Book Report - Four Pillars of Investing

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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Dec 17, 2003
Losing my whump
After so many "have you read...?"'s, I ordered this through my cruddy little local library and after a 4-5 day wait while it was sent "from the big city", I had a chance to dig through it.

Up front, this is not a book for casual reading nor is much of the content easily consumed. Several areas require reading a sentence or paragraph and then stopping for at least 10-15 seconds, often longer.

Besides complexity, there is density. A lot of points made, many of which I'm still consuming intellectually. Therefore if I get it wrong or forget something crucial, if another reader would chime in, that would be appreciated.

Main points with some supporting data. I've re-ordered the point flow in the book to fit a flow I find easier to manage.

- Actively managed investments fail to produce better results than broad index funds (specifically the wilshire 5000 'total stock market' and less so the s&p 500). Over short periods of time and in specific instances they do, but there is little long term correlation of "beating the market" that isnt explainable by simple chance. In fact, the odds of flipping a coin or (in the authors instance) monkeys throwing darts at a stock sheet, those odds would produce more winning years than are represented by actual efforts by active fund managers. There are two kinds of people: those that know they cant beat the market and those who dont know that they cant beat the market.

- There are no "investment newsletters" or "systems" that have been evaluated that actually beat the market indexes long term, and many substantially trail it.

- There are no "investment experts" or "advisors" that have any better luck investing or allocating funds than the average person with a fairly simple education in investing can manage. They do worse while charging monies that further subvert the investment return. Of all people who became rich through investing, only two (Warren Buffett and Peter Lynch) stand out. Lynch's 'run' was actually not that long and towards the end of it he barely beat the market through 'thrash' trading. Buffets style is rather unique but not unrepresentative of a bucket of good high dividend stocks and distressed businesses, actively fix the problems yourself in some instances, and keep them forever (this latter is my observation). Effectively two out of 4 billion. Start flipping coins and go grab a monkey before the monkey market starts running up the prices on them.

- Virtually everything you read regarding investment strategies and/or 'best bets' is crap. As a convergence of sciences and psychologies, the mass and nearly random (and sometimes inverse) reactions of "the market" as driven by investors is unpredictable and inexplicable.

- Short term determinations of market directions are impossible as they are usually "speculative" in nature. Every investment market ever measured runs a trend from emerging through developing through maturing through developed through (usually) extinction. This trend establishes a risk profile that is speculative, then high, descending. When it bottoms out the measured civilization often ceases to exist or becomes irrelevant. His example that plays well is a guy walking his dog from his home to the park, along a fairly straight line. The dog is on a 20 foot leash and runs randomly about. Watching the guy's direction gives you the market direction. Watching the dog gives you the speculative direction, whatever that is. Investment advisors, active fund management, writers and newsletters try to help you guess which way the dog is going. Not even the dog really knows. Betting on which way the man is going in the long term (broad indexes over 20-30+ year periods) produces a consistent and winning return.

- The value of a single stock at a moment in time is easy to calculate; the value of the overall market even easier. For each investment, type of investment, or class of investment, it returns income. To the extent that it is likely to produce future income, drawing that back into todays dollars, adjusted by the risk of success/failure to continue to exist and produce that income, you end up with a value in risk adjusted, discounted "todays" dollars.

- Future overall returns on investment in the US markets will be lower than historical averages. Bernstein uses "real returns" indicating after tax and after inflation, in order to simplify a lot of comparisons. He estimates real returns of stocks and bonds in the US going forward to being roughly equal, with bonds returning 3% and equities returning 3.5%. He notes that foreign stocks are a little cheaper than US stocks and might do better. REITS, emerging market stocks, small caps, and value stocks also should do better and can be added to a portfolio to improve returns, while concurrently reducing volatility and risk.
- Perversely, value stocks (out of favor companies who have beaten down stock prices and often pay higher dividends) consistently outperform growth companies (great companies doing well) in terms of total real returns over long periods of time, particularly when bought as a broad index. The rationale is that there really arent a lot of "great" companies, and those that are great arent great for long, while "bad" companies infrequently go completely out of business, their stock prices are low due to lowered expectations, and the solid dividend returns help prop up the overall returns. By buying a broader index, you almost eliminate the bankruptcy/failure risk.

