Second Glance: The Four Pillars of Investing

This comprehensive work by Dr William Bernstein translates the science of investing into practical action including helping you:

1. stay true to what is proven and be sceptical of what isn’t.
2. understand the history of markets and of booms and busts.
3. understand behavioural traits that work against you.
4. how to keep more of what is yours.

Some in the industry would not want you to read this work as Bernstein offers controversial views about the commercial intentions of brokers, fund managers, advisors and the media. He comes from the efficient market school of thinking, which not all subscribe to. Regardless, this book provides a rock solid foundation in personal investment strategy and includes quite a bit of content from Bernstein's highly regarded earlier book The Intelligent Asset Allocator.

Investment Theory
Firstly, Bernstein notes that investors are rewarded for exposure to risk. They are not rewarded for the risk of trying to pick the next best fund manager, as most of their performance difference comes from luck not skill.

History of Markets
Bernstein adds that from time to time, markets and investors “go barking mad '¦ from psychotically euphoric to toxically depressed” '¦ and such madness is only visible in retrospect.

Psychology of investing
Human behaviour, he says, plays a key role. Behavioural science teaches us about many human behaviours that lead us to become overconfident and make irrational decisions.

Business of investment
Fourthly, Bernstein notes: “Brokers are not your friends” and the “interests of fund companies are highly divergent to yours”.

On investment theory, Bernstein says too many focus on the wrong things.

Are the markets rational?

Bernstein says: “My answer is that it all depends on your time horizon. Turn on CNBC at 9:31AM any weekday morning and you're faced with a lunatic asylum described by the Three Stooges.”

But stand back a bit and you’ll start to see trends and regular occurrences. When the market is viewed over decades, its “behaviour is predictable”.

Random walk

Bernstein likens the market “to an excitable dog on a very long leash in New York City, darting randomly in every direction.

“The owner is walking from Columbus Circle through Central Park to the Met. At any one moment, there is no predicting which way the pooch will lurch.

“But in the long run, you know he’s heading north-east at an average speed of 3mph. What is astonishing is that almost all of the market players, big and small, seem to have their eye on the dog not the owner.”

Trends and regular occurrences

Investing is about earning a return for shouldering risk. Return on capital, adjusted for risk, is the same (Modigliani, Miller – Nobel prize winners). Bernstein says the longer a risky asset is held, the lower the chance of loss. When political and economic outlook is the brightest, returns are the lowest, and when things look the darkest the returns are the highest.

Real (inflation adjusted) returns of stocks have been about 6%, bonds 1% and cash nil. Over the long term, small companies provide a greater return than large, poorly run unglamourous companies and return more than glamourous, better run companies. Risk is higher, therefore prices are lower, and potential returns are greater, especially if you hold a diverse portfolio of those types of equities.

“Good companies are generally bad stocks, and bad companies are generally good stocks,” says Bernstein. Over the long run, corporate earnings growth produces stock price increases. Stocks generally mean revert (i.e. good return periods can be followed by poor periods). Following several decades of out-performance, future returns of stocks and bonds could be lower, eg. 3.5% real return, not the 6-7% historical return.

Active managers don’t add value

As early as 1930s, research (Alfred Cowles) appeared to suggest most active fund managers don’t beat the market, especially after fees. Bernstein says forecasters, strategists, economists consensus opinion “underperform the market three-quarters of the time”.

The only evidence of performance consistency with money managers is that the bottom 20% tend to stay there far more often than explained by chance. Even today, institutional pension plans allocate a significant proportion of funds to active managers in spite of evidence showing most would be better off indexing.

“Fund managers know only two things,” says Bernstein: “One, like everybody else, they don’t know where the market is headed, and two, their livelihood depends on appearing to know.”

Collective judgement of all experts of what a stock or bond is worth is its market price. Your best option is to own the whole market via a low-fee and low-tax index fund. Yes, you will give up the chance of exceptional returns, but also exceptionally poor returns, and you will enjoy lower fees and taxes. You cannot adequately diversify over the long term holding a small basket of direct shares.

When markets go berserk (history of investing)

“From time to time, markets can become either irrationally exuberant or morosely depressed,” says Bernstein. In good times, remember that things can go to hell in a hand basket. During good times, future returns can be the lowest. In bad times, things almost always turn around. During bad times, future returns can be the highest (E.g. bad times: from 1973 to 1979, the Dow Jones Industrial Average moved from 1000 to 875 (today 10,000).

On how to handle the panic, Bernstein says Maintain a firm asset allocation. “Do not underestimate the amount of courage it takes. Rebalance: sell what has gone up, buy what has gone down.”

Behavioural investing

The central premise is that we are not programmed to be good investors. The intuition that helped us survive sabre tooth tigers, doesn’t always help us be good investors.

Bernstein says, beware of:

• Fashion or following the herd: the most topical investment may be overpriced.
• Overconfidence: “the average investor believes he will beat the market by 2%”.
• Compartmentalising success and failure: Attribute luck to skill, forget failures.
• Recency: for example, focusing on past performance despite evidence equities mean revert.
• Entertainment: like gambling, people gravitate to low probability, high returns.
• Focusing on short term: “we feel more pain losing 30% suddenly, than the more damaging possibility of failing to meet our long-term goals”.
• Searching for patterns: “world’s wealthiest people would be librarians if patterns repeated”.
• Becoming a “whale” (the cash cows of the investment industry who are bled with commissions associated with exotic products sold to wealthy investors).

“The biggest obstacle to your investment success is staring at you from your mirror,” says Bernstein.

On the business of investing

Bernstein is not a friend to all in the financial industry. He believes:

• Brokers are not your friends, they are poorly trained stock sellers whose performance is never benchmarked, and are conflicted by service to their institutional clients. “Just bypass them”.
• Investors have to tread carefully employing fund managers whose main goal is to accumulate assets, not deliver cost-effective investment performance.
• Funds management is at least more transparent than stockbroking. “Ninety nine per cent of what you read and hear from the financial media is advertising cloaked as journalism”.
• Money managers and financial press “desperately need each other” (this is not unique: consider fashion, automobiles, travel reporting).

The market is your best advisor (you are hiring the aggregate judgement of the experts). The only real guidance you need is on your overall asset allocation and self-discipline )and we add investment structuring in the complex Australian environment).

Dr Doug Turek, the managing director of Professional Wealth Pty Ltd, is a financial adviser, wealth researcher and industry consultant.