Four Pillars of Investing
The book, The Four Pillars of Investing, by Paul Bernstein is great guide to investing and how to build a winning portfolio for inexperienced investors. This book offers great tips and lessons without becoming too technical or advanced. Instead, Bernstein tries to explain and teach readers the fundamental concepts so that they can make their own decisions by applying the concepts they’ve learned. Bernstein believes that success in investing is built upon four pillars: knowledge of investment theory, an understanding of the history, understanding the role psychology plays in investing, and an awareness of the business aspects of investing.
The book starts out with a brief introduction to the “four pillars” and how to apply them. Bernstein then goes into the topic of investment theory. This section talks about the link between risk and reward. The higher the risk the higher the reward will be and vice versa. When political and economic outlook is the brightest, returns are the lowest, when things look the darkest the returns are the highest. The stock market in the short term is very risky, but the longer you hold stocks, the lower the risk of a loss is and the greater the possible gain. Determining whether these stocks will have long-term value is very difficult to assess. A stock is worth the present value of it’s expected future income and a stock can increase in value in two ways: demand increases which causes the price to increase (capital gains), and through paying dividends. Other assets like gold don’t pay dividends and therefore can only gain value through an increase in demand. Past performance is no guarantee of future results. A stock that does well one year may not do so well the next.
The book then goes on to discuss how the market is smarter than you and that the market is too random to effectively manage and time in the short term. If you were to take the average returns for mutual fund managers, they are the same return on the broad market. The fees that you have to pay to have one of the fund managers manage your money makes the end return lower than that of the broad market. Bernstein advises investors that one way to get the same returns as the broad market without having to pay fees is to purchase index funds.
The perfect portfolio should be well diversified because diversification can substantially reduce a portfolios risk. Every portfolio should have 20% invested in riskless assets like bonds unless one plans on not touching that portfolio for a while because long term bonds are high risk and provide low returns. The other 80% should be in stocks and real estate. 30-40% should be in foreign stocks, while 10-15% should be in real estate with the remaining amount in U.S. stocks. Keep in mind that when picking stocks, value stocks historically outperform growth stocks.
Bernstein then moves on to talk about the history of investing which covers several “manias” throughout history. From time to time, markets can become either irrationally exuberant or morosely depressed. The dot-com and housing market bubble are discussed and one of the main points is that when a few people make a lot of money, many more people try to jump onboard. It’s more profitable for an investor to put in money when the market is low than when it’s high. Understanding the history of investing means that investors can make more considered, rational choices.
Bernstein agrees with a statement made by Benjamin Graham, that you are your own worst enemy. The number one impact on your investments is yourself. Diversification and indexing are keys to long-term success. This section mainly gives advice on what investors should be weary of. Bernstein makes the point that conventional wisdom is usually wrong and that herd behavior exacerbates the boom and bust cycle. It’s also important not to be overconfident and avoid exciting investments. Bernstein also makes...