The Four Pillars of Investing - by William Bernstein
ISBN: 0071385290Date read: 2008-06-07
How strongly I recommend it: 6/10
(See my list of 360+ books, for more.)
Go to the Amazon page for details and reviews.
If you've already read and loved The Smartest Investment Book You'll Ever Read, above, then read this more in-depth book next.
my notes
## CH 1 : No Guts, No Glory
High previous returns usually indicate low future returns, and low past returns usually mean high future returns. (This point cannot be made too forcefully or too often.)
The low prices that produce high future returns are not possible without catastrophe and risk. The recent high returns for the U.S would not have been possible without the chaos of the 19th century and the prolonged fall in prices that occured in the wake of the Great Depression.
When the sun shines the brightest, investment returns are the lowest. Stability and prosperity imply high asset prices, which result in low future returns. The highest returns are obtained by shouldering prudent risk when things look bleakest.
The real value of historical record is a gauge of risk, not return.
Assuming the risks are the same, there is no reason that the future return in any one nation should be higher than another. To the extent that one nation is perceived to be riskier than another, the nation with the highest perceived risk should have the highest future return, in order to compensate for the extra risk.
The shares of good companies (Wal-Mart) are called "growth stocks", and those of bad companies (Kmart) are called "value stocks". Wal-Mart is safer, and Kmart is at risk of collapse. So...
Since Kmart is a much riskier company than Wal-Mart, investors expect a higher return from Kmart than they do Wal-Mart. If Kmart had the same expected return as Wal-Mart, no one would buy it! So its price must fall to the point where its expected return exceeds Wal-Mart. The key word is "expected", since there's no guarantee. So...
One of the most counterintuitive points in all of finance: Good companies are generally bad stocks, and bad companies are generally good stocks. (Studies prove this in many nations over long periods of time. Unglamorous unsafe value stocks with poor earnings have higher returns than glamorous growth stocks with good earnings.) Eugene Fama and Kenneth French. 1975-1996 across many countries, value stocks had a 5.28% average greater return than growth stocks.
Campbell Harvey @ Duke University extended this work to entire nations: returns are higher in the bad nations with the shakiest financial systems - because the risk there is highest.
The longer a risky asset is held, the less the chance of a loss.
Be wary of data demonstrating the superior long-term performance of U.S. stocks. For most of its history, the U.S. was a very risky place to invest, and its high investment returns reflect that. Now the U.S. is a "sure thing", prices have risen, and future investment returns will necessarily be lower.
## CH 2 : Measuring the Beast
(Based on the book : "The Theory of Interest" by Fisher, 70 years ago)
Discounted Dividend Model = DDM. It's the ultimate answer to the age-old question of how to separate speculation from investment.
The value of a stock or bond is simply the present value of its future income stream. (Understand this and you'll know more than most professionals.)
Wealth is a stream of income.
This income stream must be reduced in value (or "discounted") to the present, to reflect the fact that it is worth less than currently-received income.
The rate at which that income is discounted is inversely related to the asset's value - a high discount rate lowers the asset's value.
The discount rate is the same as the asset's expected return. It's determined by the asset's perceived risk.
A rare coin or painting is a speculation, since it's dependent on someone else paying yet a higher price for them later (the "greater fool" theory).
A fine painting (by an old master), like a house, is neither a speculation nor an investment: it is a purchase. The dividend it produces is of the non-financial variety.
Only an income-producing possession, such as a stock, bond, or working piece of real estate is a true investment. Any stock price above zero proves some investors consider it possible that the stock will regain its earnings and produce dividends in the future. Ben Graham pointed out : a stock purchased with the hope that its price will soon rise independent of its divident-producing ability is also a sepculation, not an investment.
Discounted Dividend Model:
1- Provides an intuitive way to think about the value of a security. A stock or bond is a claim on real future income and assets.
2- Enables us to test the growth and return assumptions of a stock or entire market. In the dot-com boom, the entire Nasdaq sold at 100-times earnings, implying a ridiculously high earnings growth rate or a low expected return. (The latter seemed more plausible and is what eventually happened.)
