Efficient Frontier Advisors Co-Founder & Neurologist Bill Bernstein
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This week on the podcast, another banger, Bill Bernstein, neurologist, investor, author. What a perfect time to talk to the author of The Birth of Plenty and, of course, A Splendid Exchange about how trade has made us all so much wealthier. Really, a person who dives deep into the subject matter, understands it better than anybody else, and could put it into great historical context.

I thought this conversation was fascinating, and I think you will also, with no further ado, my discussion with Bill Bernstein of Efficient Frontier Advisors. So you have such a fascinating career. I want to get into some of the details before we start talking about markets and investing. You practiced neurology for 20 years? That's kind of...

unusual to say, I've had enough of that. Let me start managing assets. Tell us about that transition. Well, first of all, it kept me off the streets. And secondly, I'm easily bored. So I do move from thing to thing. And it occurred to me, oh, about 40 years ago that I live in a country that doesn't have a functioning social safety net. And so I was going to have to invest and save on my own account to accomplish that. And

And I approached it the way I thought anyone with scientific training would do, which is I consulted the peer review literature, I read the basic texts, I collected data, I built models. And by the time I had done all that, I realized I had something that was useful to other small investors. And so I began to write things up. And I discovered that

When you're writing about investing, one of the key subjects that you have to nail down is the history of finance. If you don't know the history, you're dead in the water. Can you spell long-term capital management?

Just LTCM. Yeah, exactly. You don't need to spell it. Yeah, I mean, you can solve differential equations as easily as most people brush teeth. But if you don't know the history, you're going to have your head handed to you, which is what happened to them. So I discovered that I enjoyed writing history. And so that's how I segued into writing history. And footnote, Roger Lowenstein's When Genius Failed.

is so instructive, not just because of the things you're referring to, failing to learn from history, the danger of leverage and, you know, tiny inefficiencies, but it was also a cautionary tale that was ignored a few years later, led right to the great financial crisis. The same mistakes. Yeah, there's a historian by the name of Robert Kaplan who said that all of history is half geography and half Shakespeare.

And when I heard that, it resonated. I realized that investing is the same way. It's half mathematics and half Shakespeare. And you have to manage, you have to master both of them. If you can't master both, you're dead in the water. Literally my next question, you describe it as half mathematics, half Shakespeare. Some people would call that art and science. But tell us why you need both compounding and exponential mathematics and the barred

to be successful as an investor? Well, it gets to what I call the prom queen theory of life, which is that if- Wait, wait. The prom queen theory of life. Indeed.

If you're the prom queen, then the most important thing in the world is how you dress and how you look. And that's how you judge other people. Brains, athletic ability, political ability don't matter. Well, financiers are exactly the same way. If the peak of your skill set is your quantitative ability, that is how you judge other people. And if other people can't understand your models, then they're stupid. Right.

All right. You have to, you know, the conceit of finance is that basically the math is all there is to it and that you don't have a limbic system. Yeah.

they deny the existence of their emotions and their psychology. And that's what gets them into trouble. They don't understand the history and how that feeds into mass fear and mass greed and mass delusions, which is why I wrote that particular book. Kind of reminds me of the Richard Feynman quote, imagine how much harder physics would be if electrons had feelings. Exactly. So interesting. So

Since we mentioned Shakespeare, I have to ask the obvious question. What writers and investors have influenced how you invest and how you write?

Oh, dear. Well, Jim Grant, of course, would be at the top of anyone's list. And then the person who's right at the top of that list was a Scottish guy who lived almost 200 years ago, Charles Mackay, who wrote Extraordinary Popular Delusions and the Madness of Crowds, or actually Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. And he described all of the things that we've been seeing over the past couple of decades more than 200 years ago.

So those are two well-known names.

Jim Grant is really best known as a macro analyst and a fixed income investor. How has Grant influenced how you look at the world of investing? Well, he's also a historian. You know, he's written several historically deep books, particularly about Bernard Baruch. But he certainly, you know, describes the historical episodes of manias and panics. I guess the other one would be John Kenneth Galbraith.

whose history of 1929 crash was non-parole. I mean, it was just absolutely superb. You know, it's one of those books that you just can't help but, you know, snickering out loud, you know, with every paragraph. And he has probably coined more quotes and phrases that other people unknowingly steal and don't credit him because they're just the essence of truth and wisdom.

Yeah, especially whenever anybody talks about innovation in finance, he describes it as reinventing the wheel only in slightly more unstable form. That's pretty amusing. We briefly talked about if it's in the headlines, if it's above the fold in the paper, it's already in price. So you're a proponent of modern portfolio theory and the efficient market hypothesis. Right.

How efficient? How much do market prices truly reflect future discounted cash flow? Well, Samuelson once wrote, I think in a private letter, that the markets were micro-efficient but macro-inefficient. And what he meant by that was

by microefficiency was that, as the both of us know, it is brutally hard and getting harder by the day to pick stocks in time the market. If you don't know that, you're in big trouble. But the markets also can be macro inefficient. So, the overall markets can

overshoot in one direction or the other. It's very hard to, almost impossible to figure out exactly when that's going to happen. You can look at a market that is ebullient and frothy and you can say, I know what's going to happen, I just can't tell you when. So that to me is the best explanation or the best description of macro and micro efficiency there is. But my message to anybody who's

is 20 years old or 25 years old and just coming out of their education and think they're going to be the next Warren Buffett, the bad news is you're trading against Warren Buffett. That's right. That's right. I have been told that markets can stay irrational longer than you can stay solvent. Yeah, that's an apocryphal quote from Keynes. Right. But not really. I don't believe he ever said that. No, he never... He certainly never wrote it. No, he never said it or wrote it. So...

