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Book review: The Four Pillars of Investing

The Four Pillars of Investing : Lessons for Building a Winning  Portfolio The Four Pillars of Investing : Lessons for Building a Winning Portfolio by William J. Bernstein

My rating: 4 of 5 stars
An investment adviser and I were talking about the financial books we had read, and he highly recommended this book as the next on my list. I can see why! Instead of immediately offering advice on how to invest, Bernstein takes a step back and makes sure you understand market theory, the history of the markets, the role of psychology in choosing investments, and the very real impact of expenses and the media's influence.

The book contains statistics, tables, graphs, analogies, examples, and theory in a decently proportioned mix; my eyes never glazed over because of too many numbers. All this background information ensures that your investment decisions will be based on a wealth of data, rather than blindly following his recommendations.

I agreed with Bernstein in almost all areas, with the exception of tilting or overweighting market sectors. There are 2 camps of stock fund investors: those who slice and dice the market and those who hold the total market. Bernstein points to the higher returns of value and small caps demonstrated by Fama and French and others, and recommends overweighting them and underweighting growth. John Bogle, on the other hand, preaches that the market is so efficient that there's no free lunch (higher returns) in any one sector over the long term, so it's better to just hold the entire market in a market cap weighted fund. I'm not entirely convinced either way, but I tend to side with Bogle.

Bernstein advocates wide diversification, passively managed index funds, and buy-and-hold for the long term. This book is similar to The Little Book of Common Sense Investing, The New Coffeehouse Investor, and The Lazy Person's Guide to Investing, but provides a better explanation of the theory behind the practice. As a "lazy" buy-and-hold investor, I put myself squarely in the camp of these authors.

The book presents the Four Pillars of Investing, then shows how to use the pillars to assemble a portfolio.

Pillar 1: Investment Theory
High returns require high risk.
The market is efficient. Own it all by indexing.
Build a portfolio of mostly the total US stock market, some small US, and some large international. If desired, add small and large value and REITs.

Pillar 2: Investment History
The more history you know, the better prepared you'll be for the market's ups and downs.

Pillar 3: Investment Psychology
Focus on long-term data. Large and small value outperform large growth.
Returns are random; don't imaging patterns.

Pillar 4: Investment Business
Pay attention to fees and expenses.
Ignore almost all investing media.

Here are more detailed notes:


Pillar 1: Investment Theory
High previous returns usually indicate low future returns; low previous returns usually mean high future returns.
Because of their higher risk, small caps outperform large caps by 1.5%/year on average.
Good (growth) companies are generally bad stocks; bad (value) companies are generally good stocks.
Value stocks have higher return than growth.
When the political and economic outlook is brightest, returns are lowest. When things look darkest, returns are highest.

You can have 1 of 2 mutually exclusive investing goals:
1. maximize your chances of getting rich
2. minimize your chances of missing goals or dying poor.

You can't time the market or pick winning stocks, so asset allocation is the only factor you can control.
Index the whole market.

Start with a percentage of bonds equal to your age.
Hold 15 - 40% of stocks in foreign stocks.
REITs have returns about equal to the stock market; allocate a max of 15%.
Young people should have a max of 75% in stocks, with the rest in short-term bonds.

Pillar 2: Investment History
Bubbles have occurred throughout the market's history (canals, railroads, 1920s, 1960s) and will continue.
Basic rule of technology investing: users, not makers, profit most.

Pillar 3: Investment Psychology
In the next decade, the last decade's worst-performing investment usually does better than the last decade's best-performing investment.
The most exciting assets have the lowest returns; the most boring ones have the highest.

Pillar 4: Investment Business
Ignore financial media. The collective wisdom of the market is the best adviser.
The only guidance you need is with getting your asset allocation right; after that, it's self-discipline.

Investment Strategy
Taxable accounts
Own the market in a tax-efficient index fund tracking the Russel 3000 or Wilshire 5000.
Hold municipal bonds, Treasuries, and corporate bonds.
Rebalance only with fund distributions, inflows, and outflows

Tax-sheltered accounts
Split the market into large market, large value, small market, small value, and REITs.
Hold government and corporate bonds.
Rebalance every 2-3 years.

Don't hold growth stocks; they're overvalued and have the lowest long-term returns.
For less than $5,000 - 10,000 in bonds, use a bond index fund. For larger amounts, buy Treasuries directly, and use the Vanguard Short-Term Corporate fund for the non-Treasury portion.
Don't hold more than 80% in stocks.
Keep the maturity of your bond portfolio 1-5 years.

Portfolio for age 20-30
Assumes 60/40 stock/bond split. Adjust as necessary for other proportions.
32.5% large cap
12.5% international
7.5% REIT
7.5% small value
40% cash and bonds
Later, add large value, small cap, corporate bonds, precious metals, split international by region, and add TIPS.

Use value averaging instead of dollar-cost averaging: try to hit a target amount each month. If the fund declines, you must invest more. If the fund goes up, invest less. This forces investment at market bottoms rather than tops.

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