Betting on the Market

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What Is Wealth? by Peter Bernstein

Bernstein has been in the investment world since the '50s and currently heads an investment consulting firm. He helped launch the Journal of Portfolio Management and is the author of "Capital Ideas" and "Against the Gods.")

My father was in Europe on business when the stock market crashed at the end of October 1929. He had joined a brokerage firm as a partner only a few months earlier, almost immediately after having sold his family's manufacturing company for a price he never dreamed he would get. He enjoyed telling the story over the years that he had promptly invested the proceeds of that sale into other people's companies at prices they never dreamed they would see, either. What a dream!

My mother took me along to the pier to meet the steamer when my father arrived in New York about a week after the crash. Although I was just a little boy, the memory of his arrival is as vivid as if it happened yesterday. My father came down off the gangplank, dapper as always in his gray English tweed overcoat and his homburg hat neatly poised on his head. Under his arm, he held a small brown dog named Miquet that he had bought in Brussels. My mother ran up to him, crying, "Allen, Allen, what are we going to do?"

My father smiled at her and put his hand on her cheek. "Don't worry," he reassured her, "stock prices are still higher than they were when my mother died." My grandmother had died in 1927. But by the time the market finally hit bottom at the end of 1932, stock pricers were lower than they had been at any time since 1916. They had fallen almost 90% from their 1929 highs, trampling out thirteen years of price appreciation.

Try to imagine what the same phenomenon would feel like today. I can assure you that it would be almost as awful as after the Great Crash. Imagine that this January's peaking at over 6500 on the Dow Jones Industrial Average really turns out to be the ultimate high of this fabulous bull market. Now suppose that history repeats itself so that stock prices are going to fall over the next three years until, at the end of 1999, they are all the way down to where they were at the end of 1983, thirteen years before the 1996 peak. The market would then be back to 1287-which happens to have been the all-time high of its own era-5263 points (almost a mile!) below its present lofty level. That would be a drop of 80%.

I admit that was the mother of all bear markets. Yet a similar calculation with the major market declines that have occurred since 1932 is also sobering. My father looked at the situation in terms of how long a period of price appreciation had disappeared, at that moment only two years or so. Let us take the same approach and see how far the stock market would fall if the next bear market would wipe out time periods of price appreciation similar to what happened with the sons and daughters of the mother of bear markets.

What follows is a brief exercise in arithmetic. The numbers are dramatic. After a look at these calculations, I shall try to convey a sense of what they mean as a human experience instead of as cold statistics on a page.

The record of the ten biggest bear markets....

To set this scene, I examined the record of the ten biggest bear markets since the Great Crash of 1929. The worst of these was the bear market associated with the first oil crisis in 1973, which bottomed out in the first quarter of 1975. At that point, the market had sunk so low that the Dow Jones Industrial Average was back to was back to where it had been a full eight years earlier. If the same thing were to happen today, prices would fall to levels of late 1988, when the market was at 2130-68% below the recent high of 6550. The most modest event in my analysis was the famous crash of October 1987. The market had risen so steeply prior to the crash that, at the bottom, the Dow was back only to where it had been fifteen months earlier. If that is the worst we would have to face right now, the market would drop to levels touched in the third quarter of 1995, when the average was at 4690, 28% below its recent peak.

On the average, these ten bear markets set prices back to where they had been about four years earlier--16.4 calendar quarters, to be precise. But that loss of four years of gain meant an average price drop of 48% in the Dow Jones Industrials- precisely between the extremes of the 1975 bottom and the 1987 bottom. Should the 6550 level actually turn out to be the climax of this superbull, even an average bear market would mean that nearly every stock purchase or investment in a mutual fund made since 1992 would end up showing jumbo losses, drowning in a pool of red ink. For the mass of 401(k) participants who only recently started to accumulate their savings in the form of equities, a tragedy like that would represent a lot of broken dreams about their hope-for security in their years of retirement. Many entrepreneurs with new-found wealth from IPOs would share that sense of a vanishing future. For an investor who has been in the market for a long time, profits would still remain-a 48% decline from 6550 would still be triple the 1982 low and up 75% from the 1987 low. Yet the magnitude of wealth loss would be exactly the same as the damage inflicted on the newcomers.

This line of though brings to mind my memory of a bear market long past-the bursting of the speculative bubble of late 1961 and the abrupt collapse in the Dow Jones Industrials from 714 in March to 573 in June 1962. My wife and I were on vacation enjoying spring on the Riviera near Cannes as the market was approaching the bottom-climax in late May. The morning that I picked up my copy of the Paris Herald and saw the banner headline, "NEW YORK STOCKS PUMMELED IN PANIC SELLING," the shocking reality of Wall Street made the languid Mediterranean sunshine seem like a strange dream. When my wife urged me to check in with the office in New York, I realized that I had to face the music and went off to a telephone. The colleague I spoke with said, "You think the market is way down because you are watching stock prices. You should know that what it feels like to look at a portfolio whose valuation is off thousands and thousands of dollars since just three months ago.

Our Clients' Reaction....