Speaking of apocryphal times...

You have said investors should build their portfolios for the worst 2% of market conditions rather than normal times. Tell us why you believe that and how do we go about accomplishing that? Well, that directly falls out of Charlie Munger's dictum, which is that, yes, compounding is magic, but the first rule of compounding is never to interrupt it unnecessarily. And

you're most liable to interrupt compounding, to panic and sell, during the worst 2% of times. So you design your portfolio for the worst 2% of times, which means that it should be more conservative than you think it should be the other 98% of the time. And it's a suboptimal allocation. To have less stocks is suboptimal. But what I like to say is that a suboptimal allocation you can execute is better than an optimal one you can't execute. Right.

No doubt about that. You mentioned someone 20, 25. There are a number of people who have said, and I've been swayed in this direction, hey, when you're 20, 25 years old and you don't need this money for 30, 40, 50 years, do you really need bonds to offset the volatility of equities? Shouldn't you be 100% equities at that age?

Theoretically, yes. Practically, no, because there are a few sentient beings in this quadrant of the galaxy that can tolerate 100% stocks. Huh. Really, really interesting. So you mentioned half math, half Shakespeare. Let's talk about the math side.

So when you started looking at investing and bringing a scientific rigor to the process, you created your own set of asset class databases. This is before CRISP and other widely available databases. Tell us how you went about doing this. Oh, no, no. I stole it from them.

Oh, you did?

And I transcribed all, you know, 985 data points into a spreadsheet, which I had just learned how to use, you know, sometime around 1990. And then that was the start of my models. And the other people provided me with data. Ken Fisher, bless his soul, supplied me with a fair amount of data. And I, you know, impersonated a professional investor at certain large banks and was able to get data sets from them as well. Yeah.

By the way, I find Ken Fisher to be one of the more fascinating people in finance because...

Not only did he bring a writer's perspective, I think he was the longest running Forbes columnist at like 43 years, some crazy number, writing a monthly column for them. But he was both an investor and a very accomplished business person in terms of...

Like he was early in direct mail. He was early in the internet. He was early in just as running a business, just throwing stuff against the wall, seeing what stuck and just A-B testing, iterating on a continual basis long before Google started doing that online. He was one of the early people who developed, here's what financial asset management marketing should look like. Yeah.

Yeah, indeed, he did all those things. And he's also a superb writer and observer. And I think you interviewed him. A couple of times. Yeah, once or twice, maybe once memorably. Well, there was that, sure. And, you know, he said something on one of your interviews that stuck with me, you know, for the past 20 years.

which is that he pays close attention to the headlines because he knows that if something is above the fold, it's already been impounded into prices and can be safely ignored. That's exactly right. I thought you were going in a different direction. The first time, quick digression, the first time I interviewed him right in the studio, he was kind enough to do an interview with me in the first year of the podcast, which was

You know, admittedly, pretty terrible. I was very rough around the edges. And it was very formal and rigorous and tell us about small cap and tell us about emerging market value. And it was really on the, you know, just kind of straight down the line and really boring.

And afterwards, we're having a conversation. How's the new firm going? Pretty good. We're a few hundred million dollars, blah, blah, blah. You know, we come in second very often on some of these big households. And he said to me, wait till you're five years old and a billion dollars in assets under management, and the world will open up to you because no one with real money wants to give money.

you know, a small firm with no history, a big chunk of cash. And we just started talking about how the business ran and how he delegated authority and how he built stuff. And I'm sitting there listening to them, listening to him and saying to myself, idiot, this is the conversation, not the small cap nonsense you just spent an hour chatting about. And when he finished schooling me,

I said, can you come back one day and we'll discuss that? Because this is fascinating. And he goes, sure, anytime. So a year later, we came back and had the conversation we should have had. He has always impressed with me with how insightful and unique his perspective is. I mean, we're all a little neurodivergent. He has his issues. I have mine. But I just find him to be an absolutely fascinating guy.

I mean, if we can get into just a little bit of neurophysiology, there's something called the, well, you happen to be a neurologist. So let's, let's have at it. There's something called the default mode network. Uh,

which is a part of your brain that becomes electrically active when you're at rest, and which turns itself off when you're doing any focused task. And it turns out you can locate it anatomically on imaging studies, and people who have well-developed, anatomically well-developed default node networks tend to be very good at reading other people.

and have good emotional intelligence. The opposite of that is in people who are on the spectrum, who have small default mood networks and are not good at reading other people.

And so he kind of – by the way, the firm has done fine. They've recovered from his stumble. I don't know if it was even pre-pandemic. And I thought he kind of got slagged by a lot of people unfairly. The guy has been a public figure for 45 years. He's been at least writing in public for all that time.

You know, sometimes stuff happens. And in a sort of social media gotcha environment. Yeah, to say nothing of being a spectacularly effective environmentalist. So on our last interview with him, we talked about...

all the trees and woods that he has purchased and put into permanent conservation. He's done giant studies on sequoias and redwoods. I think he's one of the leading experts in a specific type of tree known in the Pacific Northwest. He's really like a wildly fascinating guy. And I hope people don't judge him for that. I mean, I don't know what to call it, that politically incorrect snafu thing.

I don't think he meant it in any other way. And it, you know, they kind of had to reel him in a bit. But the firm is doing fine. His firm is doing fine. And there was like about a $5 billion outflow. But when you're $105 or $110 billion, all right, you got to dance with who brought you there. He built it up to that. But I find him to be really an interesting guy. Yeah. And he has the address here on Lexington, so he knows where to send the chocolates. Yeah.

