William J. Bernstein has written a wonderful book for "adult" investors who are comfortable with basic math and statistics and who also enjoy a good turn of phrase. Bernstein, a retired neurologist turned financial theorist, has written about a dozen books, perhaps most memorably The Intelligent Asset Allocator, The Four Pillars of Investing, and The Investor's Manifesto. Rational Expectations: Asset Allocation for Investing Adults (Efficient Frontier Publications, 2014) is his latest offering.
Bernstein is a firm believer in asset allocation and life-cycle planning. He is also a believer in statistical modeling. But he recognizes the inherent limitations of both planning and modeling. As he writes, "We could conduct, as I did in my prior books, complex spreadsheet and Monte Carlo exercises to predict just how many years it will take to reach a realistic retirement nest egg or at what rate it can be spent down. These calculations bring to mind the following joke: Q. How do we know that economists have a sense of humor? A. They use decimal points. There are just too many variables to pretend great precision: career and salary trajectory, personal and family health (and health expenses), to say nothing of the vicissitudes of the markets and of that cruelest mistress of all, human history. You might as well try to mathematically model your love life." (p. 117)
Even though investing is a journey into the unknown, some quantitative measures help guide the way. Take variance drag, "a measure of how asset-class volatility reduces overall return." It rears its ugly head in the relation between geometric return (the proper way of calculating investment returns) and arithmetic return. "The classic example of variance drag is the difference between two pairs of returns: +10%/-10% and +50%/-50%. Both sequences have the same A, which is zero, but their G's are vastly different. The first sequence leaves you with $0.99 on the dollar; the second, with $0.75." (p. 9)
Or consider extreme downward market movements, when "securities distributions appear to follow the same 'power-law' relationship followed by earthquakes, terrorist attacks, and terrestrial meteor/asteroid strikes, in which the logarithms of probability and of severity are linearly related. This relationship better predicts the much higher frequencies of severe events than the very low estimates from the Gaussian normal distribution." (p. 20)
Rational Expectations is a sophisticated personal finance book, many cuts above the usual pap that gets served up to investors. It explains when the "rebalancing bonus" can actually be negative, describes "tilt factors" that are good short-term diversifiers as well as those that have longer-term benefits, and warns the investor away from eloquent forecasters ("Be especially suspicious of anyone with a plummy English accent.") (p. 110)
And, for those who realize that sound investing is an informed process, it points the reader to resources with which he may be unfamiliar, such as Kenneth R. French's 2008 presidential address to the American Finance Association on the cost of active investing and some books on financial history "listed in descending order of importance." (p. 115) Heading that list are Edward Chancellor's Devil Take the Hindmost ("what manias look like; how to recognize-and hopefully avoid-irrational exuberance") and Benjamin Roth's The Great Depression ("what the bottoms look like; how to keep your courage and your cash up").
All in all, Rational Expectations is an eminently worthwhile read for the investor who hopes to retire one day, even if not from investing itself.