Primary Argument 3: The Study of Financial History is a Study in Applied Psychology and Risk Management
Following his insistence on a theoretical understanding of finance, William Bernstein introduces his third major hurdle, which elevates the investor from a mere technician to a seasoned strategist: You must immerse yourself in the study of financial history to immunize yourself against the emotional manias and panics that have defined markets for centuries. If learning financial theory is akin to a pilot studying aerodynamics, then learning financial history, Bernstein argues, is like a pilot meticulously studying aircraft accident reports. It is not about memorizing dates or past market returns; it is about understanding the conditions—both economic and, more importantly, psychological—that lead to catastrophic errors. This knowledge does not grant you the ability to predict the future, a power Bernstein insists no one possesses. Instead, it provides something far more valuable: context. It allows you to recognize the landscape of a bubble or a bust, not as a novel and terrifying event, but as a recurring drama of human behavior. This recognition is the ultimate “emotional stabilizer,” granting you the fortitude to act rationally when everyone around you is succumbing to either greed or fear.
This argument posits that markets are not just driven by spreadsheets and economic data, but by the timeless and predictable patterns of human emotion. History serves as a laboratory where these patterns are on full display. By studying the past, you learn to identify the tell-tale signs of market extremes and, most critically, gain the courage to execute the counter-intuitive actions—selling into euphoria and buying into despair—that a disciplined investment strategy demands.
The Great Paradox: Why Good Times Mean Bad Returns (and Vice Versa)
The first and most critical lesson that financial history teaches is a profound paradox that defies common sense: The health of the economy has an inverse correlation with future stock market returns. Intuitively, a person would assume the opposite. When the economy is booming, unemployment is low, and companies are reporting record profits, it feels like the perfect time to invest in stocks. Conversely, when the economy is in a deep recession, unemployment is soaring, and headlines are filled with news of bankruptcies, it feels like the most reckless time to buy.
History shows, with brutal consistency, that this intuition is precisely wrong.
- When the sky is blue, future returns are low. Think of the late 1990s during the dot-com bubble. The economy was strong, the internet promised a “new paradigm” of permanent prosperity, and a sense of unbridled optimism pervaded society. People believed that investing in technology stocks was a can’t-lose proposition. As a result, they were willing to pay extraordinarily high prices for shares, pushing valuations to absurd levels. What happened next? The stock market delivered over a decade of negative real returns, a period now known as the “lost decade” for equities. The very optimism that made investing feel safe and easy was what made it so dangerous. High prices, a direct result of investor enthusiasm, mathematically guarantee low future returns.
- When the water is stormy, future returns are high. Now consider the opposite scenario: March of 2009. The global financial system was on the brink of collapse. Major banks had failed or been bailed out, the economy was in the worst recession since the 1930s, and the prevailing mood was one of pure terror. It felt as though capitalism itself might be ending. Stock prices had been decimated, with the market having lost over 50% of its value. At that moment of maximum pessimism, when buying stocks felt like catching a falling knife, future returns were poised to be spectacular. An investor who was brave enough to buy stocks in the depths of that crisis would have enjoyed one of the greatest and longest bull markets in history over the subsequent decade.
Why does this paradox exist? It goes back to the iron law of risk and return from the second hurdle. Price is the primary determinant of future return. When everyone is optimistic, the perceived risk of owning stocks is very low. With low perceived risk, investors don’t demand a high potential return, and they bid prices up to the point where future returns are, in fact, very low. When everyone is terrified, the perceived risk is enormous. To entice anyone to take on that risk, the market must offer a very high potential return, which it does in the form of extremely low prices. As the old market adage goes, “The time to buy is when there’s blood in the streets.” Financial history is the study of where, when, and why that blood has flowed.
Understanding this historical pattern is not about timing the market to the day. It’s about recalibrating your emotional responses. It trains you to feel a sense of caution when your friends, the media, and the general public are euphoric, and to feel a sense of opportunity (however frightening) when they are despondent.
The “Shoeshine Boy” Indicator: History as a Barometer of Social Mood
Beyond the economic data, financial history is a chronicle of mass psychology. Market peaks and troughs are not just financial events; they are cultural phenomena. Bernstein uses the famous, perhaps apocryphal, story of Joseph Kennedy Sr., who claimed he knew it was time to sell his stocks before the 1929 crash when he started getting stock tips from his shoeshine boy. The anecdote’s power is not in its historical accuracy, but in the truth it reveals: a market top is near when investing has saturated the public consciousness and infiltrated everyday life.
When an asset class (be it stocks, real estate, or cryptocurrency) transitions from the domain of professionals and serious hobbyists into a topic of conversation at family barbecues and among people with no financial background, it is a five-alarm fire warning sign. This is because markets are driven by the flow of money. For prices to keep rising, there must be a continuous stream of new buyers. When the shoeshine boys, the Uber drivers, and your relatives who have never invested before are all rushing to buy, it is a signal that the pool of potential new buyers is nearly exhausted. The “smart money” has been invested for years, and the last wave of enthusiastic but uninformed “dumb money” is now providing them with the liquidity to sell their shares at inflated prices.
