Book Summary: The Four Pillars of Investing by William J. Bernstein

In this summary, you will learn

  • How to understand what finance expert William J. Bernstein cites as the “four pillars of investing,”

  • How to construct a sound and profitable portfolio,

  • Why individual investors have little hope of beating the market, and

  • What psychological shortcomings sabotage investors.


  • The “four pillars of investing” are its Theory, History, Psychology and Business.

  • Nobody can beat the stock market, including sophisticated investors.

  • Shares are the best way to build a nest egg and stave off the ravages of inflation.

  • While equities can and do go down in the short term, in the long run they go up.

  • Think of stocks as a dog on a long leash: The dog might dart hither and yon, but its owner – the market – steadily heads in the right destination.

  • Counterintuitively, bad companies often make the best investments.

  • Value stocks underperformed from 1929 to 1932 and again during the tech bubble.

  • Investors often turn out to be their own worst enemies. They foolishly buy stocks when prices are high and sell when prices crash.

  • Overconfidence is a human default mode; it’s deadly for individual investors, who think their basic knowledge qualifies them to compete with sophisticated professionals.

  • Index funds and asset allocation are the keys to a profitable portfolio. “The biggest risk of all is failing to diversify properly.”


“The Theory of Investing”

From day to day, stock markets are unpredictable. They soar beyond all logic and plunge to unreasonable levels. The wise investor knows short-term moves are random, and trying to time them is a fool’s game. Over decades and centuries, though, the direction is clear: Stocks go up. If you had put $1 into US stocks in 1790, your portfolio would have been worth $23 million by 2000. If this purely hypothetical portfolio’s returns had decreased by even 1% per year, its value after 210 years would have shrunk to $3 million, and gain or loss, taxes and commissions would have eaten away at the profits.

Stocks remain the investment of choice. From 1901 to 2000, stocks averaged 9.89% in annual returns (6% after inflation), compared to 4.85% for bonds (1% after inflation) and 3.86% for Treasury bills (zero after inflation). The inflation-adjusted returns balance the safety of Treasury bills. You cannot lose on a Treasury bill investment, but you can’t beat inflation.

“Overconfidence likely has some survival advantage in a state of nature but not in the world of finance.”

Stocks are the most lucrative investment in the long run, but they can produce gut-wrenching losses. In the market crashes of 1973 and 1974, stocks plunged 40% even as inflation soared, placing investors’ real losses at 50%. Shares did even worse during the Great Depression, losing 83% of their value from 1929 to 1932. In real dollars, the loss wasn’t as severe because of deflation. Stocks bounced back only to plunge 50% in 1937.

“When the market is viewed over decades, its behavior is as predictable as a Lakers-Clippers basketball game.”

No Wall Street guru has the faintest idea where stocks are heading tomorrow or next year. In the short term, stocks are like a dog on a leash, veering this way and that. Yet the overall path of the market is like the dog’s master, who keeps heading in a steady direction even as the canine darts here and there.

Unlike shares, bonds don’t rise significantly over time. Bonds can go down for years and then go down some more, whereas strong stock rebounds often follow down periods. For investors, the lesson is simple: If you want the heftiest returns, you must stomach devastating losses. If you seek safety, you can forget about making money.

“A young person saving for retirement should get down on his knees and pray for a market crash, so that he can purchase his nest egg at fire-sale prices.”

Ugly Stocks, Handsome Returns

To secure a comfortable retirement, invest in equities. Surprisingly, bad companies can make the best investments. Investors divide shares between growth stocks and value stocks. Walmart is the quintessential growth stock. The retailer manages well, garners admiration and is financially robust. Struggling rival Kmart is the epitome of a value stock. The company landed in bankruptcy court. Yet juicier returns accrue to the worse company. Investors know that Kmart is riskier than Walmart. They demand and get higher returns for investing cash in such a struggling enterprise.

“Remember, the capital markets are fundamentally a mechanism that distributes wealth to those who have a strategy and adhere to it, from those who either do not or cannot.”

A study of stock returns from 1926 to 2000 determined that annual returns for large value stocks were 12.87%, outperforming large growth stocks’ returns of 10.77%. Another validation came from an Oklahoma State University researcher. After the 1982 publication of the bestseller In Search of Excellence, she tracked the stock performances of the stalwarts featured in the book and compared the excellent companies with the laggards. The laggards won by 11% per year. Value stocks aren’t always winners, however; they underperformed from 1929 to 1932 and again during the tech bubble.

