the book I wanted to discuss is one which has intrigued me for some time now but left me cold – Four Pillars of Investing by Dr. William J. Bernstein. Call me a jaded personal finance reader, but this could very well be one of my shortest Book Club posts considering how little new information or one that found valuable was in the book.
I believe a lot of Personal Finance writing is done with the objective of fear psychosis making a regular investor feel vulnerable and helpless instead of well armed and empowered. In my mind, this book was an example of that kind of writing.
As suggested by the title, the book can be easily divided into the four pillars of investing which is what I will cover in this post:
Pillar One: Theory
The one point that Bernstein makes very lucidly is the fact that risk and return are inversely connected. More the probable return, riskier the asset class. This is a fundamental relationship that any investor must understand before proceeding into investing.
Another concept Bernstein often mentions is the “Survivorship Bias” which essentially means that we have only the assets or stocks that have survived, to look at for trends or data. However, those which have become bankrupt and no longer exist were probably the biggest losers and end up taking away from the real picture.
He also makes a forceful statement – high previous returns usually indicate low future returns and low past returns usually mean high future returns. He makes this conclusion for individual stocks and it struck me as too much of a blanket statement. While I agree that large cap stocks which have performed well as smaller companies become sluggish with size, stocks which have performed poorly in the past cannot automatically be assumed to have a higher probability of higher returns in the future. Individual fundamentals matter to a large extent.
Bernstein also remarks with historical evidence that when the sun shines brightest, the returns are the lowest. What he means by this is that since there has been no trough, any elevation relatively will not give that big a return rate. However, the time when the sun shines brightest can be the culmination of having the courage to invest in the darkest hours. It is just another way of saying how the rational way to get good returns is to buy low and sell high for which the probability of happening is in times of crisis and sunny times respectively.
Probably the wonkiest thing I read in the book was when Bernstein said that the shares of good companies are called “growth stocks” and those of bad companies are called “value stocks”. Ouch! Benjamin Graham must be tossing in his grave wondering where he went wrong in The Value Investor. For better definitions of these two types of stocks, do read what Investopedia has to say about growth stocks and value stocks.
Another googly for me in the theory Pillar was – Good companies are generally bad stocks and bad companies are generally good stocks. How do you then explain researching on fundamentals and future prospects of companies before investing? I would have probably understood better if he had said this statement more to the tune of good companies carry less risk and bad companies being riskier end up with a higher potential return. To me, the language is so warped.
He then discusses the Dividend Discount Model to understand the value of a stock. He talks about the bloat effect on mutual funds which means any stock movements by the fund management ends up impacting it’s price. The section is finished with the usual American gripe about how stock picking and actively managed funds are pointless and only index funds make sense for any investor. He also gives glimpses about diversification (on the basis of assets and geographies) and asset allocation.
All in all, a thoroughly painfully delivered first section with very misleading statements.
Pillar Two: History
A rightly pointed out by Bernstein, it is important to take our lessons from the history of markets so that we as individual investors can be more aware.
From his study of financial markets history, Bernstein comes to the conclusion that there are four necessary conditions for a market bubble or unjustified inflation of security prices:
- A major technological or financial practice shift
- Easy credit
- Amnesia about the last bubble
- Abandonment of time-honored methods of security valuation
Essentially, investors stop looking at fundamentals, start borrowing cash and speculatively putting it into stocks simply with the conviction that the price will go up with or without a justified reason for it. Bernstein suggests investors be on the lookout for such factors and sell out before liquidity dries out and the bubble bursts
At the time of market crashes, he opines that being social creatures, it might be difficult to go against the herd and buy more when there is such fear around. However, buying more to increase your returns is the best course of. This follows the oft-quoted maxim – buy low sell high.
Pillar Three: Psychology
Through this pillar, Bernstein takes us through some of the common behavioral finance terms to make us aware of what might be impacting our investment decisions and to make tweaks around it.
Most of the biases were the ones that a jaded personal finance reader could be said to have read multiple times – do not follow the herd, do not be overconfident, immediate past is not indicative of the future, investing is not supposed to be entertaining, do not see unnecessary patterns and mental accounting can be problematic.
Apart from these, Bernstein talks about how we humans due to our evolutionary history focus more on the short term rather than looking at future prospects. He mentions two good ideas to ignore the short-term volatility as much as you can – reduce the frequency of looking at your portfolio and have enough cash handy that with the ups and the downs of the market, your immediate daily spending does not come under risk.
In my mind, the problem occurs when Bernstein makes blanket statements – there are no great companies. His point is that most “good companies” are already overvalued and ready to fall off at the hint of underestimated earnings. He refuses to get into the layers or talk in detail about valuation. In this regard, I thought Graham’s advice to buy large bluechip stocks at the time of a short-term turmoil made much more sense. Bernstein’s insistence yet again to avoid “good companies” struck me as odd. What are “good companies” anyway? Just naming a few and not having a definition didn’t sit well with me.
Bernstein also talks about “Country Club Syndrome” whereby according to him rich people are misguided more often and end up paying a higher margin for their investments. While I agree that hedge funds and other exclusive investments might not be all they are made out to be, painting every rich guy with that broad brush was a little off-putting. I have seen many a rich folk who have reached that stage by being astute about money. I believe he really underestimates them to say that they will be misguided like innocent lambs.
Pillar Four: Financial Industry
This is a pillar which finally led me to shut the book. One statement in the introduction of the pillar makes the fear-mongering of the book most clear to me: their (financial service partner including brokers, mutual funds, media) ultimate goal is the same: to transfer as much of your wealth to their ledger books as they can.
Being a part of the financial services industry myself, you could call me biased, b. Also, I am no stranger to the hidden charges and costs applied by many firms in financial transactions. However, it’s then about going into the details and being sure of what you are getting with your money’s worth.
Yes, financial journalism is best to be ignored in most cases considering the sensationalism that they create. But, as an investor finally everyone needs to work with some or the other players in the financial services industry. Doing it with the background of everyone being out there to get your money can never be the basis of a good relationship, right?
Within the realm of personal finance, this probably counts as one of my most disappointing and disillusioning reads. Would I recommend it to a beginner? Apart from the pillar of history, hell no.
I know there are many fans of the book. So, if you have read it let me know what you thought of it in the comments below.