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I think I'm going to begin with a quote that I stole from Bill to start a chapter of my new book. To the extent you succeed in finance, you succeed by suppressing the limbic system. Your system one, the very fast moving emotional system.

If you cannot suppress that, you are going to die poor. I love that quote. Is it an exaggeration or is it accurate? No, it's extremely accurate. Let me tell you a personal story. I have a good friend who is a wealthy person and that has enabled this person to have a career in public service.

And she's done very, very well. And one day, after I'd known her for many, many years, she told me that her sister was poor.

All right. Or did not have a lot of money. And I said, I don't understand this. Was she disinherited? Did she make the family angry? And she looked me straight in the eye and she said, no, she was afraid of stocks. Really? Yeah. And so that's the difference. If you can suppress that fear, you will do very well. And if you can't suppress the fear, then you probably will die poor. So it's so fascinating you said that.

You must have a similar situation. I live in liberal New York. You live in liberal Oregon, right? But we have clients that are on the left and the right. And so anytime you put out a commentary on current affairs—

Not only because you don't want to offend half your clients, but because it's a good analytical strategy to try and go down the middle. Be objective and fact-based, but whatever your personal bias is, keep it out of it. And I wrote something up about what are the best and worst case scenarios about the tariffs. And we'll talk a ton later about tariffs.

But the fascinating thing is when you look at history and you look at a chart of everything that's happened, go back 100 years, go back to 1926, there's always a reason to sell stocks. Year in, year out, there's always some spectacularly crazy news that says, this is going to be terrible. I want to sell. And if you're selling in response to headlines, you

and you're going to wait for the dust to clear, by then it's too late. You've missed most of the recovery time.

How do we deal with that never-ending threat, that persistent, this time is different sense? And current affairs, the headlines today, does it feel like the tariffs are different? Or is this no different than the great financial crisis, the pandemic, the dot-com implosion? Go down the list to say nothing of the Kennedy assassination, 9-11. Like there are endless reasons to be panicked about what's going on in the world.

Yes, this time certainly was different. Never before in American history has a colossally incompetent American president tried to crater the economy.

And that's it's very different. Do you think that was his purpose? Is he like, hey, we cause a recession, rates come down and that's good for real estate or? I think we've talked about this one. The Rosetta Stone of Donald Trump is a call in show he did with Howard Stern, along with his daughter and his son, Junior. And and Howard looked at him and said, quick, multiply six times 17. All right.

None of the three of them could do it. 102. How hard is that? Well, that's the whole point. And Don Jr. laughed. He thought it was funny. Ivanka said, oh, no, you don't have to be able to do math to do real estate. Right.

Or investing for that matter. But the most interesting response was Donald's. He said, no, it's 112. And he argued with Howard Stern about whether it was 102 or 112. Six times 10 is 60. Six times seven is 42. 60 and 42. I mean, that's how I do math in my head. I don't know how you do it. Yeah, yeah. That's one way to do it. Or you might know that three times 17 is 51. And you could double it. Double it, exactly. Exactly.

And so this is a math problem that, you know, a reasonably bright middle school student can handle.

None of the three Trumps could do it, okay? And so this is the guy who's now directing our economy. So that's different, all right? Well, how different was that from 9-11? All right, 9-11 was sure different. I mean, arguably, George W. Bush isn't the sharpest tool in the box. Barack Obama had no national experience whatsoever, had no idea how really the national apparatus worked. You could do this...

On both sides to some degree. You're saying this time really. Oh, yeah. Yeah. Yeah. This is this is this. This is completely there were there were adults in the room during the Bush presidency and there were adults in the room during the first Trump presidency. They're all gone now.

And yet the market continued to go higher during the first Trump presidency, regardless of who was president. Because they took him literally, but not seriously. All the way around. Yeah, okay. Seriously, but not literally. This time, I think we should be taking him literally, but not seriously. Yeah, yeah. That's right. You got it reversed. Exactly. Yeah. So we talked earlier about the efficient market hypothesis. Right.

So to be fair to the president, he's been talking about tariffs his whole adult life. He says tariff is the most beautiful word in the dictionary. He says, I'm tariff man. Why were the markets so surprised by Liberation Day when here's a guy who has...

told you, I'm going to implement big, beautiful tariffs in my second term. Why did the market have to adjust revenue and earnings expectations down substantially after April 2nd if the market's so efficient? Well, I think that the reason why is because he didn't do 90% of the other things he said he was going to do. He was going to repeal Obamacare and give us a big, beautiful

healthcare system. He was going to redo our infrastructure. He was going to establish peace in the Ukraine on day one. And I think that his- Bring down the price of eggs? Yeah, exactly. And I think that his promise on tariffs just got put in the bin with the rest of the stuff he obviously wasn't going to do and didn't do. But I think people did take him seriously. They did expect-

you know, the sort of muscular U.S. foreign policy and take tough, you know, a tough stance with the Middle East, a tough stance with the Russia-Ukraine war, and he's going to bring prices down. That's why I believe most of his non-hardcore supporters voted him. I think a lot of people were kind of surprised that

by what he's done. Are you suggesting that we should not be long-term investors and step aside, or do we just have to ride this out? No, I think that this time is different in the same way that all the other times were different. I mean, you know, October 19th,

1987, boy, that was sure different. We've never seen that before, and we've never seen it since. And the smart thing to do on October 20th of 1987 was to buy stocks. Right, right. So,

So when you see, not that you had time, like I was hoping we would be down. I don't get excited about down 8% to 10%. But down 20%, you've got my attention. I want to start legging into more equities. We never quite got there on the S&P, right? I think, what, we down 18%, 17%, something like that? And it was the same thing with late March of 2020. Boy, that was fast. 34%, 17 days. So if you were looking for down 20%

you got it. You just only had a day or two to react. Yeah, I don't. I try to stay away from correction. 10% bear market, 20%. To me, that's numerology. There's no difference. You and I know. You know I find the base 10. Like, wait, you have 10 fingers and 10 toes, so 20% is a bear market? There's just no data that supports that. No, there's no difference between the market being down 19% and being down 21%.