- An index consisting of no less than 50% bonds and 50% stocks is a decent blend. More than 50% bonds reduces returns without reducing risk. More than 75% stocks increases risk without substantially increasing returns. To my eye on his charts and graphs, something between 55% and 65% equities is the sweet spot. Unsurprisingly, in several discussions here we came to roughly the same conclusion.

- A portfolio consisting of a broad market index coupled with a bond index of short term bonds is ideal. Bernstein rejects long term bonds (anything over 10 years) as irrelevant because their risk profile hugely overcomes their small margin of extra return. He likes bonds in the 5 year (give or take) area.

- You may further reduce the portfolio risk and volatility while slightly increasing return by adding small caps, value stocks, REITs, foreign and emerging market stocks. Foreign bonds and precious metals in small amounts (~3%) can also be good things.

- The usual stuff around balancing portfolios between taxable and tax deferred/free accounts to manage them as one total portfolio, with tax inefficient items like REITS and TIPS in the IRA/401k account. Make use of tax efficient indexes in the taxable account.

- Not a big fan of high yield corporate bonds, unless the return spread vs treasuries is higher than 5%, and right now its nowhere near that.

I think I got 90% of it here, and its a lot of preaching to the choir among folks here. While many of the points are arguable and all the data historical, to me it made a compelling case. Bogle declared the book good and one of the best investing books. A lot of his investing strategies are similar to Gillette Edmunds from his "Retire Early, Live Well", although Bernsteins returns on various asset classes are lower than Edmunds.

My key takeaways:

Invest your own money, do it with a low cost index or ETF provider. Run away from "investment professionals" with the exception of perhaps shelling out a few hundred bucks to someone like vanguard to help you shuffle your million dollars into the right places. Buy a portfolio consisting of 60% total stock market and 40% short term corporate or short term bond index, perhaps moving some towards intermediate bonds over time to take advantage of rising interest rates while protecting yourself from short term interest rate risk. Add 5-10% reits, 5-10% foreign stocks, 10-20% small cap and large cap value stocks, 3-5% emerging market stocks, 3-5% foreign bonds, and/or 3% precious metals to reduce volatility, increase returns, and give yourself something to do. Then leave it the hell alone, investing is not an entertainment source. Expect lower returns from the US market going forward.
Hi all, I'm New to this board
Got his out of my local oregon paper last sunday with Berstein's recommendations for ideal all-weather portfolio

Short-Term Corporate Bond (VFSTX) 40%
Total Stock Market (VTSMX) 15%
Small Cap Value (VISVX) 10%
S&P Value (VIVAX) 10%
Emerging Markets (VEIEX) 5%
European Stock (VEURX) 5%
Pacific Stock (VPACX) 5%
Real Estate (VGSIX) 5%
Small Cap (NAESX) 5%


I got my 4 Pillars book from under the bed and
re-read page 285. Sure enough, Bernstein
does not advocate "plunging" to arrive at a
ballanced asset allocation. In fact, he recommends
a minimum of 2-3 years using the value averaging
method. Then I dug up my "Bogle on mutual funds"
and re-read page 272. Sure enough, same story.

Even though data show that plunging wins over
DCA or Value Averaging about 60% of the time, it
is the other 40% that worries me. I will gladly give
up the slight extra return in favor of not making a
big bet at the peak of an "X" or "Y" bubble. Spreading
your bet over a 3 year peroid reduces the risk

That is why I have raised the issue on TIPS and
REITS on other posts. I would like to be in those
classes, but as they say, Rome was not built in a
day, all things come to he who waits, etc.


Charlie (aka Chuck-Lyn)
There are still some questions rolling around in my head. Like if you know interest rates are going to head north soon, or if stocks are at all time high P/E's. In the Bernstein example, the dog is at the end of its lead and all the way out in the middle of the street. Its coming back. Its just a matter of time.

The question of when and how fast to get in is a toughie, with the above in mind. I still instinctively want to believe that there are bad times to pile in. Like when the market is overvalued, bonds arent returning crap, and interest rates can only go up. The only unanswered question is, will it be years before things change or 15 minutes into tomorrows trading day?