Most investors have no idea how much a share is worth. When you buy a stock, you’re buying the income it will provide. To calculate the value of future income streams, apply a discount rate to determine a present value. Say you’re at the airport, about to leave for a week in Paris: The ticket agent tells you the plane is full, but she’ll give you a free week in Paris in 10 years. You don’t take the deal. Who would? A week’s vacation now is far more valuable than a decade from now. You counter that you’ll take five weeks in Paris 10 years from now in exchange for a week now, a markdown that equates to a discount rate of 17.5%.

“The Gordon Equation is as close to being a physical law, like gravity or planetary motion, as we will ever encounter in finance.”

This concept plays an important role in the Gordon Equation, which posits that the discount rate – also known as market return – equals dividend yield plus dividend growth. In the last century, the average dividend yield was 4.5% and dividend growth was 4.5%. Add them up for a total strikingly close to the actual return of 9.89%.

“Picking mutual funds is a highly seductive activity, because it’s easy to find ones that have outperformed for several years or more by dumb luck alone.”

If you’re young and have decades to go before retirement, hope for downturns. Market crashes are a gift for young investors because they can buy shares at a deep discount. Most investors have trouble with bargain hunting. Consider the example of tomatoes: Say the price whipsaws between 40 cents and $3 per pound. At 40 cents, you’d load up on tomatoes. At $3, you’d eat something else. Yet investors approach stocks with the opposite tactic, mistakenly buying when prices are high and steering clear when prices crash.

What makes up an ideal portfolio? Forget about picking individual stocks. The world’s savviest investors go for index funds – also known as passively managed investments. The California Public Employees Retirement System, a huge pension fund, keeps 80% of its stock holdings in index funds. Simply invest in the market without trying to divine which companies will do well. Sophisticated investment funds own many stocks. Owning a handful opens your portfolio to risk. Mix foreign stocks, precious-metal stocks and value stocks, since they do well when the broader share market struggles.

“Just as markets periodically suffer bouts of mania and gross overvaluation, so, too, do they regularly become absurdly despondent.”

“The History of Investing”

To make money as an investor, study financial history. Stock markets can become irrationally exuberant or illogically despondent. The savvy investor knows how to recognize the telltale signs. The tech bubble of 1999 and 2000 provides an instructive episode: Internet Capital Group didn’t actually produce anything. It invested in small, private companies. Internet Capital Group went public in 1999 at $6 per share, soared to $212 and then plunged to less than $1. For a time, the market valued Internet Capital Group at 10 times the worth of the companies it owned. This math, which seems absurd in hindsight, made sense only in the context of a mania.

“The market is no more capable of eliminating its extreme behavior than the tiger is of changing its stripes.”

Stock market bubbles command most of financial historians’ attention, but they also study declines, the sea of despond that mirrors investment mania. The most recent example came in the 1970s, when stocks underperformed for years. Shares lost value even as inflation soared. Pension funds reworked their asset allocations to ditch stocks in favor of real estate, futures, gold and even diamonds. In 1979, BusinessWeek’s cover headline read, “The Death of Equities.” It offered a roundly pessimistic view of stocks, warning that not even a bull market could undo a decade’s damage. Instead, equities soared in the coming years. The smart money fleeing stocks underscored the herd mentality that pushes investors to sell in bad times and buy in good ones, even if common sense dictates they should do the reverse.

“The Psychology of Investing”

The conventional wisdom in finance says that investors act coolly and rationally, and that they calmly apply a discount rate before buying or selling. Reality, of course, proves quite different. Humans are “supremely social” – far too prone to follow crowds into unprofitable trades. Just as crew cuts go in and out of fashion, the masses periodically favor certain types of companies. Large growth stocks like Coca-Cola, Disney and Microsoft saw huge run-ups in the 1990s. But after a stock wins the popularity contest, it’s unlikely to keep offering stellar returns.

“If indexing works so well, why do so few investors take advantage of it? Because it’s so boring.”

Investors fall victim to overconfidence. A survey asked young motorists in the US to rate how safely they drove. The results: 82% of respondents rated themselves in the top 30% of drivers. In a statistical impossibility, most drivers regard their skills as well above average. In parallel, 81% of entrepreneurs expected their new ventures to thrive. Only 39% of their peers thought they’d succeed. This high level of self-regard is deadly for investors.