It behaves the same way in both cases. Arguably, so maybe I should make our rebalance bands instead of being down 20%. Maybe it's down 16%. So you get executed and then add a second one down 24%. Until you get to March of 2009 and there you've rebalanced. You've thrown all your cash in three different times.

But, you know, if you've thrown away your cash, it kind of works out. The really strange thing about bear markets – and my frame of reference is not just 2000 to 2013. But the Dow kisses 1,000 in 1966 and it doesn't get over it on a permanent basis until 1982. Yeah.

If you just continue to dollar cost average for those 16 years or from 2000 to 2013 when the market finally got over all its previous highs, that's when you start to make a ton of money because that next cyclical – I'm sorry, that next secular move, all those bad buys you've made over the past 10 years, suddenly they start flowering.

Yeah, there's this academic parlor game we're both aware of, which is the argument is do stocks get riskier with a longer time horizon? And the correct academic answer is yes, they do. But the assumption there is that you're a buy and hold investor. All right.

But there are other kinds of investors besides buy-and-hold investors. If you are a periodic saver, you're a young person who's putting money away, then stocks are really not all that risky for the reason you just gave.

gave. On the other hand, if you're a retiree and you have no more human capital left, then stocks are three-mile island dangerous. You are... You have to explain what that means to a younger generation. Yeah, there was a nuclear accident, which was sort of the junior early version of Chernobyl at Three Mile Island outside Harrisburg, Pennsylvania. There was a movie that was... Jane Fonda. Yeah, yeah, The China Syndrome. That's right. And

And so the point being that if you're an older person, stocks are risky. And you could say, if you're like me, you don't have a lot of human capital left, well, five out of six times, stocks have higher returns in bonds. So even in retirement, I should have plenty of stocks. And that's like saying that when you play Russian roulette, five out of six times you win.

I guess five out of six times, but that six time is a doozy, isn't it? Exactly. It's all about asymmetric consequences. If you're invested too heavily in bonds and you should have been invested in stocks, well, you don't get to fly first class. You don't get to buy the Beamer. But on the other hand, if you invest too heavily in stocks and you're wrong, then you're bunking with your kids. Right.

Right. If you're an older investor and you don't have that time horizon. Right. Yeah. Someone said to me, can you really look through the next four years if you're not retiring for 10 or 20 years? Or if your kid's 529, they're not going to school for 10, 15 years? That's the easy question. The challenge is what happens if you're retiring in 25, 26, 27, right, in the next three years?

You know, that sequence of returns problem is really thorny. I think it was Bill Sharp said it's one of the most difficult problems in all of finance. How much do you draw down each year? We all use 4% as an average. But how much do you draw down each year if your first couple of years of retirement is down 5%, down 10%, down 20%? Yeah, there's this wonderful little bit of quantitative work done by Mike Kitsis and Wade Pfau about the reverse equation.

glide slope, which is you actually raise your equity allocation the further into retirement you get. If you think about it logically, it just falls right out of that. Your first five, 10 years of retirement, you want to be fairly conservative just for that reason. Then when you're 80 years old and you'll be pushing up the daisies in five or 10 years, then you can be more aggressive because you don't need that much of a liability matching portfolio at that age.

Huh. Really, really interesting. So you wrote a short book called Deep Risk, talking about different types of risk. Explain what is deep risk? What is shallow risk? Well, shallow risk is the way we normally think about risk. There's this theoretical finance dogma that risk is the same as variance or standard deviation.

And the problem with that is that's only true in the short term, the short-term volatility. And short-term volatility is not of any real importance to the long-term investor. The real risk of long-term investing is not having enough assets to pay for your living expenses 5, 10, 15, 20, 30 years from now. So what are the things, what are the advantages

events that can impair that. Well, the big one's inflation. Hyperinflation in particular is extremely common. It is almost the rule rather than the exception. Really? Sure. All you have to do is ask yourself what unit of currency that would buy yourself something in the year 1900 can still buy yourself something today. Well, the U.S. dollar can still buy yourself something. It can buy you something.

A Japanese yen sure can and can't. An English pound can and a Swiss franc maybe can buy you a candy bar if you find the right store in Geneva or more likely Bern. And so, you know, the case of the yen and the French franc and the German lire are much more common than the U.S. dollar and the Swiss franc and the English pound.