3- The above formulas can be rearranged to calculate the market's expected return, producing an equation that is stunningly simple and powerful:
### THE GORDON EQUATION:
Discount Rate (market return) = Dividend Yield + Dividend Growth
An accurate way to predict long-term stock market returns.
During the 20th century, the average dividend yield was 4.5% and the compounded rate of dividend growth was also 4.5%. Add the two and you get 9%. The actual return was 9.89%. (The .89% difference was due to the fact that stocks had become considerably more expensive: the dividend yield had fallen.)
If the stock market is simply viewed as a source of dividends, then its price should rise in proportion to those dividends. So if the dividends increase at 4.5% per year then over the very long term its price should also increase by 4.5% per year. In addition to the price increase you also receive the actual dividend each year. The total return comes from the combination of the annualized price increase and the average dividend yield.
The Gordon Equation is as close to being a physical law, like gravity or planetary motion, as we will ever encounter in finance. It can predict the long-term (30 year) expected return of the market.
What does the Gordon Equation tell us about future returns? Dividend growth is 5% and yield is 1.55% = 6.55%. Nowhere near the 10% returns of the past. Bonds will return about 6%. So stocks and bonds should be in the 6% return range.
METAPHOR FOR MARKET: a dog-owner walking an excitable dog on a very long leash in one direction. No predictable way to know which way the dog will lurch, but in the long run you know he's heading northeast at an average speed of 3 mph. (What's astonishing is that all the market players have their eye on the dog and not the owner.)
The worst possible time to invest is when the skies are clear, because perceived risks are low, causing investors to discount future stock income at a very low rate. This in turn produces high stock prices, which result in low future returns. The saddest part of this story is that "pie-in-the-sky" investing is both infectious and emotionally effortless. Everyone else is doing it.
In investing, our social instincts are poison.
The best possible time to invest is when the sky is black with clouds, because investors discount future stock income at a high rate. This produces low stock prices, which in turn, beget high future returns.
## CH. 3 : The Market is Smarter Than You Are
There is no evidence of stock-picking skill among professional money managers, from year to year manager relative performance is nearly random.
There is absolutely no evidence that anyone can time the market.
## CH. 4 : The Perfect Portfolio
Since you cannot time the market or select individual stocks, asset allocation should be the major focus of your investment strategy, because it is the only factor affecting your investment risk and return that you can control.
Past portfolio performance is only weakly predictive of future portfolio behavior. It's a mistake to design your portfolio on the basis of the past decade or two.
The most important asset allocation decision is between risky assets (stocks) and riskless assets (short-term bonds, bills, CDs, money market funds).
The primary diversifying stock assets are foreign equity (40% max) and REITs (15% max).
## CH. 5 : Tops: A History of Manias
There will always be speculative markets in which the old rules seem to go out the window. Learn to recognize the signs: technological or fiancial "displacement", excessive use of credit, amnesia for the last bubble, and the flood of new investors who swallow plausible stories in place of doing the hard math.
John Templeton: The four most expensive words are "This time, it's different."
## CH. 6 : Bottoms: The Agony and Opportunity
It's human nature to be influenced by the last 10-20 years' returns. It's hard to imagine that something doing poorly was ever a good investment.
When recent returns for a given asset class have been very high or very low, put your faith in the longest data series you can find - not just the recent data.
Be able to estimate returns for yourself.
Don't underestimate the courage it takes to act on your beliefs.
Cheap stocks excite only the dispassionate, the analytical, and the aged.
When an entire nation has acted unwisely on bad advice, the rules of the game are likely to change drastically, and that the sources of that advice should beware.
What to do during a crash? Don't panic and sell - simply stand pat. Have a firm asset allocation policy in place.
What separates the professional from amateur are two things:
1. the knowledge that brutal bear markets are a fact of life and there's no way to avoid their effects
2. when times get tough, the pro stays the course, and the amateur abandons the blueprints (or has no blueprints)
Rebalancing - maintaining a constant allocation - is a technique which automatically commands you to sell when the market is euphoric and buy when the market is morose.
