The four pillars of investing

couple getting investing advice

For the past year, I've been looking for a book to recommend for novice investors, a book that would offer sensible advice without becoming too technical. I believe I've finally found that book — The Four Pillars of Investing,

In the book, William Bernstein describes how to build a winning investment portfolio. He doesn't focus on the details — he tries to explain fundamental concepts so that readers will be able to make smart investment decisions on their own.

Successful investments, he says, are build upon four “pillars”:

  • a knowledge of investment theory
  • an understanding of the history of investing
  • insight into the psychology of investing
  • an awareness of the business of investing

These topics sound dry and dull, but I found the book lively and engaging. It's not an easy book — there are passages that require the reader's full attention — but generally the author presents essential information without making it too complicated. Best of all, his advice is sound.

Pillar One: The Theory of Investing

Bernstein begins by offering a brief overview of investment theory. This may sound intimidating, but it's not. The author presents the material in a way that makes sense, even to an average guy like me.

The most important concept in investing is that risk and return are inextricably intertwined. If you want to obtain higher returns, you must face the prospect of higher losses. If you want to avoid the risk of losing money, you must reduce the chance of higher returns. Bernstein stresses this point:

High investment returns cannot be earned without taking substantial risk. Safe investments produce low returns.

If somebody offers you that an investment is safe and offers very high returns, they either don't know what they're talking about or they're trying to scam you.

Howvever, the risk of an investment can be reduced by holding it for a very long time. The longer you own a risky asset (like a stock, for example), the less the chance of a loss. You can also diversify your portfolio — own other assets — in order to reduce risk.

Bernstein notes that past performance is no guarantee of future results. Everywhere in the investment industry, the performance of mutual funds is cited as a reason to purchase them. The author suggests this is crazy, and that regression toward the mean makes it likely that stocks and mutual 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. (This is only a general tendency, and not a hard-and-fast rule.)

If anything, the short-term returns from individual investments seem random. Bernstein writes that there is almost no evidence that professional money managers can regularly pick winning stocks. (Warren Buffett is an exception.) There is absolutely no evidence that anyone can time the market. Because of these facts, Bernstein argues that the most reliable way to obtain a satisfying investment return is to use index funds.

Pillar Two: The History of Investing

How many investment books do you know with sections about financial history? Bernstein devotes 36 pages to the subject, and it's fascinating. By looking at centuries of information about financial markets, one can learn valuable lessons. For example, the Dot-Com Bubble of the late-1990s had many precedents in investment history. Bernstein cites famous bubbles from the past, including the South Sea Bubble of 1720.

But irrational exuberance isn't the only problem investors face. Sometimes the markets are irrationally gloomy, depressing prices for prolonged periods. Bernstein writes:

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 understanding the history of investing, you can make more considered, rational 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

“You are your own worst enemy,” Bernstein writes. The number one impact on your investments is you. He explains 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.

As with the history “pillar,” just being aware of the psychological component to investing can help prevent some mistakes.

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 her best to reduce all three.

But there 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” — 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. Educate yourself and make your own decisions based on market performance.

Related >> Investing 101: A primer on mutual funds

Putting It All Together

After introducing his four pillars of investing, Bernstein explains how to use them to build a stable financial “house.” In fact, if I had read the chapter “Will You Have Enough?” before last Tuesday, I might never have posted my thoughts on retirement and financial independence; the book gives some advice on planning how much you'll need for retirement.

Related >> Thoughts on Retirement and Financial Independence

In the end, Bernstein summarizes the fundamental message of his book:

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”.

I've read a lot recently about individual investors who try to 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. Some use Warren Buffett as an example of an individual investor who has been able to achieve stellar returns. Buffett has worked full-time for more than fifty years to achieve these fantastic results. And even Buffett believes that 99% of investors would be better off choosing index funds.

Final Thoughts

I am not Warren Buffett. I don't have the time, skill, or inclination to pick winning stocks. I'm willing to “settle” for spending a few hours a year constructing a portfolio of index funds that will do better in the long-term than the results achieved by most professional money managers.

The Four Pillars of Investing is challenging in places, but it provides an excellent introduction to the theory, history, psychology, and business of investing. If you're just getting started, borrow this book from the library. Stick with it. If you're able to finish, you'll have a better grasp of investing than 99% of your peers.