German Deutschmark, Italian lira. Exactly. Okay. Exactly. Yeah. I mean, you start with a Reichsmark in the year 1920, and by 1923, late 1923, you were down to one trillionth of its purchasing power. That's hyperinflation. So that's the rule. So that's the most common thing that you have to worry about. And that is, relatively speaking, the easiest one to defend against. Now, there are other

three other things that can also... Well, wait, before you go to the other three things, how do you defend against that? Well, first of all, in the U.S., we have these marvelous instruments called tips. And all you have to do is worry about, you know, the Department of Labor rejiggering the inflation adjustment, which is something to worry about. But

of all the worries you can have, that's a relatively small one. We went through that with Michael Boskin already, rejiggered how we calculate cost of living adjustments rather than debating this like adults. Politically, they just made some, I'm not a big fan of substitution or hedonic adjustment. When steak gets too pricey and you substitute chicken,

That just means I've been priced out of stake, not that this is the equivalent. Yeah, exactly. I mean, it is a problem. But of all of the asset classes that protect you with the greatest surety against fraud,

the decrement in your future consumption, loss of your future consumption. Tips do it better than anything else I can think of. All right? Really interesting. Stocks do a relatively good job of it. You know, Elroy Dimson likes to point out that stocks are an inflation hedge simply because of their high returns. But they're also a claim on real assets. You know, companies own real estate. They own equipment. They have human capital. And those retain real value. Plus...

stocks are, their revenue and profits are in dollars, so at least in the U.S. So if there's inflation, the cost of their goods go up and their total dollars, maybe their profits get squeezed, but everything seems to rise in an inflationary environment on the equity side, right? Right. And then there's certain kinds of stocks that are especially good at protecting against inflation, value stocks do. Why? Because they tend to be overly leveraged and

And with inflation, their debts tend to get inflated away, and so that flows to their bottom line. So if you look, for example, at the period that we just talked about, from '66 to '82, value stocks actually outperformed the market by an inflation by a very good margin. And then finally, there are commodities producers. In an inflationary environment,

The petroleum stocks, gold stocks, base metal producers are all going to do fairly well

at least relatively well to the market. And then finally, you know, on the bond side, for God's sakes, keep your, keep your maturity short. You know, as we found out in 22, I noticed when you talked about real assets, you did not discuss real property. How does real property do as an inflation hedge over time? It's pretty good. But what I like to say about real estate is that it's not an investment. It's a job. Yeah. If you, if you, if you, if you, if you enjoy dealing with drug addled tenants, uh,

and fixing toilets, then be my guest. Okay. I wasn't thinking of rental properties. I was thinking of the various REITs and offices and paying a professional to manage it so you're not getting the 2 a.m. call that the toilet is overflowing. Yeah, but then by the time you're investing in public REITs, you're back in the stock market again. Right. So there's no difference. Really hard.

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I was kind of fascinated by a data point you shared talking about

old master paintings. Imagine if you bought a Rembrandt for $100 and 350 years later you sold it for $10 million. The return was a little over 3% a year. That's astonishing. All these paintings look like they've appreciated so much. Tell us about the math behind these paintings that go for $10, $20, $30 million. Well,

Well, it's really not about finance or math. What it's about is human neuropsychology. We are particularly bad at exponential calculations. And, you know, it's the old thing that even they knew back in the Far East that, you know, the emperor asks the artisan woman,

or the farmer, what he wants. He says, well, put one grain of rice on the first square of the chessboard. And by the time you get, of course, to the... Double at each square. By the time you get to the 64th square, he's the wealthiest person on the planet. Human beings are not good at that. And that's all that that's a demonstration of. Now, if you want to get into the academic finance of it, it's that...

Art has value in investment, has investment value, but it also has a complementary value, which is its aesthetic return. And Bill Baumel did the research on this, the late Bill Baumel of NYU did the research on this, and figured out that art had a much lower return than stocks or bonds simply because of its aesthetic return.

Makes a lot of sense. And that's before we get to the whole survivorship bias that you only see the most famous paintings in the world and their price tag. The tens of thousands of other paintings that aren't auctioned off each year, we don't see their returns. To say nothing of the maintenance and insurance and security costs of keeping the art as well. No doubt. No doubt about that.

It's funny because you have this whole group of investing books and then you also have this separate group of really fascinating historical books about markets and the economy and global trade. Let's start with The Splendid Exchange. It's so perfect for the moment we're in. What is the history of trade and how has it helped raise everybody's standard of living?

Well, it just gets down to Adam Smith's concept of specialization. Nations specialize, and nations have and people have an intrinsic connection

tendency to, as he put it, truck and barter. They want to trade one thing for another. So, you know, one of the great luxury commodities of the 17th century was the pineapple. If you look at the coats of arms of all these European aristocrats, about a third or quarter of them have a pineapple on them. Why? Because they came from the New World. They were incredibly precious. And

And they were delicious. Everybody in Europe wanted a pineapple because they don't grow pineapples in Europe. And so different nations have different geographical and intellectual and technological endowments. And it's if you improve everybody's standard of living by trading among nations, the things that other nations aren't good at.

So that seems fair, and we all specialize and we all do different things. It makes sense as the U.S. developed computer technology and software that we're not going to make furniture or fabrics or sneakers or those sorts of things.

But at what point does globalization go too far? At what point have we hollowed out the middle class by outsourcing manufacturing to China and other low-cost countries? That's a really good question. And it was highlighted by a series of patient, again,

Again, it was highlighted by a series of papers by an economist named David Autor, A-U-T-O-R, and his colleagues. And it showed just how badly communities that were affected by Chinese competition were harming

hollowed out. Now, the problem with free trade is that its harms are concentrated and obvious, as David Autor found out, but its benefits are diffuse. So a world in which we have to make our own shirts and our own furniture is a world in which the other 350 million Americans who don't make those things are taxed very heavily. So instead of paying $15 for a shirt, you're paying $35 for a

Instead of paying $2.50 for a head of lettuce, you've got to pay $7 for a head of lettuce. And so that's a world in which everyone else is impoverished, but in which those costs are much harder to see than the out-of-work autoworker or out-of-work furniture manufacturer. Yeah.