Ideally, when prices fall dramatically, you should go even further and increase your percentage equity allocation.
## CH. 7 : Misbehavior
- herd mentality
- overconfidence
- recency
- need to be entertained
- myopic risk aversion
- great company / great stock illusion
- pattern hallucination
- mental accounting
- country club syndrome
Overconfidence: the compartmentalization of success and failure. We remember those activities where we succeeded and forget those where we didn't.
It's more agreeable to ascribe success to skill than luck.
For each bit of excitement you derive from an investment, you lose a compensatory amount of return. A portfolio full of dull value stocks (USX, Caterpillar, Ford) is the most likely to have higher returns.
Amateurs listen to stories. Serious investors do the math.
Imagine two companies:
- Smokestack, selling at 20x earnings.
- Glamour, selling at 80x earnings.
Smokestack: for every $100 of stock, produces $5 of earnings. ($100/20 = $5)
Glamour: for every $100 of stock, produces $1.25 of earnings. ($100/80 = $1.25)
The market expects Glamour to grow its earnings much more rapidly.
If Smokestack grows its earnings at a rate of 6% per year, then after 6 years it will increase its earnings by 48%, from $5/share to $7.40/share.
If Glamour grows its earnings by 20% more than the market, 78% (1.48 x 1.20 = 1.78) its earnings will grow from $1.25 per share to $2.23 per share.
After that, Glamour will have the same earnings growth as Smokestack, earning $7.40/share.
Humans are great at recognizing highly abstract patterns. But in investing, this talent is usually counterproductive. For the most part, the pricing of stocks and bonds at both the individual and market level is random: there are no patterns! In such a chaotic world, the search for patterns is not only futile, it is downright dangerous.
There are certainly pieces of data that are predictive of future economic activity. The problem is that everyone knows, watches, and analyzes these statistics, and the results have already been factored into stock and bond prices. Acting on this information is likely to be of no value.
Something that everyone knows isn't worth knowing. (- Bernard Baruch)
Regret avoidance : holding onto a stock that has done poorly keeps alive the possibility that we will not have to confront the finality of our failure.
If you believe the markets are efficient, the performance of a fallen stock should not be any different than a successful one.
Stocks that have recently fallen have, on average, higher expected returns than the market.
We have met the enemy, and he is us. (- Walt Kelly)
## CH. 8 : Behavioral Therapy
An investment that has become a topic of widespread conversation is likely to be overpriced for the simple reason that too many people have already invested in it. (Realestate & gold in 80s, Japanese stocks in late 80s, Tiger nations in 90s, tech stocks in late 90s) In each case, disaster followed.
When "everybody knows" that something is a good deal, raise the red flags.
Identify current conventional wisdom so you can ignore it.
Present market environment : everybody knows stocks have high long-term returns. So further prices will be much harder to come by.
## CH. 9 : Your Broker is Not Your Buddy
A broker with a clientele full of contented customers is a broker who will soon be looking for a new job. Brokers need *trades* to make money.
## CH. 11 : Oliver Stone Meets Wall Street
So who do I turn to for information? The market itself is the best advisor. When you buy the market, you are hiring the aggregate judgement of the most brilliant and well-informed minds in finance. (Wisdom of Crowds)
The only real guidance you need is in two areas:
- overall asset allocation
- self-discipline
READING LIST: http://www.efficientfrontier.com/reading.htm
Random Walk Down Wall Street, by Burton Malkiel - explains the basics of stocks, bonds, and mutual funds, and will reinforce the efficient market concept.
Common Sense on Mutual Funds, by John Bogle.
The New Finance, the Case Against Efficient Markets, by Robert Haugen. wonder why value investing still works after all these years, this is your book. The prose is breezy, even quirky—Ben Graham meets Hunter Thompson on bad acid.
Value Averaging, by Michael Edleson. An extremely useful how-to guide on deploying a lump sum of money among multiple assets. Finally back in print as a Wiley Classic Edition.
