Morningstar’s vice president of research, John Rekenthaler, on Bill Bernstein’s newly released second edition of his 2002 classic, The Four Pillars of Investing.
The book covers a wide range of territory: investment theory and history, financial advisory practices, portfolio construction, and investor psychology.
When Bernstein wrote the first edition of Four Pillars, as a relative newcomer to the field, he was enthralled by the numbers. Investment research is bounded by science. In contrast with many of his quantitatively minded peers, though, he recognized from the start that investment math could also be a trap. History never repeats exactly—sometimes not even approximately.
For that reason, he addressed investor psychology.
Twenty years later, he has expanded on that message. The second edition opens by contrasting two investors:
1) Hedge fund Long-Term Capital Management, run by two Nobel Laureates
2) Sylvia Bloom, a legal secretary who died at the age of 98, holding $9.2 million in assets
The former belied its name by surviving only four years, while the latter persisted for 67 years, with great success. Writes Bernstein, “Unlike the geniuses at LTCM, [Bloom] wasn’t trying to get rich quick, but rather to get rich slow—a much safer bet.” That sentence neatly summarizes Bernstein’s counsel.
Speculators pursue high returns; investors seek appropriate returns.
Four Pillars spends little time on the obvious forms of speculation, such as buying meme stocks or trading options. No need to beat that horse; the book’s readers either already realize the futility of tail-chasing, or they bought the book because they are ready to absorb that lesson.
Four Pillars instead addresses the type of errors that educated investors might unknowingly make—and that Bloom did not. They include:
1) becoming seduced by investment narratives, as made by intriguing but ultimately mediocre theme funds
2) succumbing to recency bias
3) believing too strongly in one’s own abilities, thereby discounting the wisdom of the crowd (Is the marketplace crazy? Perhaps. But that occurs far less often than most investors believe.)
The most dangerous delusion comes not from how investors perceive the outside world, but instead from how they view themselves.
The first edition of Four Pillars included a risk-tolerance table, to help readers establish their equity allocation. For example, investing 80% of one’s assets in stocks might lead to a 35% portfolio decline, under unusually bad (although not the worst possible) circumstances, while owning 40% would cut the loss to 15%.
Writes Bernstein in the second edition:
I neglected to ask whether readers had actually lost 15%, 25%, or 35% of their portfolio. Simply looking at this table or running a portfolio simulation on a spreadsheet is not the same as facing real-world losses. The stock market only rarely falls for no good reason – bear markets are almost always the result of incipient financial system collapse, hyperinflation, or the prospect of nuclear annihilation. The fear of real geopolitical and economic catastrophe makes such times the most dangerous mountain passes on the highway of riches.
That is, it is not enough to have been in the right place at the right time, as wealthy Americans have been during the past 40 years. Investors must also know how to convert their paper opportunities into tangible dollars, by making sound decisions that withstand the test of time. Underinvesting is an obvious problem, as one can’t pocket stock market gains without stocks. But overinvesting can also be a costly error. Getting rich slowly means finding the appropriate personal level.
That conclusion may seem simple, but enacting it proves surprisingly difficult. Over the years, tens of millions of investors have crashed upon the asset-allocation rock. Such a fate, however, is unlikely to befall those who read Four Pillars. By the time the reader encounters Bernstein’s homily on risk perception, the book already established 200 pages of context, with another 100 yet to follow. The advice is therefore not hollow. It echoes.