Chief Executive Book Review #27

The Four Pillars of Investing

Lessons For Building a Winning Portfolio

By: William J. Bernstein © 2002 McGraw – Hill (IBSN 0-07-638529-0)

All investors want to buy low and sell high when, in fact, they do just the opposite. As the market goes down, more and more people are selling and when it is rising more and more people are buying. Thus the majority of investors buy high and sell low.

As the price of many products goes down, for example, tomatoes, people buy more tomatoes and when the price goes up they buy fewer. This is the opposite in investments.

To avoid the problem, the author recommends:

Asset Allocation

True asset allocation strategy involves setting a ratio of stock to bonds and keeping that ratio the same over time. Take, for example, a ratio of 75% stocks and 25% bonds. Over time the ratio will get out of balance because of the performance of your individual stocks and bonds.

For example, if your stocks are doing well, the ratio of the value of stocks to bonds may go to 80% and 20% bonds. To bring the ratio back to 75% you will have to sell some of your stocks when they are doing well and sell at a high price. You should re-allocate at least once every year.

Asset allocation gives you the discipline to buy low and sell high. It has been estimated that more than 90% of the variation in investments returns are due to asset allocation and less than 10% to timing and stock selection.

According to the author, “since you cannot successfully time the market or select individual stocks, asset allocation should be the major focus of your investment strategy, because it is the only factor affecting your investment risk and return that you can control.”

The market is smarter than you are.

According to the author, no one person or stock broker is smarter than all people who buy stocks.

“The gross returns obtained by money managers were in the aggregate market returns. Hence, they were the market.”

“The average net return to investors was the market return minus the expense of active stock selection. Since this averaged between 1% to 2% the typical investor received about 1% to 2% less than the market return.”

“There are almost no managers capable of persistently beating the market by the 1% to 2% margin necessary to pay their expenses.”

The author therefore recommends buying broad based stocks and bond index funds that charge a much smaller management fee. (Usually .2%)

Other points made by the author:

1. Almost all of the differences in the performance of money managers can be ascribed to luck and not to skill.
2. Brokers are not your friends and the interests of the mutual fund companies are highly divergent from yours.
3. High previous returns usually indicate low future returns, and low past returns usually mean high future returns.
4. Highest returns are obtained by shouldering prudent risk when things look the bleakest.
5. The pattern of annual stock returns is almost totally random and unpredictable. The return of last year, or the past five years, gives you no hint of next year's return.
6. Unglamorous, unsafe value stocks with poor earnings have higher returns than glamorous growth stocks with good earnings.
7. Only an income producing possession such as a stock, bond, or real estate is a true investment.
8. When you purchase a rapidly appreciating asset with little intrinsic value, you are dependent on someone more foolish than you to take it off your hands at a higher price. This is called the greater fool theory.
9. No one can reliably predict where the market will go tomorrow or next year.
10. At times of great optimism, future returnsare lowest; when things look bleakest, future returns are highest.
11. The 10% annualized returns of the past century is a thing of the past.
12. Going forward, stock and bond returns should be in the 6% range with real returns in the 3.5% and 3.0% range respectively.
13. The highest risk of all is failure to diversify.
14. Currently about half of all pension stock holdings are indexed.
15. Ninety nine percent of what you read and hear from the financial media is advertising cloaked as journalism.
16. Highly talented tennis players should have a strategy to play to win, less talented players should have as a strategy to play to avoid losing. Just get the ball over the net and avoid unforced errors. The best investment strategy for the average investor is to avoid losing.

"Much of the advice you get from lawyers, bankers, accountants, brokers, etc. comes with a motive or desired result. With CEBI, the only motive is to help others succeed." Chet Cromwell President Conversion Tech International