The Four Pillars of Investing

Tuesday, 8th July 2008 (by J.D. Roth)

For the past year, I’ve been looking for a book to recommend for novice investors, a book that would offer sensible advice without becoming too technical. I believe I’ve finally found that book.

In The Four Pillars of Investing, William Bernstein describes how to build a winning investment portfolio. He doesn’t focus on the details — he tries to explain fundamental concepts so that readers will be able to make smart investment decisions on their own.

Successful investments, he says, are build upon four “pillars”:

•a knowledge of investment theory
•an understanding of the history of investing
•insight into the psychology of investing
•an awareness of the business of investing

These topics sound dry and dull, but I found the book lively and engaging. It’s not an easy book — there are passages that require the reader’s full attention — but generally the author presents essential information without making it too complicated. Best of all, his advice is sound.

Pillar one: The theory of investing
Bernstein begins by offering a brief overview of investment theory. This may sound intimidating, but it’s not. The author presents the material in a way that makes sense, even to an average guy like me.
The most important concept in investing is that risk and return are inextricably intertwined. If you want to obtain higher returns, you must face the prospect of higher losses. If you want to avoid the risk of losing money, you must reduce the chance of higher returns. Bernstein stresses this point:
High investment returns cannot be earned without taking substantial risk. Safe investments produce low returns.

If somebody offers you that an investment is safe and offers very high returns, they either don’t know what they’re talking about or they’re trying to scam you.

Howvever, the risk of an investment can be reduced by holding it for a very long time. The longer you own a risky asset (like a stock, for example), the less the chance of a loss. You can also diversify your portfolio — own other assets — in order to reduce risk.

Bernstein notes that past performance is no guarantee of future results. Everywhere in the investment industry, the performance of mutual funds is cited as a reason to purchase them. The author suggests this is crazy, and that regression toward the mean makes it likely that stocks and mutual funds with high returns in the past will have low returns in the future. The opposite is also true — poor performing investments are likely to improve in time. (This is only a general tendency, and not a hard-and-fast rule.)

If anything, the short-term returns from individual investments seem random. Bernstein writes that there is almost no evidence that professional money managers can regularly pick winning stocks. (Warren Buffett is an exception.) There is absolutely no evidence that anyone can time the market. Because of these facts, Bernstein argues that the most reliable way to obtain a satisfying investment return is to use index funds.

Pillar two: The history of investing
How many investment books do you know with sections about financial history? Bernstein devotes 36 pages to the subject, and it’s fascinating. By looking at centuries of information about financial markets, one can learn valuable lessons. For example, the Dot-Com Bubble of the late-1990s had many precedents in investment history. Bernstein cites famous bubbles from the past, including the South Sea Bubble of 1720.

But irrational exuberance isn’t the only problem investors face. Sometimes the markets are irrationally gloomy, depressing prices for prolonged periods. Bernstein writes:
The most profitable thing we can learn from the history of booms and busts is that at times of great optimism, future returns are lowest; when things look bleakest, future returns are highest. Since risk and return are just different sides of the same coin, it cannot be any other way.

By understanding the history of investing, you can make more considered, rational choices. Familiarity with the history of investing might have prevented (or at least mitigated) the recent tech and housing bubbles.

Pillar three: The psychology of investing
“You are your own worst enemy,” Bernstein writes. The number one impact on your investments is you. He explains that diversification and indexing are the most reliable methods to obtain long-term investment success.

“If indexing works so well,” he writes, “why do so few investors take advantage of it? Because it’s boring.” Many people believe investing should be exciting. But that’s not the case.
Bernstein provides a list of techniques to deal with psychological pitfalls:

•Recognize that the conventional wisdom is usually wrong. Don’t participate in herd behavior that exacerbates booms and busts.
•Don’t become overconfident. Don’t believe that you’re smarter than the market.
•Ignore the past ten years. Recent performance has little bearing on the future of a particular stock or mutual fund.
•Avoid “exciting” investments. You shouldn’t invest for entertainment. This isn’t gambling. You invest to protect and grow your principal.
•Don’t let short-term losses affect your long-term strategy. Too many people panic at the first sign of trouble.
•Know that the overall performance of your investment portfolio is more important than any single part. You will have investments that decline in value from year-to-year. Diversification helps to mitigate these losses.

As with the history “pillar”, just being aware of the psychological component to investing can help prevent some mistakes.

Pillar four: The business of investing
In the fourth section of the book, Bernstein demonstrates how the financial industry is designed to part you from your money. Brokerage fees, mutual fund expenses, and taxes all produce heavy “drag” on your financial portfolio. A smart investor does her best to reduce all three.

But there are other enemies lurking in the wings, too. Inflation is the silent destroyer of money. Meanwhile, traditional financial journalism tends to hype hot mutual funds and brokerage houses — spreading what some people call “financial pornography” — in order to boost sales. Bernstein notes:
You can only write so many articles that say, “buy the market, keep your costs down, and don’t get too fancy,” before it starts to get very old.

So the magazines and newspapers resort to sensationalism. He says that in general you’re better off ignoring the financial media. Financial experts don’t know where the market is going or why. Educate yourself and make your own decisions based on market performance.

Putting it all together
After introducing his four pillars of investing, Bernstein explains how to use them to build a stable financial “house”. In fact, if I had read the chapter “Will You Have Enough?” before last Tuesday, I might never have posted my thoughts on retirement and financial independence; the book gives some advice on planning how much you’ll need for retirement.

In the end, Bernstein summarizes the fundamental message of his book:
With relatively little effort, you can design and assemble an investment portfolio that, because of its wide diversification and minimal expense, will prove superior to most professionally managed accounts. Great intelligence and good luck are not required. The essential characteristics of the successful investor are discipline and stamina to, in the words of John Bogle, “stay the course”.

I’ve read a lot recently about individual investors who try to beat the market. Some are able to do so in the short-term, but few are able to do this consistently in the long-term. Some use Warren Buffett as an example of an individual investor who has been able to achieve stellar returns. Buffett has worked full-time for more than fifty years to achieve these fantastic results. And even Buffett believes that 99% of investors would be better off choosing index funds.

Final thoughts
I am not Warren Buffett. I don’t have the time, skill, or inclination to pick winning stocks. I’m willing to “settle” for spending a few hours a year constructing a portfolio of index funds that will do better in the long-term than the results achieved by most professional money managers.

For more information on this book, check out:
•Introduction from The Four Pillars of Investing
•Chapter one from The Four Pillars of Investing
•A rave review from the authors of The Bogleheads’ Guide to Investing (which is itself a great book on investing)

The Four Pillars of Investing is challenging in places, but it provides an excellent introduction to the theory, history, psychology, and business of investing. If you’re just getting started, borrow this book from the library. Stick with it. If you’re able to finish, you’ll have a better grasp of investing than 99% of your peers.

Link
http://www.getrichslowly.org/blog/.../the-four-pillars-of-investing