on 16 overseas investment legends,

with Warren Buffett and his deputy chairman Charlie Munger

bracketed together.

It’s a journalist’s dream to be able to contact well-known

people and get an interview. The reality is that, often, you have

to be lucky. You also need people to help you. Gary Brinson,

for instance, had largely dropped out of sight after leaving

the UBS group in 2000. Before then, he was one of the most

infl uential men in investment management. But I happened

to interview one of his former colleagues at Brinson Partners,

Jeff Diermeier, in Australia and he kindly put me in touch

with Brinson. Earlier initial meetings with people like David

x | Investment Legends

Fisher and Peter Bernstein had only come about through the

intervention and kindness of other local investment people.

The meeting with Barton Biggs was organised through his

long-time friend, Dave Marvin of Marvin & Palmer. The

interviews with Anthony Bolton, Lew Sanders and Marty

Leibowitz were organised thanks to the help and cooperation of

Australian executives of their groups, such as Michael Bargholz,

Australian head of AllianceBernstein who, though overseas,

secured Lew Sander’s approval at short notice. Diermeier, the

chief executive of the CFA Institute, also invited me to the CFA

conference in Zurich, where I was able to interview Marc Faber

on his home turf.

So, in May 2006, I set off. All the subjects had agreed to an

interview — except for Buffett and Munger who, pursued by

journalists all the time, are oblivious to such requests. Instead,

with thousands of others, I made the pilgrimage to Omaha,

Nebraska, to the Berkshire Hathaway annual meeting. There,

instead of just a one or two hour interview, I was able to listen

to Munger and Buffett answering questions for about six hours

at the annual meeting and several hours of grilling by the press

at their press conference the next day.

In the interviews with the legends I was not attempting

to secure immediate news stories (though Bill Gross did

provide me with a nice tale on Ben Bernanke’s fi rst slip-up

in his relatively new role as the chairman of the Federal

Reserve Board). In any case, because of the time gap between

the interviews and eventual publication, I deliberately did not

question the legends in detail on current investment matters.

Rather, I sought to fi nd out what had shaped them during their

life and their education, what brought them into the industry,

a little of their investment philosophy, the people who had

infl uenced them during their career and who, among their

peers, they admired.

There was, inevitably in such a group of high achievers,

some cases of ego and the occasional disagreement with

Introduction | xi

another legend. But I also discovered a brotherhood among

investment managers — a willingness to admire their peers

who had succeeded and excelled, and a recognition that what

mattered was to achieve the best results for those whose

money they were investing. And I found I had, perhaps

inadvertently, assembled an array of investment people whose

styles and activities covered the vast, complicated world of

investment today.

I always had the idea of a book in the back of my mind. Even

halfway through the interviews, Ray Dalio told me forcefully

that I had to turn the interviews into a book. Subsequently,

Peter Bernstein’s typically generous praise emboldened me.

When I took the deep breath and committed to the idea, Lesley

Beaumont of John Wiley became a willing helper. (Her father,

Geoff Wright, had originally turned me into a book author

with Understanding Finance with the AFR in the late 1980s.) So,

late in 2007 I returned to the original interviews as published

in the AFR in October and November of 2006. I have updated

them, using additional material or parts omitted originally for

space reasons. In addition, most of the legends kindly helped

to update their interview by telephone or email and staff at

John Wiley guided the project.

By the time this process was underway, world investment

markets were being rocked by the turmoil in credit markets,

sparked by the subprime crisis in the US. Normally, newspaper

journalists thrive on such a major story that sweeps through

markets, but, for someone writing a book with a slightly

longer life than a news story, this turned out to be a major

distraction. In general, because of the fast-moving nature

of fi nancial crises, this book does not attempt any detailed

analysis of markets or economic conditions as they developed

late in 2007 and into 2008.