“As [economist John Maynard] Keynes said, it is the duty of shareholders to periodically suffer a loss without complaint.”

Many investors remain overconfident due to simple ignorance about the sophistication of the professionals. Hundreds of thousands of institutional investors have access to high-end databases. These tools allow them to screen thousands of publicly traded companies based on hundreds of metrics. Given that level of competition, do you really think you have an edge from your Value Line subscription and a basic understanding of price/earnings ratios and dividend yields? Too many investors deceive themselves into thinking they can outsmart the smart money.

The “recency” phenomenon leads people to believe the immediate past is a prelude to the future. Asset classes tend to perform well for a few years and then fall apart for a few years, a statistical reality known as “mean reversion.” Consider these asset classes: From 1985 to 1989, Japanese stocks provided the best returns. But from 1990 to 1994, they posted the worst returns. Sometimes an asset class defies the odds and outperforms for years. That was the case with US small-cap stocks, which were the top-performing asset class for the entire period from 1975 to 1984. But in the ensuing five years, US small-caps turned in the poorest performance.

“Obsession with the short term is ingrained in human nature; the impulse is impossible to ignore.”

Instead of stock picking and market timing, investors should focus on indexing and asset allocation.

Alas, this seems boring. People mob casinos for a reason: Gambling is exciting. At the racetrack, bettors love to wager on the long shots. Cashing in a ticket on one high-odds winner can make racing fans forget all their losing long shots.

“The biggest obstacle to your investment success is staring out at you from your mirror.”

Betting on the horses isn’t an investment; it’s entertainment. Too many investors seek sizzle in their investments – that’s why initial public offerings of sexy companies tend to attract more capital than they should. In fact, a snoozer portfolio of value stocks like Caterpillar and Ford proves more profitable. Just as people tend to overrate the instant payoff of high-risk bets at the casino, investors tend to be overly scared of short-term losses. This “myopic loss aversion” can cause investors to spurn risk without realizing the graver danger of long-term underperformance.

“The Business of Investing”

Even if you’ve mastered the theory, history and psychology of investing, you still must fight off the brokers – looking to stick their hands in your pockets – as well as the financial media, which seem to exist solely to stoke angst and volatility. Brokers are the biggest threat. To be licensed as a stockbroker, you don’t need to prove your understanding of equities markets. The only barrier to entry is passing the Series 7 licensing test. Brokers’ interests and priorities directly oppose those of clients. The investor wants to minimize trades, fees and commissions; the broker must maximize them.

“The pattern of annual stock returns is almost totally random and unpredictable.”

The US Securities and Exchange Commission conducts little scrutiny of brokers’ fees or their performance for clients. The spread – the difference between the bid and ask prices – proves worrisome. When you buy shares of, for example, Walmart, you acquire them at the higher ask price. When you sell, you get the lower bid price. For a large issue like Walmart, the spread is less than 1%. For smaller, thinly traded issues, the gap can be as much as 6%. If you buy 100 shares from a broker engaging in “principal transactions,” the broker buys at the lower bid price from another client and flips them to you at the higher ask price.

“You are not capable of beating the market. But do not feel bad, because no one else can, either.”

Another trap for investors is “load” fees on mutual funds. If you buy the class A shares of a mutual fund, the fee is front-loaded and typically costs 4.75%. If you hold the fund for a decade, that shaves 0.46% per year from your returns. Because mutual fund B shares are back-loaded, you pay the fee when you sell. One study found that load funds underperformed no-load funds by 0.48%. With load funds, you pay more for worse performance. Vanguard, Fidelity, Charles Schwab and TIAA-CREF all offer index funds with reasonable expense ratios.

Watch out when financial publications profile the latest star money manager. This drives money into the manager’s mutual fund, probably just in time for the fund to experience its inevitable reversion to the mean. Better to ignore financial reporting on television and cancel your subscriptions to financial magazines and newspapers. Financial journalists rarely prove expert; they don’t read the latest scholarly research in the Journal of Finance and the Journal of Portfolio Management. They have no time to perform due diligence. Financial journalists simply regurgitate what they read elsewhere in the financial media and sell it to you.


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