The Four Pillars of Investing - critical summary review

“The Four Pillars of Investing” by William Bernstein, first published in 2002, survived its latest editions with only a few changes – although written just before a few monumental events in the world of money and finance. The book is a remarkable testament to its enduring wisdom and timeless bits of advice in a field naturally fraught with predicaments and uncertainty.

Founded on the notion that "scientific basis of investing” exists, consisting of four broad areas – theory, history, psychology, and business – Bernstein's book is not “a humble how-to tome,”  to use his own words. It is more than a decent introductory study guide to investing – “a financial tour d’horizon” that self-taught investors should find immensely accessible and useful.

So, especially if you’re new in the world field, get ready to peek behind the curtains of the investment process to learn all about its four pillars, and prepare to add some science to the building of your future portfolio!

Pillar No. 1: The theory of investing

In 1798, a French expedition commanded by Napoleon invaded Egypt. Three years later, the last French troops, dispirited and starving, were mopped up by Turkish and British forces. It’s not that Napoleon’s forces didn’t possess the desire or confidence to conquer Egypt; it’s just that they had only the most rudimentary maps and barely any knowledge of the Egyptian landscape or the African climate. The invasion was doomed from the beginning. 

Unfortunately, most investors are just like them: enthusiastic and fired up, but unprepared and completely unaware of the nature of the investment terrain. Getting to know this terrain is what the first pillar of investing, its theory, is all about. At its basics, it is an edifice of four important blocks: the relationship between risk and reward, the estimations of risk, the interplay between investors, and the mechanics of portfolio design. And these are the lessons in each of these spheres.

1. No guts, no glory. “Risk and return are inextricably enmeshed,” writes Bernstein. “Do not expect high returns without frightening risks, and if you desire safety, you must accept low returns.” It’s the simplest logic there is: if the stocks of unattractive companies offer lower returns than those of attractive ones, no one buys them – and vice versa. So, anyone promising high returns with low risk is, in the words of Bernstein, “guilty of fraud.” 
2. No measurements, no point. Few things – if any – are more important in investing than being able to estimate long-term returns on major investments. Fortunately, it is relatively easy to estimate the long-term return of a stock market: you just need to add its long-term per-share earnings growth to its dividend yield. In essence, the long-term return of high-grade bonds is the same as the dividend yield, since bond coupon payments do not grow. 
3. The market is smarter than you. There is absolutely no evidence of “stock-picking skill among professional money managers” (their relative performance is nearly random), and there are even fewer proofs that “timing” the market is possible. Consequently, asset allocation – the only factor you can control – should be “the major focus of your investment strategy.” The best and most reliable way of attaining satisfying returns is by indexing.
4. The elements of a perfect portfolio. Predicting what portfolio compositions will perform best in the future is not possible, so there is no magical formula for asset allocation: it will always be “a function of your tolerance for risk, complexity, and tracking error.” If you want to take a prudent course, then your core stock holdings should be the broad market (Wilshire 5000) and a lesser amount of small U.S. and large foreign stocks. As a general rule of thumb, foreign equity should comprise no more than 40% of your stock holdings, while real estate investment trusts less than 15%. Though worthwhile, exposure to small stocks, value stocks, and precious metals stocks is not essential.

Pillar No. 2: The history of investing

The theory is one thing, but recognizing it in practice is a completely other; the latter is almost impossible without a proper understanding of the intricate contrivances of history. And that’s what the second pillar of investing entails. Put simply, without sufficient knowledge of financial history, you are less likely to earn money as an investor and more likely to lose it. The reason is simple: as that adage goes, without history, you’re bound to make the mistakes you were supposed to learn from. 

“Of the four key areas of investment knowledge, the lack of historical knowledge is the one that causes the most damage,” writes Bernstein. Consequently, you cannot simply learn enough about this topic. For now, though, it wouldn’t hurt that you commit to memory these four simple – and yet, all-important – investment lessons, derived straight from the history of the field:

1. The more things change, the more they stay the same. Famously uttered by the French novelist Alphonse Karr in the 19th century, these words should be the subtitle of all historical books, especially the ones dealing with investment. Whatever happens – whether a boom or a bust – it’s probably just a variation of something that has already happened. That’s why knowing more about past episodes of mania or depression guarantees better preparation for the ones bound to occur in the future.
2. Markets are not rational. Markets make “regular trips to the loony bin in both directions,” becoming either “morosely depressed” or “irrationally exuberant.” History teaches us that both of these phases are just that: phases. Just like no mania is eternal, no depression lasts forever as well. Things almost always turn around. So, always be on the lookout.
3. The boom/bust cycle is inherent in the logic of the market. “The market is no more capable of eliminating its extreme behavior than the tiger is of changing its stripes,” writes Bernstein. In other words, many people said that the boom/bust cycle had ended, but the fact it is still here almost guarantees that it will remain to be around for at least as long as capitalism lasts.
4. Use the boom/bust cycle to earn money. Paradoxically, at times of great optimism, future returns are lowest; conversely, when things look bleakest, future returns are highest. But it cannot be any other way because risk and return are just different sides of the same coin. Bernstein advises: “There will be times when new technologies promise to remake our economy and culture and that by getting in on the ground floor, you will profit greatly. When this happens, hold on tight to your wallet. There will also be times when the sky seems to be falling. These are usually good times to buy.”