Many of our clients took it philosophically; we had done some selling at the end of 1961, and they had lived through an equally serious bear market in 1957, just five years earlier. But when I returned home from France, with the market about to touch what subsequently turned out to be its ultimate low point, I was greeted by a relatively new client who was literally hysterical. He was convinced he was going broke.

Over the years, this man had built his business into a national franchise; everything he owned was invested in it except for his home and checking account. When his company went public with an IPO in mid-1961, what had been a substantial fortune in illiquid wealth was now, in part, transformed into a substantial fortune in liquid wealth. His lawyer had suggested that he come to us for advice on how to manage his totally unfamiliar situation.

He was much more risk-adverse than our typical new clients during the 1960s, even the prototypical widows who made up a large portion of our clientele in those years. He was not kidding when he pointed his finger at me during that first meeting in November 1961, exclaiming, "Listen to me, young man, you don't have to make me rich. I am rich!" That was fine with me. My natural bias was to be conservative anyway, and I and my colleagues had in any case begun to worry about the speculative flavor that the market exhibited as 1961 was drawing to a close-and that had provided our new client, like my father, a fancier price for the shares he had sold than he probably had any right to expect. We recommended that he invest only one-third of his assets in the stock market-and even that only in big-name blue chips, retaining the rest of his wealth in a blend of bonds and cash. He was in enthusiastic agreement and complimented me generously on my willingness to accommodate his own views.

But by May he was incapable of seeing that the bear market had hit his total portfolio by only 6% or so (his bonds had actually appreciated a little), nor did he note that his own business was continuing to prosper. All he could see was the losses in his equities. We had a tumultuous meeting with him, in which intense invectives replaced the high compliments I had received from him six months earlier. Over our strenuous protests, he insisted that everything was to be dumped the following morning. A year later, the market rose through the 700 level where the selling was executed.

You do not have to be a beginner at investing to succumb to that kind of irrational behavior. Consider another client-- a friend's father-- who came to me some time during the1960s. He had been a broker on the stock exchange floor for many years. Like my father, he had sold his interest in a family business during the 1920s and then invested the proceeds in the stock market. At the bottom in 1932, every stock in his portfolio but one was selling below what he had paid for it-in most cases far below his cost. That single exception was IBM. In fear of losing the one profit that remained, he sold the IBM in December 1932.

Investors look at the hole more often than they look at the doughnut. More important, investors tend to measure their wealth, not by its level but by where it is compared to where it has been. My client's decision to liquidate the IBM was motivated by where it was selling relative to what it had cost him, and in the process he ignored what a screaming value it was at that deeply depressed price.


On the way up, the process of capital appreciation gives each new level of wealth a degree of permanence in our minds--a degree of permanence that is hardly deserved even though it feels that way. When I look back on the days when I managed other people's money, I can recall many clients during bull markets who thanked me for the way that I was making them richer. I always reminded them that they were thanking the wrong person. Their gratitude was due instead to all those other nice investors out there who were willing to pay higher prices for their assets than we had paid when we acquired them. The market that sets the value on your wealth is not an impersonal being, although conventionally we talk about it that way: the market is the decisions made by a bunch of human beings, some dumb, some smart, some greedy, some fearful, some informed, some misled, but all human beings making decisions and choices.

Seen in those terms, what we like to consider as our wealth has far more evanescent and transitory character than most of us are ready to admit. What appears to be "ours," in other words, is ours only by leave of the rest of the fraternity of investors, not one of whom is in any way committed to paying up for what we hold. They own the option, not each of us as individuals.

It is also essential to keep in mind that wealth is literally meaningless without future. If there were no future, accumulation of wealth would be insanity. But that means that fluctuations in our wealth are intimately and inextricably involved with our view of the future. Hence, people who attach a degree of permanence to any particular level of wealth begin to plan and shape their futures accordingly. If the wealth disappears through no fault of their own, but purely because other investors have placed a new value on these assets, their view of the further is not only disrupted-in some cases, with a loud sucking sound, their future can vaporize entirely, along with their egos. A pile of wealth that is shrinking is sliding back toward the past, sometimes years into the past, rather than into the future. Panic selling is a desperate gasp to keep the future from vanishing into a black hole.

When that happens, plans begin to change. A decision that made sense at 6550 begins to look problematical at 5550, even though nothing may have modified except the level of the stock market and the valuation of the portfolio. Nearly every major stock market decline has been followed by a drop in real business investment and often by a slowdown in consumer spending; in the fourth quarter of 1987, after the stock market crash, consumer spending stopped dead in its tracks. On the occasion when that process proliferates, an entire economic landscape is transformed from sunshine to storm, such as after the stock market top in the early months of 1973.

I am not trying to make a market forecast. On the contrary, we do seem to be living through a period of low risk in which the world of economics and finance appears to be immune to shock, at least compared with most of past history. The odds on a cumulative bear market do look small right now, even if equity returns are likely to be modest over the next few years.

But remember this: I make that hopeful assertion with stock prices in record territory and bear markets so far in the past that they have been extinguished from investors' collective memory bank. Even though I could defend that hopeful assertion at length, our view of the future is always a creature of our imaginations. Whether we are amateurs or professionals, our imaginations are colored and limited by the performances of the market.

What looks like a dimple when the market is high looks like a scar when the market falls. Which is reality?

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