William Bernstein, author of The Four Pillars of Investing, joins the show to talk about the most recent edition of his highly influential work.
Listen now and learn:
- What are the four pillars of investing
- The history of risk and common traits of a bubble
- Potentially attractive segments of the market
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Show Notes
Today, my guest is William Bernstein, a neurologist turned investment advisor. Bill has authored several finance and history books, but he recently published a revised version of The Four Pillars of Investing, a book that was very influential on my own education:
This updated edition of the investing classic provides the foundational knowledge you need to avoid the most common pitfalls and build a portfolio in today’s roller-coaster world of investing.
Here are my notes from our conversation…
From Neurology to Investment Advice (1:30)
I find it fascinating that Bill started his career as a neurologist. As he tells the story, he came to the realization about 45 years ago that his ability to retire comfortably was his own responsibility, so he approached this task the way he feels anyone with rigorous training ought to: he read the peer-reviewed literature, gathered data, and built models.
After going through this process, he realized his output could benefit other small investors like himself, especially since such models weren’t accessible to them at the time. The advent of the internet allowed Bill to share his articles and early books online. This began his transition to a writing and investment advice career, and he has since found a particularly strong passion for writing about history, given its importance in investing.
Bill has routinely called out other physicians for not being good investors. The part that he says is genuinely disappointing is they take such a casual approach to investing.
As he describes it, physicians wouldn’t treat even a minor ailment without consulting peer-reviewed studies. However, when it comes to investing their life savings, they seem to exert minimal effort. To draw a parallel, it’s like a neurosurgeon opting to gather knowledge from articles in USA Today rather than rigorous academic sources.
Much like medicine, investing requires an evidence-based approach.
The Four Pillars of Investing (4:00)
The first pillar is investment theory, which revolves around understanding the connection between risk and return. If one desires safety, one must be content with lower returns; however, higher returns require bearing volatility and substantial losses occasionally.
The second pillar is history, which is of paramount importance. Knowing historical trends and patterns prepares an investor for future challenges and opportunities. History teaches that the highest returns often come from the most tumultuous periods.
The third pillar is the psychology of investing. Our evolutionary instincts, designed for short-term survival, don’t necessarily serve us well in the long-term financial world. Mastering this psychology is crucial.
The fourth pillar is the business of investing, which is understanding the industry’s intricacies and evading potential pitfalls.
When asked if he had to prioritize one of the four pillars as the most crucial, Bill was quick to say that history stands out. If you are well-versed in history, you’re less prone to panic and more likely to remain steadfast when investing inevitably makes you feel uncomfortable.
This resonated with me because I rarely participate in client meetings where I don’t bring up the frequency and magnitude of market losses. It’s a completely normal part of investing. But if you’re not expecting losses, your natural instincts kick in and your reactions often lead to bad decisions.
The Common Traits of Historical Bubbles (7:00)
Financial economists often grapple with the concept of bubbles. The very term makes them uneasy mainly because bubbles resist mathematical modeling. Even Sir Isaac Newton acknowledged this challenge centuries ago.
Bill explains that a bubble typically exhibits four characteristics:
- The speculative subject becomes everyday chatter.
- Individuals leave stable jobs to day trade.
- Skepticism is met with vehement hostility.
- Outrageous predictions emerge about the speculative entity.
Identifying a bubble doesn’t precisely pinpoint when it will burst. Still, understanding these characteristics can offer some insights.
The Biggest Investor Mistakes (11:00)
The allure of bubbles often blinds people to potential mistakes. From Bill’s perspective, the largest error people make is not treating investing as a subject of serious study.
The foremost error, as I’ve mentioned before, is not treating investment as a subject deserving of serious study.
Overconfidence is another pitfall. Investors often overestimate their ability to pick securities, believing their trading opponent is some naive trader when, in reality, it might be someone of Warren Buffett’s caliber. They also believe they can time the market or choose successful money managers.
But perhaps the most hazardous overconfidence is overestimating one’s risk tolerance. Everyone feels they’re a long-term investor until adversity hits.
There are two types of risk that Bill highlights in his book: shallow risk and deep risk.
Shallow risk is the kind most think about, which is volatility, such as short-term market downturns. Typically, these declines reverse over time and you end up profiting in the long run. That’s shallow risk.
Deep risk is more sinister and involves something like losing more than half of your purchasing power for at least a generation. The examples of deep risk that Bill shares are investing in Japanese stocks in late 1989 or the risk with long-term bonds as witnessed in 2022.
Differences in Expected Returns (14:30)
Investor distaste for International stocks is a classic case of recency bias.
Around 15-20 years ago, the question was, “Why not invest more internationally?” Now, with U.S. stocks outperforming, it’s the opposite. But past actions in the financial markets don’t necessarily predict the future. When Bill notices an asset class that has trailed for decades, that’s where he becomes intrigued.
Going forward, valuations might suggest that expected returns for U.S. stocks will be lower than International stocks.
On the topic of projecting future returns, Bill uses the Gordon Growth Model because he feels it has been fairly accurate historically. He does note, however, that the equation is less accurate when market multiples change significantly.
More broadly, Bill and I agree that some stocks have higher expected returns than others. Historically, stocks with a lower price relative to fundamentals (value stocks) have outperformed stocks with a higher price relative to fundamentals (growth stocks). But that hasn’t been the trend for over a decade now.
One possible reason for this trend is that the advantages of value stocks are now common knowledge and hence no longer advantageous. Bernard Baruch once said that “something that everybody knows isn’t worth knowing.”
Alternatively, the market might be overvaluing growth stocks. Empirical data seems to support the latter, suggesting value stocks are not just out of fashion but may offer higher future returns.
At the end of the day, though, portfolio returns are more greatly influenced by asset allocation than security selection.
What Has Changed in the Last 20 Years (23:00)
Since publishing the original edition of The Four Pillars of Investing, Bill’s thinking on behavioral finance has evolved to play a more critical role. Bill now sees investing as a blend of math and human behavior. Relying solely on mathematical models without considering the human element can lead to mistakes.
Similarly, Bill feels that the importance of uninterrupted compounding cannot be understated. We should design portfolios keeping in mind the toughest scenarios, those worst 2% of times.
When it comes to the business of investing, the most profound change has been the drastic reduction in investment expenses and fees.
Resources:
- Bill’s Website
- Bill’s book The Four Pillars of Investing
- EP.107 Are US Stocks Enough For Your Portfolio
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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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