The Intelligent Investor, by Ben Graham. Although it has great relevance to the markets in general and should be read by any serious investor, it is particularly pertinent to those who feel compelled to buy individual stocks.
Devil Take the Hindmost, by Edward Chancellor. You simply can't learn enough about market history, and Chancellor's story of boom and bust in the capital markets, beginning in the 17th century, is pure mind candy.
## CH. 12 : Will You Have Enough?
Young savers should be praying for a bear market, so they can accumulate shares cheaply.
Manage all of your assets as one portfolio.
Plan on spending, at maximum, the expected real return of your portfolio. (ie: 3%-4% of its value)
The most successful prescription for a successful retirement is to get into the habit of curbing your material desires. Now.
Do not invest any money in stocks that you will need in less than five years.
Have 6 months of living expenses in safe investment vehicles in a taxable account.
## CH. 13 : Defining Your Mix
You will not know what kinds of economic, political, or even military adversity will befall your portfolio.
If inflation, you would emphasize gold, natural resources, real estate, and cash, as well as a fair amount of stocks.
If deflationary depression like 1930s, you'd only hold long-maturity government bonds.
If the world lost confidence in U.S. leadership, you'd want a portfolio heavy in foreign stocks and bonds.
Since we don't know, own as many asset classes as you can, so you can avoid the catastrophe of holding a portfolio concentrated in the worst ones.
Like amateur tennis : bad players hit too hard, out of the court, trying to be tricky. Better off just volleying it back safely. You don't win as much as you avoid losing.
The name of the game is not losing.
S&P 500 = not the biggest 500, but 500 firms chosen by S&P as representative of the makeup of the U.S. industry.
S&P 500 is capitalization-weighted: if GE has $400B market cap and American Greetings has $700M, the index fund would have to own 600 times as much GE as American Greetings. If GE plunges in value, nothing changes. The index doesn't need to buy or sell.
S&P 500 holds about 7% of the total number of companies, but they make up 75% of U.S. market cap.
Wilshire 5000 = "total market" : 7000 stocks
Russell 3000 = the 3000 biggest companies. (The remaining 4000 amount to only 1% of US market cap.)
The index funds that track Wilshire 5000 or Russell 3000 don't own all stocks in them - just representative sampling of the market.
So they don't track the index precisely. Passively managed = owns some but not all.
When and where do you own a total-market index fund? In two situations:
(1) - an ideal core holding in a taxable account because of its tax efficiency. No turnover.
(2) - but not in a retirement account. There, you want to break the U.S. market into separate parts.
LUMPERS SAY: because market is ruthlessly efficient, no segments offer superior long-term returns. breaking into subclasses is expensive, distracting, and exposes you to unnecessary risk
SPLITTERS SAY: historical data shows value stocks have higher return than growth stocks, and small stocks have higher return than large stocks. it's logical to overweight value and small size.
Large Value + Large Growth = Large Market (S&P 500)
Small Value + Small Growth = Small Market (Russell 2000 or S&P 600)
Since growth stocks have market caps much larger than value stocks, they overwhelm them in most indexes, so growth and market behave nearly identically.
How do you draw the line between large and small? Russell 2000 is most common. CSRP 9-10 Decile Index for academics. (DFA tracks?)
How do you draw the line between value and growth? Split market by ratio of price-to-book values by thirds. Value=bottom third. Growth=top third. Blend=middle third.
Small Growth is a very bad actor in the long term, with the lowest return of the 4 corners and high risk. Use small-market fund in place of small-growth, and large-market fund in place of large-growth.
REITs : often behave very differently from the four corners of the market.
In sum : the 5 major domestic asset classes you should use are:
- large market
- small market
- large value
- small value
- REITs
Avoid owning the Vanguard Total International Fund in a taxable account, since it's a fund of funds, with 3 regional funds. Not eligible for the foreign dividend tax exclusion, which allows you to deduct the taxes on dividends from foreign stocks on your US tax return.
Overriding principle of bond investment : keep it short!
Treasuries can be bought at auction directly from the government without a fee. http://www.treasurydirect.gov/
It makes no sense to purchase municipal bonds in a tax-sheltered account. The choice is between government and corporate issues.