Some of the legends had been uneasy about aspects of

markets in 2006 during the initial interviews. Gary Brinson and

Bill Gross, in fact, specifi cally pinpointed the subprime loan

xii | Investment Legends

problems in May that year. Jeremy Grantham was also talking

a bear market. Many of them have been active commentators on

the ongoing saga since the middle of 2007 and this is refl ected

in some individual interviews. It may take time before it is

possible to write defi nitively on the subprime crisis. What is

clear is that it is having (and will continue to have) a major

impact on investment markets, but that might need to be the

subject of another book.

The subprime crisis has also had its impact on some of

the legends. Abby Joseph Cohen at Goldman Sachs moved

to a less bullish view. And the bears, such as Marc Faber

and Jeremy Grantham, came into their own, with Grantham

producing a much more pessimistic view of the next few years

than the general consensus in his interview in late 2007. And

Peter Bernstein, with his historical perspective, was shaken by

the decline.

Now I realise that many readers — while fascinated by

the characters represented here — also might hope to fi nd

some profi table answers about how to approach their own

investments. To allay any disappointment, the book was

always intended to be more about the ‘legends’ rather than

about ‘investment’. Hopefully, most of the legends reveal

something about the qualities it takes to invest successfully

and to build a successful investment portfolio and business.

Some of them had very strong ideas about how to approach

investment; others were agnostic and simply preferred to

follow what had worked best for them. But, if I may borrow

from Barton Biggs’ own book, Hedgehogging, ‘This book is not

a how-to primer. There are no enduring answers about how to

invest successfully in these pages because I have none.’

The investment lessons preached by Warren Buffett fi ll

many books (there are several available on the market). The

Berkshire approach isn’t about market timing. Buffett and

Munger seem to have refi ned the knack of investing down to

a few points: they don’t pretend to know everything and don’t

Introduction | xiii

venture beyond the sphere of knowledge. More importantly,

they need to trust the managers of businesses they invest in.

What does this collection of legends tell us about

investment? The messages are wide and mixed but one

important one stands out: you should make large, signifi cant

investment decisions only when you can recognise that markets

or stocks are at extremes — and these extremes don’t come

along very often. The corollary of this is simple: be a long-term

investor rather than a short-term speculator. A pretty boring

lesson, really. But it was repeated, interview after interview.

Gary Brinson stresses the limited number of examples of

extreme valuations in his investment life; Jeremy Grantham

thinks there were only a handful of such big moments in his

life. Charlie Munger believes investors should follow the rule

of successful racehorse betters who wait (and wait … and wait,

if necessary) until they can see a good bet. His investment

partner, Warren Buffett, advises to invest only in what you

understand and, in a baseball analogy, preaches to swing only

when you get a really ‘fat pitch’. Even apparent contrarians like

Marc Faber emphasise that you need to understand economic

and market forces before going against the general fashion and

Ray Dalio makes it clear that it is important to make sure that

you know how, as well as when, to bet.

Against all the active managers trying to fi nd the right

stock among thousands, Jack Bogle argues that it’s better to

buy the whole haystack in an index fund rather than to spend

time and money searching for those needles. While there’s

a lot of glamour in what the active managers talk about, for

the average investor, the Bogle approach is a good starting

point — concentrate your efforts on what you can control,

notably costs and taxes.

The Australasian legend, Sir Ron Brierley, might feel

diffi dent among the overseas luminaries. But he has done

what most of his local contemporaries failed to do — thrive

and survive in the ultra-competitive area of making money via

xiv | Investment Legends

takeovers. He became a legend during the entrepreneurial days

in Australia when he realised that many listed companies were

worth much more dead than alive. There was one difference in

his takeover career: he survived the investment crash and rose

again. He also has produced investment returns, running at

more than 17 per cent a year compound in Guiness Peat Group

shares (his current listed investment vehicle) since he acquired

control in 1990.

