Monday, July 17, 2017

The Four Pillars of Investing

While reading William J. Bernstein’s book The Four Pillars of Investing, I was unsure of how to summarize it. After finishing I’d say that it aims to give readers the right knowledge and expectations to become successful do-it-yourself investors. Without a solid grounding in each of the four pillars, investors are at risk of making expensive mistakes.

The first pillar, called “theory,” is less intimidating than it sounds. It teaches the link between risk and reward and that “high previous returns usually indicate low future returns, and low past returns usually mean high future returns.” This is particularly true of stocks because they show more mean reversion than you’d expect just from randomness.

We tend to think of money market funds as safe, but they get their returns in part from commercial paper that “does occasionally default.” There is no excess return without some risk.

Bernstein explains the Gordon equation, which states that the market return is equal to dividend yield plus the rate of dividend growth. He goes on to explain that to this we have to add the rate of stock buybacks and subtract the rate of new share issuance. One point I’d add is that companies can make their dividend growth appear higher for a few years by increasing the proportion of earnings they pay out in dividends. For this reason, one might substitute earnings growth for dividend growth. But this has its own problems for companies that game their earnings accounting.

An amusing bit was using Trump Casinos as an example of a business with a high risk of defaulting on loans. I doubt Bernstein had any idea that years after writing it, his book would come to seem political.

It’s not hard to see what Bernstein thinks of active management when he refers to a mutual fund’s advisory fees as “what the chimps get paid.” He also says “It should be painfully apparent by now that most of the investment industry is engaged in nonproductive work.” He sums up his arguments with “Stock picking and market timing are expensive, risky, and ultimately futile exercises. Harness the power of the market by owning all of it—that is, by indexing.”

Because of the possibility of high inflation, the author believes that “Long-duration bonds are generally a sucker’s bet.”

The second pillar is the history of investing. The main purpose of this pillar is to teach readers that market bubbles and crashes happen fairly regularly, and we need to keep our wits about us and stick to a plan. As George Santayana said, “Those who cannot remember the past are condemned to repeat it.”

I’ve written before about Bernstein’s distinction between investing and saving, and I won’t say any more about it here.

I enjoyed a joke at the expense of the company “Yahoo!” where Bernstein asked if the name is an interjection “or was it simply a noun, meant to describe the company’s shareholders.”

The third pillar is the psychology of investing. People consistently make many types of investing mistakes. The first step in avoiding these mistakes is to understand them.

Some examples of mistakes are assuming “that the immediate past is predictive of the long-term future,” and our search for patterns that aren’t there. “The pricing of stocks and bonds at both the individual and market level is random: there are no patterns.”

Another mistake is seeking status through the types of investments you use. “Wealthy investors should realize that they are the cash cows of the investment industry and that most of the exclusive investment vehicles available to them—separate accounts, hedge funds, limited partnerships, and the like—are designed to bleed them with commissions, transaction costs, and other fees.”

The fourth pillar is the business of investing. This pillar is a warning about the financial industry. “The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks.” “Under no circumstances should you have anything to do with a ‘full service’ brokerage firm.”

Most mutual-fund companies aren’t much better: “The primary business of most mutual-fund companies is collecting assets, not managing money.”

The sections of the book on the four pillars are strong, but the “assembling the four pillars” section isn’t as strong. A couple of the reasons for this aren’t Bernstein’s fault: the discussion of specific investments is getting dated and is too U.S.-centric for a Canadian like me.

My main criticism is that he ends up building portfolios that are too complex. For most people, the potential benefit of slicing up portfolios into ETFs or funds based on market caps, growth/value, geography, and other factors is too small to justify the extra work. No doubt some people could manage all this well, but many investors would make mistakes and end up spending too much on commissions, spreads, higher MERs, and realized taxes. Simpler is usually better.

The short section on investing with children is excellent. He advocates buying index funds for children, letting them watch the ups and downs once each quarter, and letting them spend some dividends. I tried to do something similar for my sons, but mostly failed. Bernstein’s approach would have been better.

Bernstein is very positive about an approach to investing called value averaging. It doesn’t work. I’ve discussed why here and here, and described some experiments I ran here.

The subsection on rebalancing places a lot of emphasis on which method gives the highest returns. This can be misleading for investors. When you own many stock funds based on various factors, rebalancing can give a small boost in returns. However, most investors just rebalance between stocks and bonds. The purpose in this case is to control volatility, not boost returns.

Overall, I found this to be an excellent book for steering investors toward making good decisions about the things they can control, and remaining calm about the things they can’t control. Readers who get through the whole book are likely to become better investors.


  1. WRT the Children/index funds: May I ask, what part failed?

    I'm doing something in that vein, but a little different.

    Taking all their red packet money, replacing with slips of paper showing the amount, investing it. Waiting until they are (~12?), let them add up the slips. [Make a deal/sign a contract here about not asking for the money.] Then let them see what the value is and explain how to make more without doing anything.

    Also doing an allowance for the financial responsibility side, and to convince them they do not need that money. Perhaps to also get them to add to the investment part.

    1. @aB: I bought shares of BMO for my sons. It probably taught them a little, but I never sat them down to look at the shares' change in value and the increasing dividend. I think they had some awareness of the increasing dividend, but they rarely withdrew some of the dividends in cash. I think that would have made the exercise less abstract.

  2. Bernstein is a strong supporter of index investing, but he is not averse to the idea of market timing by adjusting weightings based on regions or market sectors. Right now he is advocating reductions in N.American allocations.

    1. @BHCh: True. His admiration of value averaging is inconsistent with passive index investing as well. It's rare that I encounter anyone who both advocates passive indexing and uses it for his or her own portfolio.

    2. Agreed. I think the book is awesome even though I don't necessarily buy into everything he advocates. Bernstein is very good at debunking nonsense but there is also a bunch of subjects where he does not come across as someone who has all the answers with certainty. That's a rare quality among investment gurus. And a good one.

    3. @BHCh: My doctor is like that. Every time he tells me he's not sure of what is wrong, I trust him more.