The 4 pillars of investing

By Larissa Fernand |  19-06-20 | 
 
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About the Author
Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

William Bernstein is fascinating in more ways than one.

He began his career as a neurologist and then transitioned to being a financial theorist and money manager. Add the dozen-odd books he has authored, and you get an extremely prolific writer.

One analogy that he presented during an interview stuck with me.

Investing is like losing weight.

To lose weight, you have to exercise more, eat less and eat right. Simple, but not easy.

To become wealthy, you have to save more, spend less, and invest right. Simple, but not easy.

His thoughts and writings have a place in any serious conversation about investing. Yet, they are elegant in their simplicity. One of them being the four pillars of investing.

According to him, mastery of them can result in a coherent strategy that will enable individuals to accomplish investing’s primary aims: achieving and maintaining financial independence and sleeping well at night. A deficiency in any of them will torpedo your investment plan.

The below has been extracted from his book The Four Pillars of Investing with inputs from his conversation with Barry Ritholtz and his conversation with Ben Carlson.  

Pillar I: Theory

The most fundamental characteristic of any investment is that its return and risk go hand in hand. The correlation between risk and return is almost like the law of gravity in investing. A market that doubles rapidly is just as likely to halve rapidly, and a stock that appreciates 900% is just as likely to fall 90%.

Whether you invest in stocks, bonds, or for that matter real estate or any other kind of capital asset, you are rewarded mainly for your exposure to only one thing—risk. Investors must explore the interplay of risk and investment return.

The next thing to grasp is the theory of diversification - how you mix assets. Asset allocation is a major driver of portfolio returns, and it should be fundamental, even more crucial than asset selection.

There are riskless assets, risky assets and assets you should not be dabbling in – as Tobin’s Separation Theorem alludes to. Junk bonds, for example, are a mistake. I am neutral on Duration, though a case can be made that Duration is a certain risk, particularly in an inflationary environment.

(Tobin's Separation Theorem: Find the risky portfolio that maximizes the return to risk and then form a new portfolio that combines this risky portfolio with cash or leverage to find the level of risk and volatility that you are comfortable with.) 

The biggest risk of all is the failure to diversify properly because it is the behaviour of your portfolio as a whole that matters. A portfolio can behave in ways radically different than its component parts, and this can be used to your advantage. The science of mixing different asset classes into an effective blend is called "portfolio theory" and occupies centre court in the grand tournament of investing.

Pillar II: History

It is a fact that, from time to time, the markets and investing public go barking mad. The madness is obvious only in retrospect. But a study of previous manias and crashes will give you at least a fighting chance of recognizing when asset prices have become absurdly expensive and risky and when they have become too depressed and cheap to pass up.

Remember the investors who got suckered into the dot-com mania? Their unappreciation of history came home during the tech bubble of the late 1990s, when people had absolutely no idea that they were living through something that had happened many times before.

There is a script to the movie, and if you read the script, you know how the movie ends.

From time to time, the investing public becomes almost psychotically euphoric, and at other times, toxically depressed. Centuries of recorded financial history tell us about the short-term and long-term behaviour of various financial assets.

Finance, is not a "hard science." It is instead a social science.

The difference is this: a bridge, electrical circuit, or an aircraft should always respond in exactly the same way to a given set of circumstances. What separates the "hard" sciences of physics, engineering, electronics, or aeronautics from the "social" sciences is that in finance (or sociology, politics, and education) apparently similar systems will behave very differently over time.

Put a different way, a physician, physicist, or chemist who is unaware of their discipline's history does not suffer greatly from the lack thereof; the investor who is unaware of financial history is irretrievably handicapped.

For this reason, an understanding of financial history provides an additional dimension of expertise. Familiarise yourself with the wondrous clockwork and history of the capital markets. As George Santayana famously said, “Those who do not learn from history are doomed to repeat it”. 

Pillar III: Psychology

Most of what we fondly call "human nature" becomes a deadly quicksand of maladaptive behaviour when allowed to roam free in the investment arena.

An example: people tend to be attracted to financial choices that carry low probabilities of high payoffs. In spite of the fact that the average payoff of a lottery ticket is only 50 cents on the dollar, millions "invest" in it. While this is a relatively minor foible for most, it becomes far more menacing as an investment strategy. One of the quickest ways to the poorhouse is to make finding the next multi-bagger your primary investing goal.

The individual investor's state of mind affects his or her decision making. Understand behavioural finance to learn how to avoid the most common mistakes and to confront your own dysfunctional investment behaviour.

Pillar IV: Business

The business aspects of investing refers to the people who are selling you the products. Investors tend to be almost touchingly naïve about stock brokers and distributors. They are not your friends.

When a broker calls suggesting that the price of a particular stock will rocket, what he’s really telling you is that he is not overly impressed with your intelligence. Otherwise, you would realize that if he actually knew that the price was going to increase, he would not tell it to you or even his own mother. Instead, he would quit his job, borrow to the hilt, purchase as much of the stock as he could, and then go to the beach.

Where is the chink in your armour?

The average investor most often comes to grief because of deficiencies in Pillars I and III.

They usually fail to understand the everyday working relationship between risk and reward and routinely fail to stay the course when things get rough.

Of course, this is just a caricature. The failure modes of individual investors are as varied as their personalities. Introspect to find yours.

Investment Involves Risk of Loss

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