These investment legends are, like most top people in any

industry, intelligent, well educated and street smart. A few,

like Peter Bernstein, were marked out for a life in investment,

but many arrived via more circuitous routes. Several showed

their entrepreneurial streak early by dabbling in the stock

market — Ron Brierley in New Zealand, and Ray Dalio and

Lew Sanders in the US (in Dalio’s case, like Peter Lynch’s,

using tips heard caddying at the local golf course). Bill Gross

approached the markets a different way — via the blackjack

tables in Las Vegas. Marc Faber gravitated into economics

because that course at his Swiss university left him more time

for skiing. David Fisher and Anthony Bolton drifted into

investment from other areas of business, while Barton Biggs,

though a son of an investment manager, tried writing and

teaching before fi nding his niche. (Biggs, who studied literature

at Yale under Robert Penn Warren, produced a delightful book,

Hedgehogging, in 2006, which was ostensibly about investment

management and hedge funds, but which also contained

beautifully crafted essays on Fibonacci numbers and the

20th-century economic great, John Maynard Keynes.)

Jeremy Grantham migrated from England to America to

the Harvard Business School (and to escape the drudgery

of his stepfather’s business) — and found himself in Boston

at the right time in the go-go 1970s. Both Lew Sanders and

Abby Joseph Cohen recognised earlier than many in the

investment industry how computers could be harnessed to

make analysis easier, quicker and better. Marty Leibowitz’s

Introduction | xv

training and inclination appeared to set him up for life as a

mathematical-based investment academic, but he still spent

many fruitful years in Salomon’s bond department and

running TIAA-CREF, the largest defi ned contribution pension

fund in the US, as its chief investment offi cer. Gary Brinson

overcame modest beginnings to specialise in fi nance — and fell

in love with the new capital markets theorists, while Jack Bogle

discovered mutual funds and indexing in his Princeton senior

thesis (sparked by an article in Fortune Magazine).

Many of the legends have played a major role in shaping

the business of investment management, both in theory and

in practice. Some have been mainly market players, adapting

and learning their skills over the years. Others — such as

Gary Brinson and especially Marty Leibowitz — have been

responsible for pushing out the boundaries of investment

thinking. Bill Gross was one of the fi rst to recognise how to

apply theories about generating alpha and transporting it

across asset classes. Similarly, Ray Dalio recognised early how

the distinction between alpha and beta sources of investment

returns could be used in practical investments — and coined

his own term for it: post-modern portfolio theory.

And, while all this was happening, Peter Bernstein was

thinking, writing and observing it all — and, essentially,

pulling the threads together to make sense of it in his two

books, Capital Ideas and Capital Ideas Evolving. If it had not

been destined by a strict alphabetical order, I would have

made Bernstein the fi rst chapter anyway, as the quintessential

investment legend who, with his own insights and contri-

butions, has made sense for us of the unprecedented changes

in investment since the 1950s.

Warren Buffett is almost in a category of his own. He has

been the subject of hundreds of books and is the world’s

best known and most celebrated investment manager, as

demonstrated by his multi-billionaire status. He has an

encyclopedic memory of investment decisions and one-liners,

xvi | Investment Legends

is a wizard at the bridge table and had read every book on

investment in the Omaha public library before he was 11 (some

of them twice). He has a sense of fun that extends to entertaining

shareholders by strumming the ukulele. Most signifi cantly,

however, he and Charlie Munger have produced investment

results which, according to investment theory, simply shouldn’t

be possible. But still, the fi gures show, they have outperformed

over more than 30 years. No wonder shareholders of Berkshire

Hathaway fret about who can replace their chairman. Charlie

Munger, the often neglected one of the pair, has a keenly honed

mind which ranges across many disciplines. He can turn in an

instant from wisecracks to talking about Gaussian distributions

(named after the German Carl Friedrich Gauss, who fi rst set

out the normal distribution curve in 1809).

By the time I had completed the last interview with Anthony

Bolton in London (who combined meticulous research and

long-running investment outperformance with composing

modern classical music), I felt had been privileged to talk with

some of the most infl uential people in the investment industry.

I had heard some fascinating stories of how these people found

their way into their jobs and seen fi rst hand, their enthusiasm

and passion for their job.