Once you're in, you're in...but the getting in still bugs me.

I "solved" this in my own tiny mind by getting into a broad asset class divided portfolio but with a main holding that isnt an index and is primarily known for extremely low volatility even through hard times. If stocks dropped, I'd move into indexes and then forget about it.

Other question: the failure of actively managed funds also notes another frequently observed area: good active management guys do good when they only have a limited amount of money to work with, its when the money flows exceed their good ideas that they falter. Or is this just not the case? I guess the short question I'm asking is, could one buy 30-40 stocks and a bond index or a passel of bonds, and then revisit the stocks periodically, drop a few out and add a few in, focusing on value? Maybe just pick the top 10 of the small, mid and large cap value vanguard index holdings?

As far as DCA'ing in, would you go into a money market and buy everything in appropriate parcels, or would you put it all in the short term corp index and dca into the total stock market index, or :confused:

More or less stream of consciousness questions.

The top 10 stocks of an Index are just the 10
with the largest market cap, not the 10 best
buys. If you believe Bernstein, you are not
likely to beat the market over time. I continue
to feel the urge to buy individual stocks as I
once did, but have successfully resisted for
6 years taking it one day at a time. Maybe
we should start a SPA group (Stock Pickers


Charlie (aka Chuck-Lyn)
If you believe Bernstein, you are not likely to beat the market over time.
Yes, if you believe Bernstein.  Of course, he basically just parrots academic research.  So the real question is whether or not you believe the underlying research.

Personally, I'm a believer in market timing because it has saved my butt more than once.   Bernstein argues that there's no single (simple) timing system that works all the time.   I buy that argument, but that doesn't mean that there aren't sometimes signals as big as train wrecks that you should clearly heed.

IMHO, it is simply wrong to read this mainstream MPT stuff and say "I give up; these guys have proven that it doesn't pay to think!"
You guys might find the notion of "incubator bias" quite interesting. Mutual fund companies start numerous funds that aren't available to the public with the fund company's own money. Then, after a while (say 1-2 years), the incubator funds that do well are "released" for the general public to invest in, and the incubator funds that don't do well are liquidated. The fund companies are allowed to count the returns before the incubator funds are turned into public mutual funds in the mutual funds' return. This is what happened with Fidelity's Magellan fund. It started out as a fund that only company insiders put money into. And it started out as a small/mid cap fund. No wonder its performance was so great, as compared to the S&P 500. Then, when it got large, crapola.

Take Dodge&Cox Stock (DODGX) for example. Did it always invest in mid-large value stocks? Or did it invest in small/mid value stocks before its asset base rose so much it had to stick to mid/large value stocks?

The performance of mutual funds after stellar perfomances has been rather dismal. This could be because (1) the market figured out their trick and then it no longer works (2) the hot sector that the fund was mainly invested in turned cold (3) the manager(s) left (4) it was luck, etc. We really don't know why, but we do kind of know that outperformance is rather fleeting.

The really good long-term performing managers have a couple of things in common. (1) Low costs (2) management teams or stable management (3) low turnover (4) low style drift (5) shareholder rights.

Here are some links on mutual fund performance/persistance and such:

One of the best reviews of performanceOn Persistence of Mutual Fund Performance, by Mark Carhart.

Some more articles on MF performance.

Do Past Winners Repeat

Cherry Picking - a personal favorite.

And, in case you feel like buying individual stocks, people like Terrance Odean and behavioralists are here to say that's an even worse idea, especially for men. I think the urge to buy individual stocks is very appealing for many people (again, especially men). I get kind of discouraged when I see numbers like 90% of the U.S. market is dominated by institutional investors (pension managers, MF managers, etc.). I really, really, don't like the odds of trading against those people.