So we certainly have problems in the United States. There's wealth inequality. There's income inequality. I think the worst of the pandemic inflation is behind us. But we have these real problems with which a lot of people are blaming on trade and globalization. What's wrong with that thesis?

The analogy I like to use is Churchill's comment about democracy, which is it's the worst form of government that's ever been tried, except for all the others that have been tried from time to time. I think that's close to the exact quote. And so the alternative to free trade is protectionism. Right.

And protectionism, as we found out during the 30s, is a disaster in multiple dimensions. What happens when you raise tariffs is what we're seeing now is, in the first place, prices go up. Automakers have to pay more for their steel prices.

People who are making agricultural products and processing food have to pay more for their imported basic inputs. And so domestic prices go up, you get inflation. And we're already starting to see the expectation of inflation going up. I think the median expectation is now 6.7% in survey data. And once you see the expectation of inflation going up, then inflation goes up because that's how inflation is driven. Then you see retaliation.

which we're already seeing in spectacular fashion. And you see trade wars, but that is not even the worst cost of protectionism. Because what happens with that is that it inflames international relations. And

And it was apparent to people in 1945 that one of the causes of the Second World War was the protectionism of the 1930s. And that gave rise to the New World Order that we put in place basically in 1945, you know, with what became the World Trade Organization, the IMF, and Bretton Woods.

And they said, never, never again. This is never going to happen again. Why did the Japanese attack Pearl Harbor? Well, it's because we embargoed oil.

All right. And they knew what would happen if we cut off their their oil supplies. And I fear the same thing would happen today. Imagine, for example, an inadvertent naval encounter in the Straits of Taiwan between U.S. and Japanese naval vessels. The difference between a peaceful and a non-peaceful outcome may very well be the state of mind of the policymakers on both sides whose emotions have been inflamed by the trade ruckus.

Huh, really interesting. So Pax Americana, 80 years of growth and economic success, much of which accrued to the benefit of the U.S.,

Are you implying that that is now at risk? - Yes, absolutely. There is a man, a fairly well-known economist by the name of Albert Hirschman, who has a fascinating biography. He was Jewish, he was raised in Berlin,

Not only was he Jewish, but he was also a socialist. So he fled the Nazi persecution, fought in the French army against the Germans, then wound up in Marseille, spiriting people like Hannah Arendt out of Marseille into the United States.

And he saw quite clearly that World War II was in large part triggered by the trade frictions of that period. For example, one of the things that inflamed the Germans so much was because they couldn't pay their way out of the World War I reparations because they couldn't export.

Lords of Finance, Lequad Ahmad's book goes into great detail about that. Yeah. And so he wrote about that in 1945 and he says we have to establish a world order in which that doesn't happen again. Huh. So here's the best case scenario. And I want to talk a little bit about this because Splendid Exchange and Birth of Plenty are sort of two sides of the same coin. Best case scenario.

Best case scenario, this is just a negotiating tactic. We're going to cut all these side deals and all this brouhaha. Hey, you took them literally. We should have taken them seriously. Is there a way out that doesn't destroy the post-World War II order that has accrued so much wealth to the United States? It is possible. Uh,

I don't think at this point it is probable. I think that so much damage has been done. I don't think that any foreign power is ever going to trust us again.

Donald Trump renegotiates NAFTA. We get the USMCA. His new treaty in Trump one time. In Trump one. And then he repudiates that. And let's say that a Democrat gets elected in 2028. Let's assume that he or she not only gets the presidency, but also gets a democratically dominated Congress election.

The other nations of the world are going to look at us and say, yeah, but we don't know who's going to be elected in 2032 or 2036. We can't trust these people ever again. That sounds like a worst case scenario. I think that's the most – I don't think that's the worst case scenario. I can think of worst case scenarios than that, which I've just – I described previous to that in terms of geopolitics. But I think that's the most probable scenario. I don't think that anyone is ever going to trust the United States again. Right.

So I'm an optimist because I was fortunate to be born when I was, where I was, into the family I was. I know that shapes how I see the world. I'm kind of hopeful that the 2026 Congress changes hands soon.

The tariff power is retaken back by Congress, which is within their authority to do. And that whoever gets elected in 28, regardless of which side of the aisle, just does a global goodwill tour and kind of rolls back the past four years.

Am I being Pollyannish about this? Am I too sanguine about the potential to repair the worst damage that you're suggesting? Well, you and I are engaging in a forecasting exercise, which is well beyond computational impasse. Human beings, as Philip Tatlock described, don't forecast very well, even the best experts. My judgment, my forecast would be that your scenario is possible but less probable than yours.

than mine, but I wouldn't be surprised and I would hope that you're right. But if you want a worst-case scenario, which I think is as probable as yours, the current ructions trashing the Treasury market, I see rates rising and I see us falling into a debt spiral and away we go.

So Ben Hunt of Epsilon Theory wrote a piece a week or two ago called The Car Crash of Pax Americana and lays out that exact case. Nobody wants to buy our treasury, so how do we finance our debt? The dollar, our exorbitant privilege, the dollar as the world's reserve currency, is replaced with a basket of euro, yen, yuan, things like that. And

And people just start to realize how good they had it and frittered it away on a very ill-advised policy that the last time we tried it in 1930, Smoot-Hawley didn't work out well.

Either. So if that's the case, why would I want to own dollar-denominated U.S. assets? Isn't that an argument for head for the hills? Why, indeed. And that is certainly an argument for international diversification, to invest in countries whose economies are run by adults.

So once you buy it, the exchange rate no longer matters if you're purchasing Europe and if you're purchasing Japan or India or wherever. And there is inflation in the U.S. and there is a decrease in the value of the dollar. It doesn't matter after you've made the purchase.