Finally, don’t forget that no matter how much history you know, dealing with both buoyant and morose markets is difficult. “Sometimes even the best-prepared can fail,” concludes Bernstein. “But if you are unprepared, you are sure to fail.” 

Pillar No. 3: The psychology of investing

The South Sea Company was a British joint-stock company founded in 1711 as a public-private partnership to consolidate and reduce the cost of the national debt. To this end, it had the monopoly to trade with South America granted – even though, due to Spain and Portugal controlling most of the continent, there was no realistic prospect that any trade would ever take place. And, in fact, it never did – but this hardly mattered to the thousands of people speculating with the company’s seemingly invaluable stocks at the time. Believe it or not, Isaac Newton was one of them: when the South Sea bubble eventually burst, he might have lost as much £22,000. “I can calculate the motions of the heavenly bodies,” he is reported to have said on occasion, “but not the madness of people.”

The lesson: more brainpower doesn’t lead to more money. Neither theory nor history is enough to make you a great investor, because your very nature “overflows with behavioral traits that will rob you faster than an unlucky nighttime turn in Central Park.”  In other words, when it comes to investing, you are your own worst enemy. There is no escape from that: evolution has crafted you in such a manner. However, if you want to mitigate the negative effects of your biology on your investment strategies, heed to the following nine pieces of advice:

1. Avoid the thundering herd. Conventional wisdom is usually wrong. If it wasn’t, most people would be rich.
2. Avoid overconfidence. “You are most likely trading with investors who are more knowledgeable, faster, and better equipped than you,” writes Bernstein. “It is ludicrous to imagine that you can win this game by reading a newsletter or using a few simple selection strategies and trading rules.” 
3. Don’t be overly impressed with the past. If history has taught us anything, it is that the past is not certainly a valid indicator of future success. However, for various evolutionary reasons, our brains are programmed to ignore this. You shouldn’t: more likely than not, if an asset has performed poorly over the past five or ten years, it should do quite well in the next decade.
4. Exciting investments are usually a bad deal. If you want to be entertained, then go to the movies or a concert of your favorite band. Seeking entertainment from your investments is not only the wrong thing to do, but something almost guaranteed to strip you from all of your money.
5. Try not to worry too much about short-term losses. Investing should not be a sprint but a marathon. Instead of falling prey to myopic risk aversion – i.e., focusing too much on avoiding temporary losses – diversify your portfolio as much as you can to avoid poor long-term returns.
6. Don’t allow yourself to be tricked by “the great company/great stock illusion.” Good companies are not necessarily good stocks: the market tends to overvalue growth stocks.
7. Beware of forecasts made on the basis of historical patterns. It’s a human urge to see patterns where there are none. In truth, asset class returns are fundamentally random, and historical patterns are not likely to return going forward.
8. Focus on your whole portfolio, not the component parts. Calculate the whole portfolio’s return each year.
9. Don’t go down with the country club syndrome. The country club syndrome is an affliction of the very wealthy. If you are one of them, then you are probably suffering from it. It manifests in the form of your broker bleeding your wealth dry via unnecessary and excessive expenses and unfounded risks. 

Pillar No. 4: The business of investing

For you, it might be a way to get your children to college or buy your family a house sooner rather than later; for many others – especially the brokerage houses, mutual funds, and the press – investing is a business. They differ in their methods, but their ultimate goal is the same: “to transfer as much of your wealth to their ledger books as they can.” So:

1. Avoid brokers – or at least remain very suspicious of their choices should you choose to utilize one. Average investors are far too trusting of their brokers, and, naturally, they use this as leverage to enrich themselves. Also, since they won’t be able to receive any commission until your stocks cash in, brokers are willing to sell much more than they should be.
2. Don’t put too many of your eggs in a mutual fund basket. The dice in the mutual fund industry are loaded against you from the get-go, making it hard to make it out with any meaningful returns. Should you want to take the gamble on mutual funds, though, take some extra time to research the money flow within your prospective fund management companies.
3. Don’t trust the media. 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.” In fact, simply by finishing this summary, you might already know as much as most journalists do; and if you also care to read the book, you'll probably know more about investing than your broker ever will as well.

Final Notes

An engaging read for any would-be investor, “The Four Pillars of Investing” is not only understandable and entertaining, but also a quite thorough, cautious, and thoughtful introduction to the scientific basis of the tricky art of investment. 

True, it might not help you become the next Gordon Gekko, but it will certainly teach you that this is not a valid objective for any normal human being. And that’s more than a great start.

12 Min Tip

Investing is not a destination, but an ongoing journey through four continents: theory, history, psychology, and business. To master it, you don’t need to time the market – but hit the books.