I also think that there are just as many good reasons for interest rates to stay where they are, as for interest rates to rise. Just b/c interest rates have fallen to near historic lows, or just b/c equity prices have risen to near historic highs, is absolutely zero reason to believe that rates will surely rise or stock prices will surely fall. Could they? Of course. Heck, anything could happen. But, in the past, waiting for rates to rise, or waiting for prices to fall has not resulted in good returns. You could be waiting for a very, very long time. We just have to accept that future expected returns will likely be lower at these stock prices and low bond yields. :( If you don't like the expected rewards for investing in either, don't.

- Alec

Assuming you had a lump sum to invest like a
retirement buy-out or an inheritance, I would
invest the bond allocation immediately using
something like the Total Bond Market Index.
Then I would put the rest into Short Term
Corporate with the intent of value averaging
into stock index funds according to your preference
over a 3 year period. Personally, I like the KISS
method so I would value average into the Total
Stock Market Index until reaching my desired
overall asset allocation. Then I would transfer
the whole shooting match into one of the Target
Retirement Funds and go fishing like Cut-Throat.


Charlie (aka Chuck-Lyn)
I also think that there are just as many good reasons for interest rates to stay where they are, as for interest rates to rise.

Could you give a couple of reasons you think rates could stay this low say mid- to long-term?

Just b/c interest rates have fallen to near historic lows, or just b/c equity prices have risen to near historic highs, is absolutely zero reason to believe that rates will surely rise or stock prices will surely fall.

Short-term rates currently have a negative real yield. I'd say that even without looking at the underlying causes, that should seem unsustainable at face value.

And ultimately, stocks should be a measure of the economy, unless you believe that there is absolutely no anchor for stock prices. Even the MPT folks believe that there's an underlying value system, although they hand-wave away bubble behavior as inexplicable anomalies that can't be recognized until after the fact.
Hey Wabmester! Re. "inexplicable anomolies that can't be explained until after the fact", that sounds like a
pretty good definition of life to me :)

John Galt

Could you give a couple of reasons you think rates could stay this low say mid- to long-term?

I really don't have any reasons. Kind of off the wall, but what if something totally unexpected happens, like a huge terrorist attack that sends stock plummeting worldwide. Or something that sends us into another depression. Or something like Japan. Or the FED has gotten so good at controling inflation. Unlikely, yes. Possible, certainly.

We have only really had one period of massively rising rates. There is no reversion to the mean in interest rates or bond prices, as there seems to be in stocks. And, it doesn't really matter what I think or you think. What we, and everyone else thinks is already reflected in today's bond prices and yields. Given that ST yields are so low, and there is a steep yield curve, the market seems to be saying that it thinks that rates will rise. Interestingly enough, if the FED does decide to raise ST rates, that doesn't necessarily mean that intermediate and long rates will rise as well. If the FED move is anticipated (and consequently already priced into current bond prices), longer term rates won't move much at all.

From DFA's site (thanks for the link btw):

...there is no reliable method of forecasting future bond prices, and therefore future interest rates.

Bond prices (and therefore their yields) reflect all available information and follow the classic "random walk" pattern. In this type of market, the best estimate of future bond prices/yields is simply today's price/yield. New information is unpredictable. Summarized, Fama's research showed that the best estimate of future yield curves is simply today's yield curve. It is not a statement that the curve will not change, but a statement that the changes are unpredictable.

Future interest rates changes, inflation, and future yield curves are unpredictable. So, I don't even try.

And ultimately, stocks should be a measure of the economy, unless you believe that there is absolutely no anchor for stock prices. Even the MPT folks believe that there's an underlying value system, although they hand-wave away bubble behavior as inexplicable anomalies that can't be recognized until after the fact.

Yes, stock prices should be the discounted value of future earnings. However, to paraphrase Ben Graham (I think), "In the short term, stock returns are like a voting machine, but in the long term stock returns are like a weighing machine". To say that there has to be some anchor for stock prices is saying that there has to be some anchor for the rate at which future earnings are discounted. If people view earnings as risky, the discount rate rises, and if people view earnings as certain, the discount rate falls. All bubbles are is people becoming more certain of future earnings, which in turn lowers expected returns. Are these earnings in fact more certain to materialize? I don't know.