Yeah, there will be damage on a global scale no matter where you invest, but you will mitigate the damage by investing abroad. That's the argument for international diversification. It hasn't had a lot of fans the past 15 years, but it's coming back into fashion.

So, yeah, no, you've definitely seen this year to date overseas, especially Europe, and even some of the emerging markets start to do much better than they have. What's fascinating about Splendid Exchange is you trace the rise of trade and the benefits of an interrelated economy here.

Back to the plague, the Black Death. Tell us how the plague led to changing up trading patterns. Well, it's a fairly well-established economic historical subject, which is that what the plague did is it overvalued labor. A third, a half of the population of Europe disappeared. And so that greatly empowered workers. It drove prosperity. And it also probably...

you know, a century, a century and a half later, drove the voyages of discovery to the Indies. What were people looking for in the Indies? Well, they were looking for this really important economic commodity, which was nutmeg, mace, and cloves, which were great luxuries. And it's what made Portugal wealthy early on and then drove the wealth of the Dutch and then finally the English. Huh, that's really interesting. So...

One of the things you wrote in Explanated Exchange is,

Is that coming true now in what you see for the people who are demanding protection from international trade and globalization in the current administration? Yeah, when trade opens up, then someone is hurt. If you're making furniture in the United States and people in China can make it more cheaply than you can, then yes.

You're going to be hurt as a furniture maker. On the other hand, if you're a consumer of furniture and there are thousands and thousands of times more consumers of furniture than there are makers of furniture, then you benefit greatly from that. But trade always produces losers and winners. And that was part of the fun of writing Splendid Exchange was identifying who the losers were

Three and four hundred years ago and two hundred years ago and one hundred years ago, four hundred years ago, the big losers with trade were the people who grew sugar on the island of Madeira.

which was a sugar-producing island from about the 15th century, or actually the 14th century on. And they made a lot of money until people started growing sugar in the Caribbean and in Brazil. And Madeira sugar producers got clobbered. And did they demand and get protection? Yes, they did, because they were losers in the system. And in the 19th century, the big losers, and they drove a protectionism you still see today, were European farmers.

And it was all the fault of Henry Bessemer, who learns how to produce or develops a process for producing high-quality steel, which goes into steel rails, which enables the grain exporters of the American Midwest and of Argentina and of the Ukraine to export vast quantities of cheap grain, which bankrupted European farmers who demanded and got protection. And they have protection even to this day because of that.

And then let's talk about the birth of plenty. What is the relationship of trade to all the abundance that we seem to be enjoying, or at least up until recently? Well, yeah, it's the same basic thing. It's the ability to purchase things more cheaply than would be available to you from domestic producers. It's that simple. The birth of plenty was really...

really, though, about the four basic preconditions for strong economic growth, which are property rights and capital markets and scientific rationalism and modern transport and communications systems. And so it's not until you see those four things come together that you see the sort of modern economic growth that's really only been present in

for the past 200 years. It really wasn't until relatively early in the 19th century that this idea that the economy grew, per capita GDP grew at 1% or 2% per year, became a reality. Before 1800, per capita GDP growth was zero. Wow, that's amazing. So before we get up to our speed round, let's talk about your next book. What are you writing now? What are you working on? Yeah.

I'm still working on it, and whether or not I get a publisher for it is open to question. I'm interested in two basic subjects. One is the radius of trust and societal radius of trust that feeds into the strength of institutions, rule of law, property rights.

Why did modern prosperity or prosperity of the modern sort arise in northern Europe, in England and in Scandinavia and in Germany? Well, it's because those societies have high radiuses of trust. You tend to trust strangers. And the origins of that are just extremely, extremely interesting, having to do with prohibitions on cousin marriage. It's way too complicated to get into today.

Uh, then the other subject, uh, that I'd love to write about is something that I call the paradox of religion, which is that it is very well established that religiosity is beneficial to the individual. People who are religious live longer. Uh,

They are healthier psychologically. They have better social connections. They're healthier and happier in every way you'd want to measure. On the other hand, when you look at the national level, religiosity is inversely correlated with the health of a society. So, you know, obviously the most religious places on Earth, Somalia, the Indian subcontinent, you know, sub-Saharan Africa are also the poorest nations on Earth.

The richest nations on Earth are the ones that are the least religious. What I like to talk about is what I call the Somalia-Sweden scale of religiosity. And there's a concept in economics called the paradox of thrift, which we're all familiar with, which is thrift is good for the individual. It's bad for the society. And...

What you see with religion is that it's the same way. Religion is good for the individual, but religion is bad for the society overall for obvious reasons. You get religious conflict. Well, let's break that down. My savings, my thrift, is your lost sales. So that's pretty easy to intuit. Why would...

my improved psychology and happiness and what have you as a religious person end up making the whole country...

more poor, less wealthy, if everybody's religious. Because it accentuates religious and personal differences. If you are deeply religious, you tend to be more distrustful of people of different religions. So the societal radius of trust is highest in the least religious societies because there's less reason for personal conflict. And tell us about...

What is this radius of trust you keep referring to? Give us a little, flesh that out if you would. Well, the best example I can think of, sort of the most pungent example, is what Jared Diamond talks about in his field work in New Guinea, which is that when two New Guinea Highlanders from different valleys meet, the first thing they do is they try and figure out how they're related, right?

