2007-12-03

Reading The Four Pillars of Investing

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

A neurologist from Oregon seems an unlikely candidate for financial author and theorist. Perhaps it is not surprising, then, that William J. Bernstein, Ph.D., M.D.--author of The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk and The Birth of Plenty : How the Prosperity of the Modern World was Created--contrasts much of his financial advice with conventional wisdom. He writes, "Your social instincts will corrode your wealth by persuading you to own what everyone else in the market owns."

Of stockbrokers Bernstein writes, "He also occupies the lowest rung in the hierarchy of investment knowledge." Of the financial press he writes, "Ninety-nine percent of what you read about investing in magazines and newspapers, and 100% of what you hear on television is worse than worthless." U.S. stock returns are a "random walk" that no one can predict and few in the industry understand. (See the "drunkard's walk" in Conned Again, Watson!; this concept also inspired the title of Burton G. Malkiel's A Random Walk Down Wall Street, which I have borrowed from the Seattle Public Library or SPL.)

Perhaps some of Bernstein's assertions are not surprising: "Risk and return are inextricably enmeshed." While this stands in contrast to occasional low-risk, high-return offers, most readers know these to be too good to be true. Other authors, too, warn against overconfidence, Mistake 1 in Rational Investing in Irrational Times: How to Avoid the Costly Mistakes Even Smart People Make Today by Larry E. Swedroe (also out from the SPL). Edelman and Bernstein emphasize that "You are your own worst enemy."

However, unlike your coworker on the telephone daily with his broker (a broker who Bernstein writes "services his clients in the same way that Bonnie and Clyde serviced banks"), writers Edelman and Bernstein agree that "Stock picking and market timing are expensive, risky, and ultimately futile exercises." Edelman and Bernstein both follow modern portfolio theory; Bernstein especially believes the market is efficient. And in response to the high-fee funds recommended by your financial consultant, Bernstein warns, "The primary business of most mutual-fund companies is collecting assets, not managing money. Pay close attention to the ownership structure of your fund company and of the fees it charges."

Some authors--like Edelman--look at the 10.40% total return of the S&P Stock Index from January 1, 1926 to June 30, 2003 (while noting that past performance is no indication of future results). Bernstein, however, begins with Venetian prestiti prices from 1300 to 1500. "[T]he odds always favor data gathered over the longest time periods." He proceeds through economic history and then uses the Gordon equation to estimate the long-term expected return of the market as 6%.

Bernstein's combination of theory, history, psychology and business (the four pillars) is appealing to me because of its academic approach and statistical emphasis. The Four Pillars of Investing offers an intellectual investigation into the folksy advice to build portfolio income, written in an equally engaging style.

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