I have been a reader of books on investment legends for

decades, such as John Train’s Money Masters series and Peter

Lynch’s One Up on Wall Street. In preparing for the interviews

and writing the book, I turned to several more recent volumes

on Warren Buffett and to Charles Ellis’ Wall Street People. In

addition, Ellis’ book about Capital Group, Capital, was a great

help in understanding David Fisher.

This book, incidentally, also illustrates the fundamental

interdependence of all players in the investment markets.

While Fisher is a fundamental, active stock-picker, the Capital author, Ellis, is a great believer in the virtues of index investing

and his book has a foreword by Burton Malkiel, another index

believer (and author of A Random Walk Down Wall Street).

Introduction | xvii

Indeed, Malkiel remarks in his foreword that it might seem he

and Ellis were pretty unlikely people to produce a book about

a company which has prospered by active stock picking. This

in turn led Malkiel to defend the effi cient market theory (on

which index investing is based) in an intriguing way. He argued

that the theory of effi cient markets needs a few professionals

(presumably like Fisher) operating to ensure all the information

is incorporated immediately into markets. In return for their

time and effort, they are ‘allowed’ to earn above-average

market returns. As Malkiel argues, ‘the market could not be

effi cient if everyone simply invested in index funds. Paradoxical

as it may sound, markets need fi rms such as Capital to ensure

that low-cost indexing is, in fact, a winning strategy.’

Charles Ellis had fi rst entered my investment consciousness

back in the late 1980s when I belatedly discovered his paper

called The Loser’s Game, in which he compared the investment

game to the game of tennis in which the professionals aimed

for the winning shots. It was not until 2007 that I managed to

meet Ellis and discover another ‘titan of fi nance’ (as his friend

Malkiel calls him). Typically unfazed by my late recognition of

him, Ellis generously agreed to write the preface for this book.

Given his place in the industry and his own book, Wall Street People (with James R Vertin, 2001, John Wiley & Sons) it might

have been better if he had done the entire book.

It is a measure of the legend status of my subjects that, after

doing the interviews once for the newspaper series, most of

them agreed to back-up interviews for this book. I thank them;

they were quality professionals — and also some of the nicest

people I’ve interviewed. I hope this book manages to capture

their experience, skill, passion and enthusiasm.

Barrie DunstanMelbourne, AustraliaApril 2008

The Chronicler

and Historian

Chapter 1

Everybody simply forgot that risk exists. Amazing — never been anything

like [the subprime crisis] that I can think of.

Peter Bernstein was a troubled investment legend during in the

2007 travails. Always a student of risk, he has been troubled by

the reckless disregard of it by the investment world leading up

to the whole subprime episode (where people don’t put down

a house deposit and the repayments don’t cover the interest).

The ‘not too hot, not too cold, just right’ climate (the so-called

‘Goldilocks’ scenario) ruled for much of the last decade. Now,

he fears that the ‘Goldilocks’ markets and economy are dead.

But, says the veteran Bernstein, this is a thing of the past —

along with many investors’ mistaken perception that the

investment environment was virtually risk-free.

When someone as experienced and respected as Bernstein

produces a troubling and pessimistic view, the investment

world is likely to sit up and take notice — even if it hadn’t been

paying much attention to Bernstein (and others) in the run up to

the mid 2007 subprime crisis. More to the point, he was several

months ahead of the pack with these ideas in early 2007 — which

is not unusual for this legend of the investment world.

Bernstein’s legend status is widely acknowledged by all

thinkers and most practitioners in the business and yet, outside

the upper echelons of the industry, he is probably unrecognised.

Peter Bernstein

4 | Investment Legends

Bernstein turned 89 in January 2008 and his experience

virtually covers the entire investment period from the 1929

Wall Street crash and the Great Depression through the ups

and downs of the 20th century and the volatile start to the 21st

century. He has become the chronicler

and historian of the modern investment

movement; fi rst with his 1992 book,

Capital Ideas, in which he set out for the

fi rst time how modern portfolio theory

fi rst made its way into mainstream Wall

Street. His 2007 sequel, Capital Ideas Evolving, brought the story up to date,

listing how the capital ideas were implemented as all invest-

ment managers chased alpha (or added value).