And it's not the MPT folks that you're talking about, it's the EMH folks. The simple truth is, IMO, stock prices change on future information when it comes out. This is most certainly unpredictable. People like Robert Schiller were screaming bubble back in the early 1990's, yet it didn't burst or become "a bubble" until 2000. People have also screamed bubble when bond yields surpassed stock yields (sometime in the 1950's I think).

Is it possible to kind of tell when stock returns should be lower in the future? Yes, kind of. With any accuracy? Not really. Is it possible to tell when bubbles will burst or how long the bubble will last? Nope.

Life is all about things happening that could not be predicted. History is full of occurences that no one expected. WWI, WWI, Hyper inflation b/w the two, Oil crises, plagues, etc. Predicting future movements in prices of anything is a fools erand, in my opinion. If you, or anyone else feels that expected returns for stocks, bonds, or anything are not worth the risk, just don't take the risks. But acting on any thoughts that prices are certain to move in one direction or the other is not a sound way to invest.

- Alec
Lots to reply to!

Regarding the top 10 stocks in each fund being just the largest 'cap'. True, but in many cases these compose 30-50% of the total holding, or the meat. I guess the question would be, does the "meat" return the largest piece, a middling piece, a small piece, or random percentages of the total return of the index?

Regarding "beating the market", I dont think there is any research that tracks individual peoples portfolios and determines if a 500k-2M portfolio can consistently beat the market. There is plenty of anecdotal evidence showing smart funds investing in small-mid caps can outperform (a la Lynch) and then mire down when the fund inflow overcomes the ability to continue to invest in the same style. I havent looked at TMF portfolios in a million years, do any of theirs show consistent market beating performance?

Regarding research and market timing. Yep, you have to buy the underlying research to buy collective suppositions and determinations based on them. After looking it over, I didnt find any summaries or conclusions based on the data that seemed unreasonable, nor did I find any of the studies to show any particular bias. There is either an awful lot of consistent coincidence in how the financial markets in the US and other countries, both current and historic, or things over long terms DO move in a particular manner.

It IS after all true that when one buys an equity, one is effectively buying the future net income of that company, presumably at a price that factors in its growth expectations (clearly a variable), risk of loss (another variable) and the investment time horizon. For a large basket of companies such as an index, the variables become far less variable. Once that net index "value" is established, anything above or below that indicates short term speculation of higher/lower returns or higher/lower risks. Using off the shelf calculations, that puts the DOW's reasonable value at somewhere between 5000 and 6000. Unless one wants to speculate that the future returns of the DOW or S&P500 will be twice what they have been historically (unlikely) or one wants to propose that post-9/11 risks are twice as high (for which a case can be made, but 2x is a lot), then the prices dont wash.

Regarding interest rates. Unless the economy starts firing on all 8 cylinders, job creation comes back, and all this starts to carry inflation with it, there shouldnt be any reason for interest rates to rise. In many late stage economies, with stabilty and lower risk environments, interest rates tend to drift low and remain there. I do believe the fed will bring rates up about 1-1.5 points higher, simply to give themselves some room to reduce if the economy slugs out, and to balance short term rates with inflation such that there isnt a negative yield proposition in place.

Market timing. I think you can look at something and make a judgement that isnt dumb, but the problem as was pointed out is how long will it stay excessively bad or good, and will you get back in on time. Some data I've seen shows that much of a market up or down happens suddenly, unexpectedly, and in a very short number of days. If you arent there on time, you're screwed. That having been said, looking at Nasdaq 4000 and then 5000 in late 1999/early 2000, it didnt require a lot of intuition to know that was wrong. Had I not gotten out in January of 2000 and avoid getting back in until last year, I wouldnt have been able to ER. Buying in a bit after the market wreck after 9/11 didnt require a lot of brains either; things would recover or the stock market wouldnt be our biggest problem. Aside from a few major "I have to get in/out of this" moments in our investing lives though, the right allocations and staying in appear to be a good idea.

