Saturday, February 20, 2010

Book Report: The Four Pillars of Investing

I just finished an excellent book on investing: The Four Pillars of Investing, by William J. Bernstein. His style is very engaging, especially for a subject that is inherently technical. There are a lot of ideas and I especially like learning about the theory of investing (pillar 1). Here's a brief synopsis of the pillars:

Pillar 1: The Theory of Investing

Risk and reward are inexorably linked no matter what the asset class (stocks, bonds, etc.) and it is relatively easy to determine long term expected returns. Results touted by money managers and mutual funds are almost all due to luck, not to skill. Portfolio theory and diversification are the names of the game.

Pillar 2: The History of Investing

Markets can become irrational with both optimism and pessimism. As recent events have shown, this boom/bust cycle has not ended (nor will it). And the counter intuitive point "is that at times of great optimism, future returns are the lowest; when things look bleakest, future returns are highest." Just like risk and return predict.

Pillar 3: The Psychology of Investing

The biggest obstacle to success in investing is you the investor, and our nature of of looking for the next Microsoft or lottery ticket. This leads to high trading churn (enriching traders rather than ourselves) and making poor buy/sell decisions.

Pillar 4: The Business of Investing

The incentives of most brokers and mutual fund companies are not aligned with the interests of the investor. They exist to make money - your money.

Investment Strategy: Assembling the Four Pillars

Most small investors are deficient in the areas of theory and psychology. As defined benefit plans (pensions) are being replaced by contribution plans (401k) it is increasingly important for 'average investors' to educate themselves on investing.

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