The Four Pillars of Investing By William Bernstein

The The Four Pillars of Investing is a book written by William Bernstein. In it, he describes the fundamentals of building a winning portfolio. The book is not too detail oriented so is perfect for people not too interested in the technical side of investing. Bernstein instead focusses on the
fundamental concepts and reading this book will help you make smart investment decisions on their own.

The Four Pillars and described by Bernstein are :

  1. A knowledge of investment theory
  2. An understanding of the history of investing
  3. Insight into the psychology of investing
  4. An awareness of the business of investing

Although the topics at first sight look dry and dull, I can assure you that the book is both lively and engaging. The book is written in an easy to understand manner without too much technical jargon but there are certain parts that delve into detail a bit more and require your full attention. Having stated this, once you read the book and understand the four pillars, you can easily replicate his advice in your own portfolios.

Pillar one: The Iheory of investing The book begins begins by giving a brief overview of investment theory. This may sound dull and intimidating, but it’s not. Bernstein presents the material in a way that makes sense, even to an average investor like myself.

The most important concept in investing is that risk and return are inextricably intertwined. If you want to obtain higher returns, you must take on higher risk and consequentially face the prospect of higher losses. If you want to avoid the risk of losing money, you must reduce the chance of higher returns (i.e. investing in bonds) .

In essence, if somebody offers you an investment opportunity that us both safe and yields high returns, they either don’t know what they’re talking about or it’s a scam you.

However, they are certain techniques you can use for reducing your exposure to risk. One technique is that the longer you hold an investment for, the lower the risk will be. Another technique in reducing risk is through diversification – own different asset classes and your risk will be reduced.

Bernstein states that the worst reason to buy a certain investment or (mutual) fund is by looking a past returns. Although past returns may be a good indication of how well an asset has done, it does not guarantee to give these same great returns in the future. This is because mutual funds tend to regress toward the mean thus those 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 (constrain investing).

Pillar two: The History of Investing How many investment books have you read with a whole section dedicated towards financial history? Bernstein devotes 36 pages to the subject, and it’s fascinating. By looking at the past, one can learn valuable lessons. As Mark twain says “History doesn’t repeat itself but it often rhymes”.

Bernstein states that “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 delving into and understanding the history of financial markets, you can make more considered, rational investment 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. The number one impact on your investments is you. “You are your own worst enemy,” Bernstein writes and goes on to explain 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.

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 their best to reduce all three investing pitfalls. .

Whilst fees and taxes are mentioned more often than not, they 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” (not to be confused with actual pornography such as the videos you can find online here — 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.The best thing to do is to educate yourself, learn why the market behaves the way it does and make your own decisions based on market performance. You can even just simply download an app to get you started.

Putting The Four Pillars Together

After introducing his four pillars of investing, Bernstein explains how to use them to build a stable financial “house” or portfolio. Bernstein puts this brilliantly “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 ”.

Having read countless articles on investing online, I have stumbled across swathes of individual investors who try and 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.

If you don’e have the time and skill to consistently pick winning stocks year after year, the best thing you can do is buy index funds. All you need to do is spend a few hours each each year constructing a portfolio of index funds that track the market and you will do better in the long-run than most professional money managers.