Bernstein not only lived through the revolution of

investment thinking but he knew the major players, even

as they shaped their theories. Many went on to receive the

Nobel Prize: Harry Markowitz, Robert Merton, Merton Miller,

Franco Modigliani, Myron Scholes and William Sharpe — along

with Fischer Black, who almost certainly would have won

a Nobel Prize if he was still alive when Scholes and Merton

got theirs in 1997, he says. And he traces the lineage of capital

ideas back to Paul Samuelson, whose handiwork, Bernstein

observes, runs through the development of the much of the

recent thinking.

But Bernstein was interested in how the theory could be

put to use in practical investment and his book, Capital Ideas Evolving, includes discussion on two of the legends included in

this book — Bill Gross of PIMCO, who pioneered what is now

known as portable alpha (inspired by remarks by a PIMCO

director, Myron Scholes) and Martin Leibowitz of Morgan

Stanley — who also showed how the theory could be used in

portable alpha strategies.

He has become the chronicler

and historian of the modern

investment movement ...

The Chronicler and Historian | 5

Bernstein describes himself as a child of the Great Depression.

He saw his father sell his grandfather’s leather business in

1929, and then put the proceeds into the stock market — which

promptly crashed and nearly wiped out the family. He had

early exposure in the investment business when his father was

a broker during the troubled times after the crash.

But the man who lived through all the changes of the last

60 or 70 years says that, in 2007, he has been ‘knocked for a

loop’ by the credit markets’ sudden rediscovery of risk and

says ‘I wish I had called it more directly.’ During the (northern)

spring, he warned several times about the risks involved. ‘I

had several occasions to point out [with] conviction [that] we

were in a low-risk environment (Goldilocks, for short) had led

people to take on so much high and inadequately compensated

risk that we were, in fact, in a high-risk environment.’

While he was right on this, Bernstein says he underesti-

mated in his own mind the degree to which people had acted

on that assumption — and had increased the degree of risk in

the system. Of the failure of the Amaranth hedge fund, which

blew up speculating in natural gas contracts, he said: ‘What

happened to that hedge fund shows that when you’re really

right, you always overstay and get murdered. It’s better not

to be right so much.’

He doesn’t see anything changing in the way people

manage money — except that, clearly, they are going to put more

emphasis on the risk of their valuations. He says, ‘I suspect that

all the fancy risk-management strategies in the hedge funds

and the Goldman Sachses of the world were managing the

wrong risks!’ By the time he had given his assessment, Merrill

Lynch, Credit Suisse, Citigroup, Deutsche and UBS — as well

as the initial bellwether, Bear Sterns — had all reported millions

of dollars of write downs and billion-dollar quarterly losses. In

addition, the losses had already claimed the scalps of the chief

executives at Merrill Lynch and Citigroup.

6 | Investment Legends

‘The big write-offs among the major investment banking

players … are an inevitable consequence of the repricing of

risk,’ Bernstein says and, speaking in November 2007, he

added: ‘I should imagine there will be more.’ He doesn’t think

that the fallout in credit and stock markets from the subprime

crisis has necessarily made the markets less micro-effi cient.

‘But they have again demonstrated Samuelson’s dictum that

they are a long way from macro-effi cient. And [they] always

will be,’ he says. He adds with emphasis: ‘This is a point of

high importance.’(Paul Samuelson in 1998 argued that markets

were micro-effi cient and macro-ineffi cient, which was generally

interpreted to mean that investors could do better by relying

on asset allocation, rather than picking stocks.)

While the investment markets have spent a lot of time

worrying about the effects of the subprime meltdown on

the fi nancial services sector, Bernstein

says his main concern is the impact

of the changed credit environment

and the decline in housing prices on

households. ‘We may be in for an

extended period of slow growth, or even negative growth,’

he says. ‘This is a unique period,’ he observes. ‘We are on

the edges of a recession without having had the boom and

the usual tight money, etc. That makes forecasting even more

hazardous than usual.’ And, on the international front, he adds,

‘the geopolitical trends scare the bejesus out of me.’