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Amanda
Amanda
12 years ago

JD, thanks for the comments about this book. I just picked it up with the goal of tackling it on my summer vacation. Can’t wait to read- sound like it’ll be great!

Four Pillars
Four Pillars
12 years ago

Definitely my favorite investment book!

If you believe in managed funds then read it.

Mike

Curt
Curt
12 years ago

Sounds like a great book. I will have to read it. I realize that Warren Buffett is you investing idle, but as the stock market sinks even Warren is losing money. This year is going to be one of the worst years for stocks in 30-years.
–Got gold?

Mo Money
Mo Money
12 years ago

This sounds like a great book. I will definitely get it after reading this post.

Jeff
Jeff
12 years ago

I second that, my favorite investment book out there. I read it about four years back and it was life changing, from a financial perspective.

I recommend it to everyone who is trying to learn about investing, even recommend it to people who think they already know about investing; like my Financial Advisor brother in law.

Don
Don
12 years ago

You cannot adequately review a Bernstein book without using the word “rebalance.” Most of the risk reduction you expect to get from your diversified portfolio comes as a consequence of rebalancing.

Admittedly this is more apparent in his other book “The Intelligent Asset Allocator,” but I personally think it can’t be repeated enough. Unless you rebalance periodically, you aren’t getting the reduction in risk that you think you are.

Ed
Ed
12 years ago

Nothing like a serious Couch Potato portfolio using Index Funds, leave it alone, re-balance once a year and forget about it. It works!

RacerX
RacerX
12 years ago

Great point about highs and lows. Things are usually not as good as it looks during peaks, nor as bad during Bear markets. Good arguments for being a contrarian investor!

ThatGuy
ThatGuy
12 years ago

While this was a good summary and probably a very informative book, I would like to say that it isn’t entirely true. Specifically, risk vs. reward isn’t as linked as we have been lead to believe. Not to mention that the way the finance community defines risk is through volatility and not through actual capital loss. This type of thinking is seen in “The Intelligent Investor”, which is a book that Buffet recommends. Further, you might want to check some of Buffett’s letters found at http://www.berkshirehathaway.com/letters/letters.html Graham and Buffet do a much better job explaining why risk and reward are… Read more »

James M
James M
12 years ago

I highly recommend this book. My personal favorite on the topic. Read it and suggest it to your personal finance friends. I give it as a college graduation gift. (Is that lame? 🙂 )

Mark Nelson
Mark Nelson
12 years ago

When I see somebody recommend a book about investing I kind of cringe. This however seems like a good book. The only investing in mutual funds I do is in index funds. That is pretty sound advice. I personally invest through other vehicles but that would be another post.

MITBeta @ Don't Feed the Alligators
MITBeta @ Don't Feed the Alligators
12 years ago

This sounds like a great book — perhaps a somewhat scaled down version of A Random Walk Down Wall Street.

It should probably be noted that Buffet isn’t really so much an investor in stocks as he is in companies themselves. Sure, he ultimately ends up owning a lot of stock in companies, but that’s not really the same thing as being a stock investor.

Mark
Mark
12 years ago

Warren Buffett, arguably the world’s greatest investor, disagrees with what you call the most important concept in investing — i.e. that risk and return are inextricably intertwined. With all due respect to William Bernstein, I agree with Buffett. Here is what Buffett had to say: “I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, “I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive,… Read more »

MillionDollarJourney
MillionDollarJourney
12 years ago

Great review J.D. As most investors aren’t inclined to do a lot of investment research, their best bet is to simply index and ride it out. As mentioned in the book, this approach will beat the majority of actively managed mutual funds.

StockTrendInvesting
StockTrendInvesting
10 years ago

This post is of course already a few years old but I only came accross it now when checking out the reviews of The 4 pillars of investing. Thanks for the review. It gives a good overview. I fully agree with the part on index funds. My opinion differs maybe on market timing and beating the market, or maybe it is a matter of words. Market timing in a time frame of days or weeks is too advanced for me. But being more often right than wrong in defining major turning points in markets when looking at trends that are… Read more »

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