OK, you know, this person, you that person, this person, you're going to call that Jewish geography. Yes. And so you you figure that out. And the first person who figures out, oh, my God, this this person on the other side of me doesn't know anything about me, turns around and runs like hell because he knows if the other person figures that out, he's going to try and kill him.

them. Okay. So this is a society where, where people are so mistrustful of people from different tribes that murder is often the result. All right. Now in Western societies, you get at it by what's called the trust question, which is, and it's very, very, very common question in sociological surveys, which is, do you generally believe that other people can be trusted or do you endorse the statement that you can't be too careful about who you trust?

And you can measure societal radius of trust that way. And a society in which people say, yes, most people can be trusted and very few people say you can't be too trusting of people, those tend to be much wealthier places.

Those are the places where you leave your wallet on the sidewalk by mistake and it gets returned to you. Sure. Japan is notorious for that sort of thing. Exactly. So let me ask you an odd question. Can both of those things be true at once? Can you – hey, we're social primates. This is how we evolved and adapted. And so we want to cooperate. Right.

But maybe we need to be a little less gullible about people selling us crappy financial products. So are those two things compatible? Yeah. I mean, there certainly are exceptions. No matter how trusting you are, you know, you have to be very suspicious of the people who calls you from a non-identified phone number. Really, really interesting. Even if you're a trusting Midwesterner from Peoria, you still have to have your guard up.

So I only have you for a short period of time and you've done the favorite questions so many times I feel like they're redundant. So rather than go through all of those, I just want to ask you, tell us what you're reading now. What are some of your favorite books and what's keeping you occupied right here and now?

Well, the person I think who I've read more of in the past year than anyone else is a man by the name of Robin Dunbar, who is an evolutionary psychologist and an evolutionary biologist at Oxford. And what he did was he figured out that the size of primate social groups was directly related to basically the size of their brains, the size of their neocortexes.

Meaning the larger your evolutionary brain has developed, the bigger a circle of friends you could keep clear in your head. We're talking primates...

Up to and including humans, is that right? Well, yeah, up to and including humans. Now, Dunbar's number for human beings who have the largest neocortex, the largest brain sizes, if you will, is about 150. And so you and I can keep about 150 people straight and be able to read them and be able to interact with them and have a good social and trusting social relationship with them.

And that's the natural size of the human band. So, for example, when you look at church congregations, when a church congregation gets to be beyond 150, say towards 200 or 250 people, it splits. Right.

because the group can't cohere, it can't keep itself together. What is the basic military unit that you see around the world in all militaries? Well, it's the company, okay? That's 120, 140 soldiers. That's Dunbar's number. And chimpanzees have a Dunbar's number because they have smaller brains of about 50. That's the size of a chimpanzee tribe or a chimpanzee clan. Lemurs have very small brains. You can't keep more than two lemurs together. Really? Yeah.

And so...

Dunbar has immersed himself of the world of how we keep our social interactions straight, how we juggle them all, uh, and how we're able to do it. And it turns out, for example, that there are some people who have great emotional intelligence who can, who have probably have done bars number of 200 or 250 or 300. That was probably Bill Clinton. You know, Bill Clinton had this ability to read people when what was said of Bill Clinton that, you know, when you were talking with him, uh,

It wasn't just he was talking only to you. You were the only person in the room. And that's a person with a high Dunbar's number, also with a very large size default mode network, which we talked about earlier, which is the part of your brain that maintains your social intelligence. So Dunbar has a series of books out. One is called Friends, which I can't recommend highly enough. And then the other is called The Evolution of Religion.

Which has to do with religious groups and how religious groups cohere and how it has to do with his number. Both books are just complete and total brain candy feasts. Really? All right. I'm going to put those on my list for sure. And then, of course, the other two people who I read repeatedly over and over again are Joe Henrich –

who's the head of theoretical biology at Harvard. He's the guy who wrote the weird book, you know, W-E-I-R-D. Oh, sure. W-E-I-R-D, Western Educated Industrialized Research.

rich and democratic. And it turns out that most human societies are not weird. Most human societies are traditional societies and that we in Western societies are the weird ones. Huh. Fascinating. And he's also the one who's written about how radius of trust evolved, you know, through the prohibitions against cousin marriage. It's the Henrik hypothesis, which is just a fascinating hypothesis. So those are the kinds of people I enjoy reading. Huh.

Really, really interesting. Oh, and then fiction, Nick Harkaway. Don't know the name. He's the pseudonym of Jean Le Carre. Oh, okay. Jean Le Carre, who of course is also a pseudonym. And he's taken up the Smiley series. And it's hard to imagine. You don't want to read it because who wants to read a book by the son of a great novelist? He's better than his father. No kidding. Yeah.

Wow, that's amazing. He wrote a book called Carla's Choice, which is you won't be able to put down.

Carlos Joyce. If you're a Smiley fan, you know who Carl is. K-A-R-L-A. All right. A Russian spy. Huh. Sounds like fun. Bill, thank you for being so generous with your time. We have been speaking to Bill Bernstein, author of so many fascinating books, The Intelligent Investor, Four Pillars of Investor, on and on. His most recent book is on the delusions of crowds. If you enjoy this conversation, well, be sure and check out any of the previous episodes

500 or so we've done over the past 10 years. You can find those at Bloomberg, iTunes, Spotify, YouTube. Be sure and check out my new book, How Not to Invest, The Ideas, Numbers, and Behaviors That Destroy Wealth and How to Avoid Them. I would be remiss if I did not thank the crack team that puts these conversations together each week. John Wasserman is my audio engineer. Anna Luke is my producer. Sean Russo is my head of research.

I'm Barry Ritholtz. You're listening to Masters in Business on Bloomberg Radio.

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