Split your taxable accounts among all three of the bond classes: municipal, Treasury, corporate. The Treasuries will have a lower after-tax yield, but be safe and liquid, and free from state tax. The yield differences aren't enough to be fretting over.
It makes no sense to buy a bond index fund, because 50% is invested in Treasuries which you can own separately without paying fund fees. Buy treasuries directly.
A stock fund with no turnover will produce no capital-gains distributions. You'll be taxed only on the relatively small amount of stock dividends the fund passes through to you.
REIT and junk-bond funds distribute almost all their return in the form of dividends. These dividends are taxed at the high ordinary income rate. So you will want to hold only tax-efficient funds in your taxable account, reserving the most tax-inefficient ones for your retirement accounts.
Value funds are tax-inefficient because if a stock increases in value it must be sold since it no longer qualifies.
In tax-sheltered, you're more free to aggressively rebalance the foreign and domestic components. Instead of just owning foreign market, you can break it down into regions. Go flat out for yield in your bond portfolio and not have to worry about taxation until you withdraw cash.
The easiest structures to design are those where more than half of assets are tax-sheltered.
If you have less than 50% of your assets in sheltered vehicles, you should place value stocks and REITs in them - and break foreign assets into regions (Euro, Pacific, emerging) - to benefit from rebalancing.
## CH. 14 : Getting Started, Keeping It Going
Dollar Cost Averaging / "DCA" : investing the same amount of money regularly in a given fund or stock.
Advantage is lower average price. More shares bought when price is low.
Do not underestimate the discipline it takes to carry out a successful DCA program.
Even better than DCA is "Value Averaging" described by Michael Edleson in his Value Averaging book.
Instead of blindly investing $100/month, you draw a value averaging path, with a target amount that increases by the same amount each month. ($100 in this example.)
In other words : you aim at having $100 in the account by January, $200 by February.. to $1200 in December year 1, $2400 December year 2, etc.
So if the value declines, more than $100 will be required to reach the desired total each month.
If the fund goes up, less will be required. (Perhaps none, some months.) But don't sell to rebalance, because of capital gains tax.
For bonds, no reason to do this. Invest it all immediately.
For the rest, set a value averaging path per-asset-class (per holding).
Value averaging should not be done with ETFs, because of the separate fee per-transaction.
This is simplified, but Edelson's real method also builds-in further growth into the path.
He recommends quarterly, and a minimum of 2-3 years for funding.
Rebalancing can raise return by 1%.
Rebalancing forces you to buy low, sell high.
Bucking conventional wisdom is a profitable activity.
Rebalancing forces you to be a contrarian.
Financial contrarians tend to be wealthier than folks who like to follow the crowd.
How often to rebalance?
In a tax-sheltered: every 2-3 years. The tendency for prior best-performers to do worse in the future and vice-versa seems to be strongest over about 2-3 years.
Taxable accounts: it makes sense to rebalance only with mandatory fund distributions, inflows, and outflows.
###### (From Money Magazine: http://money.cnn.com/2009/02/06/pf/105769815.moneymag/)
Now that you know just how long and rigorous this event really is, how do you train for it? The basic workout is consistent asset allocation. The point isn't to come up with the perfect strategy as much as it is to have one that you'll stick with in up-and-down markets. Then, once a year, rebalance back to those levels. In the good years, this means selling some stocks to get things back into balance, and in the bad years it means selling some bonds to buy more stocks. The latter is harder to do than the former.
There's no better way of keeping yourself fit than regular rebalancing, particularly during bear markets.
By making it a routine math exercise instead of an annual review of the market or your strategy, you'll find it easier to tune out your emotions.
The good news is that unlike an elite athlete, an emotionally fit investor doesn't have to wake up at 6 a.m. every morning to work out (or tune in to CNBC). In fact, it is better not to think about investing most of the time. I know no greater investment pro than Vanguard founder John Bogle; he tells me that he peeks at his holdings only once a year. In this race, the edge goes to the disciplined couch potato.