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Four Pillars of Investing

Jonathan Clements  |  March 31, 2018

SUCCESSFUL INVESTING IS SIMPLE, but it’s rarely easy. Yet millions of investors, both professional and amateur, assume they know what they’re doing. “We live in this mystical state where everybody thinks they can practice finance,” notes William Bernstein, retired neurologist and author of a fistful of acclaimed finance books. “But you shouldn’t practice without understanding the science of finance.”

What science? Bernstein, whom I’ve known for more than two decades, says it has four elements: investment theory, history, psychology, and the business of investing. Those four elements form the core of one of Bernstein’s best books, The Four Pillars of Investing. “The most important of those four pillars is investment theory—and the most important concept is that risk and reward are inextricably linked.”

When are rewards likely to be greatest? When the danger also seems great. “When things look awful, expected returns are high,” Bernstein says. “When everybody is talking about a given stock, the expected return is going to be lousy. Can anybody spell Tesla? Can anybody spell Apple?”

Historically, you could have earned handsome returns simply by owning a diversified portfolio of stocks. Problem is, at this point, that’s widespread knowledge. Result: Bernstein estimates that today’s expected long-run annual return from stocks is maybe 7%, versus 10% historically.

Want to do better? That might be possible if you rebalance into stocks when share prices plunge and perhaps even increase your allocation. “You need to be able to buy when everybody is running around like decapitated poultry,” Bernstein says.

But he also notes that isn’t easy. “We tend to be overconfident not just about our investment abilities, but also about our ability to tolerate risk.”

All this is made harder by Wall Street, with its relentless focus on forecasting short-run returns and picking market-beating investments. That focus fattens Wall Street’s bottom line at the expense of investors. “Financial companies service customers in the same way Baby Face Nelson serviced banks,” Bernstein quips.

What’s the solution? Save diligently, diversify broadly, buy index funds, think long-term—and pay careful attention to risk. “If you’ve won the game, stop playing,” Bernstein argues. “And to me, stop playing is buying a TIPS ladder.”

If you have enough for retirement, you might purchase individual inflation-indexed Treasury bonds, otherwise known as TIPS or Treasury Inflation Protected Securities, with the amount and maturity of each bond geared to your likely spending needs. Why inflation-indexed Treasurys? Arguably, they are the safest investment available, because they’re backed by the federal government and they protect holders from inflation.

“If you look at financial history, the biggest threat by far is hyper-inflation,” says Bernstein. “For short-term protection, the best place is TIPS. For long-term protection, it’s stocks, because they’re a claim on real assets.”

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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