By their very nature, funds like Vanguard's Total
Stock Market Index have average performance.
Typically, such funds are in the upper 50% of all
funds, but rarely get in the top 10%. The beauty
of such funds is that they are "average" year after
year. There are always "hot" fumds that outperform
1 or 2 years then fall back in the pack when the
manager runs out of luck or his style is out of
fashion. The trouble with investing in such funds
is that you identify them with a rear view mirror and
invest too late to reap the reward. I had such an
experience with Vanguard's International fund in
the late 80's just at the time when foreign stocks
fell out of favor. There are pobably many brilliant
small investors who have bested the market over
a long period but I don't know any personally and
certainly don't consider myself among them.

The only fund I know that has outperformed the market
over 20 years is Vanguard's Health Care Fund. I
was lucky to have been in it most of that time but
got out last year thinking their time in the pickle
barrel was way overdue. Big Brother looms large in
the future of the health care industry.


Charlie (aka Chuck-Lyn)
Bogle likes graphs, Bernstein stats/distribution curves to show the relentless power of average over time when including expenses of active management(not even taxes which would be worse). If memory serves - life gets chewy north of ten years and alpha is pretty much gone with the wind at thirty - although never completely.
I look in the mirror and don't even trust self discipline to rebalance asset classes. Hence 70-80% balanced index 'out of the can'.

Not having wetted a fishing line in close to five years - the male instincts are hobby DRIP stocks. Not beating the market is no problem since I've never done it. Poster boy for men and market studies that are now popular.
I look in the mirror and say "Oh Lord, why am I so


Charlie (aka Chuck-Lyn)
Yep, and I look in the mirror and think, "Damn, you look good!" I was on a road trip the other day and almost blurted this out to 2 burly truckers in a rest stop.
Egomania can be a blessing, up to a point :)

John Galt
GRe: Book Report - Four Pillars of Investing

Be careful what you say to two burly truck drivers.

Yep, and I look in the mirror and think, "Damn, you look good!"  . . .

I look in the mirror and say "Oh Lord, why am I so

I look in the mirror and think, "I'll bet I could get all the dust off of that with a used dryer sheet." :)
Clean your mirror with a used dryer sheet and look yourself in the eye - 'Will I have the courage to rebalance asset classes when the market goes bonkers?'.
Regarding "beating the market", I dont think there is any research that tracks individual peoples portfolios and determines if a 500k-2M portfolio can consistently beat the market. There is plenty of anecdotal evidence showing smart funds investing in small-mid caps can outperform (a la Lynch) and then mire down when the fund inflow overcomes the ability to continue to invest in the same style. I havent looked at TMF portfolios in a million years, do any of theirs show consistent market beating performance?
I believe the TMF real money portfolios (Foolish Four, Rule Breaker, etc.) were all liquidated a while back during one of the downsizings. I wasn't sure, but I sure couldn't find any mention of them on the main site. And from my memory they weren't doing well at all after mid-2000; the Rule Breaker in particular held several stocks that tanked. In my eye TMF has long since abandoned their "fool" do-it-yourself look-here's-how attitude and are simply trying to sell stock picks along with the rest of the "wise". I see on the recent ads that Tom Gardner has shed his jester's suit and hat and sports a suit, tie and bald head with references to something working since 1958. I don't even read the site anymore, except for a couple of articles I didn't like linked from Yahoo Finance and then just looking for the real money portfolios today.

Sorry about the offtopic commentary, but back on point I don't think the TMF real money portfolios help make a case for the small guy picking stocks.

I know in mid-2000 I was considering buying individual stocks but kept putting it off. I'm glad I did because Cisco, Nortel and Intel were the kinds of companies in which I was considering buying stock. If somebody can beat the market, it sure ain't me!
Fool still has some info on the site, its of course "you must pay" (I think not). The internet archive did have some info and it was amusing reading.

Both mail rule breaker/maker portfolios were dissolved several years ago while severely underwater. In looking at the numbers though, it appears they were still ahead of the s&p500 in losses when they pulled the plug.

Even more amusing was reading a long page of about 20 separate non mea culpas.

See it here

The web archive, if you havent visited it, can amuse for hours. You can go back in time to see web sites that no longer exist, or what was news years ago.

Even more fun was reading one of the major fools articles from several years ago announcing that the nasdaq was headed to 500, along with extensive math and formulae proving this direction. The nasdaq found a bottom about a week later and has since nearly doubled, rather than halved.
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