Studying history allows you to recognize the modern equivalents of the shoeshine boy:
- In the late 1990s, it was TV commercials featuring day traders buying their own private islands and people quitting their jobs to trade stocks full-time.
- In 2005-2007, it was the explosion of house-flipping reality shows and the widespread belief that real estate prices could only go up. It seemed like everyone was getting a real estate license or becoming a mortgage broker.
- In more recent years, it has been the mania around “meme stocks” or cryptocurrencies, where stories of overnight millionaires dominate social media and create a powerful sense of FOMO (Fear Of Missing Out) among the general public.
History teaches that when making money in a particular asset seems easy, obvious, and available to everyone, the period of easy money is almost certainly over. Conversely, history also teaches us what market bottoms feel like. They are periods of profound silence and disgust. After a major crash, no one wants to talk about the stock market. Those who have lost money are embarrassed and demoralized. The financial media runs covers with titles like “The Death of Equities.” This widespread revulsion and abandonment is the very sentiment that creates the generational buying opportunities.
The Practical Application: History as the Foundation for Discipline
Bernstein is adamant that this historical knowledge should not be used to make all-or-nothing market timing bets. You will never be able to precisely pinpoint the top or bottom of a market. Trying to do so is a recipe for disaster, as you are likely to sell too early and miss out on further gains, or buy too early and suffer more losses.
So, what is the practical purpose of this knowledge? Its true value lies in providing the psychological courage to adhere to a disciplined, pre-determined investment plan. This is where the simple three-fund portfolio and the concept of rebalancing come into play.
Rebalancing is the act of periodically (e.g., once a year) resetting your portfolio back to its original target allocation. For Bernstein’s simple portfolio, this means ensuring that U.S. stocks, international stocks, and bonds each represent one-third of the total value. This simple, mechanical act is a brilliant and non-emotional way to implement the core lessons of financial history.
Let’s see how it works in practice:
- Scenario 1: A Raging Bull Market (Euphoria). Imagine you start with $30,000, with $10,000 in each of the three funds. After a fantastic year for stocks, your U.S. and international stock funds have each grown to $15,000, while your bond fund has only grown to $11,000. Your total portfolio is now $41,000. Your stock allocation has drifted up to over 73% of the portfolio ($30k / $41k), and your bond allocation has shrunk to 27%. Your emotions, fueled by the great returns and optimistic headlines, are screaming at you to let your winners run. But your disciplined plan, informed by the lessons of history about the dangers of euphoria, tells you to rebalance. To get back to a 33/33/33 split, you would need to sell off a portion of your appreciated stocks and use the proceeds to buy more bonds. You are mechanically and unemotionally selling high. You are trimming your exposure precisely when assets are expensive and popular.
- Scenario 2: A Crushing Bear Market (Despair). Now imagine a terrible year. Your U.S. and international stock funds have each fallen by 40% and are now worth just $6,000 each. Your bond fund, a safe haven, is still worth $11,000. Your total portfolio has shrunk to $23,000. Your stock allocation is now just over 52% ($12k / $23k). Every fiber of your being, every terrifying headline, every panicked news report, is telling you to sell your remaining stocks before they go to zero. But your disciplined plan, informed by the historical lesson that periods of maximum pessimism are periods of maximum opportunity, forces you to rebalance. To get back to your target allocation, you must sell some of your stable bonds and use the proceeds to buy more stocks. You are mechanically and unemotionally buying low. You are increasing your exposure precisely when assets are cheap and hated.
Without a deep appreciation of financial history, the act of rebalancing during a market panic feels like madness. It is an act of defiance against your most primal survival instincts. History provides the intellectual framework that allows you to override those instincts. It whispers in your ear, “I’ve seen this movie before, and I know how it ends.” It reminds you that market crashes are not the end of the world; they are temporary (though painful) events that sow the seeds for future growth. It gives you the conviction to buy when others are panic-selling, and to trim when others are greedily buying.
In conclusion, Bernstein’s third argument is that financial history is the investor’s most potent psychological tool. It is not a crystal ball for prediction, but a mirror reflecting the unchanging and cyclical nature of human behavior in financial markets. By studying the bubbles and busts of the past—from the Tulip Mania of the 1600s to the dot-com bubble of the 1990s and the financial crisis of 2008—you learn to recognize the emotional climates that signal danger and opportunity. This hard-won knowledge provides the essential context and emotional fortitude required to stick with a disciplined investment plan, particularly the counter-intuitive act of rebalancing, which forces you to buy low and sell high. It is the bridge between knowing what you should do (the theory from hurdle two) and actually being able to do it when the pressure is on.