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The Four Pillars of Investing

14 Dec 2008


I read this because I ran into a brick wall in a discussion with someone I work with. I pledged to read it so that I could more articulately defend why I disagreed with the concept of portfolio theory.

I got educated like a red-headed stepchild with this book. I had written off portfolio theory as bullshit, based on a few books that said the right things, but based them on unsupported axioms. This book does it right. There’s a mountain of evidence here that I was wrong. Touché.

Berstein lays it all out, including a detailed list of human cognitive biases (my favorite kind of bias) displayed in investing. I had conquered most of them on my own, but lo and behold, there was I stared down by ‘overconfidence’, in big letters. Combined with the mountain of numbers in this book, I can now look at this and know my odds of choosing investments to beat capitalism itself for the next 30 years. To be concise, they are ‘poor’. Although I did a very good job this year, I must humbly submit to facts, count my blessings that my first year messing with investments was such a critical one, having avoided huge amounts of potential losses, and submit to dullness.

Further, he goes to great pains to stress that most people have a lower tolerance for risk than they think they do. And, considering it, I do–my losses this year have occasionally been significant on an occasional trade, but never significant in terms of my savings. Thinking of how quick I am to take profits lest they be lost, I would not have had the fortitude to withstand a significant loss in a position that I know is correct (although really, I sort of did with gold, because I know that is correct). At any rate, there’s very convincing data here. It’s the same kind of reassurance that lets me get on an airplane.

I still have some disagreements. In particular, there’s a contradiction within these 4 pillars: one is that you can’t predict the markets better than the markets can. And the second is that markets occasionally go bonkers with despair or euphoria. It would seem logical that one could not predict the timing of bubbles, but one could make some intelligent decisions about them–say, by avoiding them entirely until after the bust.

But perhaps this is not such a contradiction. The book goes through great pains to note that 90% of returns are based on the choice of asset allocation, and much less related to the choice of individual securities within those asset classes. So perhaps it’s okay to change the relative percentages of asset classes over time–he even mentions that daredevils might want to increase stock exposure after crashes. I’m not sure, though. Bernstein also recommends rebalancing every 2-5 years, which directly contradicts other, copious advice, which recommends it be done more or less as often it can be done fee and tax efficiently.

The biggest problem, though, are some macroeconomic concerns I still have. The dollar is going to lose a lot of value. That’s not a prediction, it’s a fact. So is the pound. So is the Euro. Realistically, the only currencies that are actually being used to purchase physical goods are the renminbi, the yen, and the won–even Brazil sells its oil for dollars. I’m not convinced portfolio theory will hold up in a reasonable way to the changing of the benchmark used to measure it. I have to think on that some more. I should be able to work it out for myself based on this book.

At any rate, this is probably the first book I would give to anyone saving $5000 for the first time. The bias bits and the history of bubbles are incredibly important.