‘In any case,’ he says, ‘Goldilocks is dead, and not just

because of the massive revaluation of risk, which I believe is

likely to continue. It is no longer a low-risk environment.’

Bernstein also notes that there are other changes afoot,

which potentially alter many of the other assumptions that

investors have been factoring into their thinking over many

years. ‘Globalisation is getting rough at the edges,’ he says.

Then there is infl ation, which he has been warning about for

some time. ‘Infl ationary pressures persist even as activity

‘This is a unique

period,’ he observes.

The Chronicler and Historian | 7

weakens — think of what those pressures would be like in a

more robust environment.’

He also senses a shift in the political environment. He says

this is moving in favour of the people at the bottom of the

ladder and it will become increasingly unfriendly towards the

owners of capital. ‘Productivity change has defi nitely slowed

down,’ he says. ‘The process Reagan started has run its course.

Things are not moving so smoothly around the world, either,

as the price of prosperity is rising.’

Given the danger that faced the credit markets in 2007,

Bernstein says he fi nds it diffi cult to pass judgement on the

Federal Reserve Board (Fed) when it fi rst began to cut rates

aggressively (by 50 basis points) in mid August 2007. ‘They

knew more than I knew when they cut the rate by 50 basis

points,’ he concedes. And, he says, he was disturbed at the

immediate negative response of the bond market and the

rise in the price of gold. ‘In hindsight, I guess I would have

favoured 25 basis points with a hint that there would

be another 25 at the next meeting, but the situation may have

been too frightening for that approach.’

At the time, there was furious debate on whether, by

cutting the rates, the Fed was risking the moral hazard of

appearing to bail out the very players who had got themselves

into the mess. Bernstein says it appears that the Fed made

every effort not to be seen to be bailing out players, but that

‘the main thing was to prevent a total collapse in the

fi nancial system.’ He says this probably was a greater danger

that he had recognised.

‘Everybody simply forgot that risk exists,’ he says.

‘Amazing — never been anything like it that I can think of,’ and

he adds, ‘The Fed had to let [its] gut override measurement.’

It’s clear from his comments that Bernstein thinks

investors should by now have become more defensive in

their portfolios — and he continues to have his doubts about

whether the more recent fashion of diversifi cation by investing

8 | Investment Legends

in so-called alternative investments is going to prove as

successful as some people thought.

In 2003 Bernstein shocked many investment people

by arguing that, if it seemed there was a major change in

investment conditions, then people should alter their long-

range investment asset allocation strategy. Bernstein had long

favoured a ‘policy portfolio’, weighted 60 per cent in equities

and 40 per cent in bonds. However, in 2003 he almost created

a scandal by advocating changing this to a more defensive

allocation. In changed circumstances, he said ‘market timing

might not be a bad idea.’ He argued that the 60/40 portfolio

was in danger of becoming rigid and, he added, ‘I think the

long run ain’t all it used to be.’

He still seemed to be thinking along these lines in 2007

when he contemplated whether current portfolios are appro-

priate. Bernstein says people should be more defensive. In US

institutional portfolios, holdings of bonds plus cash are down

to 10 to 15 per cent. ‘Diversifi cation is supposed to take care of

everything! But they are less diversifi ed than they think they

are — and the portfolios are illiquid because of the big positions

in alternatives.’

Bernstein says he has warned in the past ‘that these chickens

could come home to roost, and this may be the moment.’ He

says just about every institution has to liquidate assets to

meet their annual spending needs. ‘So the present posture of

these portfolios is not appropriate — unless today’s problems

are just fl uff, soon to be a memory.’ And, he warns, he doubts

that the problems may be merely transitory — ‘because of the

long-term impact on the household sector and the shifting

political environment.’