Yep it’s time for another book review and giveaway!  Again leave a comment for a chance to win this awesome book.  This time I am reviewing the book “the 4 Pillars of Investing” by William Berstein.  I loved his first book “The Intelligent Asset Allocator.”  It was a bit dry but hardcore on the math and statistics of asset allocation.  But the 4 Pillars of Investing is a much different book and just as good.  If you want to learn more about investing leave a comment below and I will draw it next Wednesday 9/17!  But let’s move on to the book itself and a review about the principles of investing.

What are the 4 pillars of investing?  The book explains that the four pillars are the theory, the history, the psychology, and the business of investing.  Each pillar is examined in depth and then finally constructed to build a winning portfolio.

The book starts by examing the first pillar of investing theory.  The first theory examined is the relationship of risk and return.  Simply put nothing in life is guaranteed, and without being willing to lose money you can’t make money in the stock market.  Expeted returns are just that, expectations.  There are no guarantees that you will make the historical returns.

The second chapter asks the question about how to value stocks.  Dr. Berstein tells us about Irving Fisher a prominent economist of the 20th century.  He helped define the the parameters of measuring the value of stocks.  Stocks are measured by the amount of “income” they produce.  The higher the risk, the higher the potential return, this can affect the “value” of the stock.  Also explained in this chapter is real returns.  Most people say stocks return 10%/year.  Which is true, but 10% is the nominal return with 7% being the actual return and 3% being inflation.  Thus valuation and returns of stocks need to be considered.

The third chapter is my favorite.  It talks about why index funds rule.  It explains that beating the market and buying actively managed funds is next to impossible.  There is no evidence supporting the fact that actively managed mutual funds are able to beat the market and that managers can consistently repeat their performances year after year.  Looking at graphs in the chapter you can see that the top 30 funds never outperform the S&P index.  And of course it does discuss Warren Buffet and Peter Lynch as two people who consistently beat the market.  I might add Bill Gross, a bond manager, to the list as well.  However three people out of thousands over a period of years!  Well you get the gist.

The fourth chapter just explains the perfect portfolio.  It summarizes the first three chapters and helps to integrate the ideas.  For example, it tells us that to build the perfect portfolio we have to determine our risk tolerance and time frame.  Those two decisions will guide us to determing the mixture of bonds and stocks we need in our perfect portfolio.  Of course remember it emphasizes that past performance has no bearing on future returns.  So just because the past returns on a portfolio of 80% stocks/20% bonds returned 10%/annually, you cannot guarantee yourself of the same thing.

The next 2 chapters look at the history of investing.  It examines the stock market when manias occur.  The fifth chapter talks about stock investing being like gambling. It becomes addicting that you are making money so quickly.  But eventually like gambling the house eventually wins and you eventually start to lose money.  He looks at the very first bubbles in the UK, during which people were sold on new innovations and techologies in the 18th and 19th centuries which eventually went bust. 

Of course Dr. Berstein says that we can’t identify busts until after they happen.  I gotta wonder.  Robert Schiller predicted the tech bust of 2001 and the housing bust in 2005.  Overexuberance in both cases he says for stocks and then real estate.  So is it really that difficult to see craziness in people getting caught up in hype? Thinking everything is easy money?  I think a bigger challenge is predicting when to get back in and catch the opportunity.

The next pillar, the psychology of investing, covers the topics of misbehavior and behavior modification.  In misbehavior we examine why people don’t use index fund.  Why people think they can beat the market.  Truth is we all get overconfident.   Also as we gain wealth, the book says we feel pressure to take more risk and be like the “Rich”.  We start to invest with people we think can make us money. 

The next chapter is to examine how to change our behaviors.  The book suggests not becoming overconfident.  Easier said than done.  The book also suggests continuing on a steady investment and not straying from it because some areas of your portfolio have ben successful.  Remember past investment returns are not future predictors again.  Plus the book emphasizes that exciting investments are usually high risk and low returns!

The final pillar is the business of investing.  The book starts out by telling us that brokers are not our buddies.  Brokers are trying to sell us products, not sell us investments.  They are trying to get money in their pockets, not necessarily yours.  The final message of the chapter is “full service” brokerages are not necessary.  And many people get roped into these types of services because they are “friends” with their brokers.  I hate to say it but my parents use Merrill Lynch because they feel unable to do their own investing.  Nevermind they are buying only C shares of every mutual fund and when I try to push just invesitng in mutual funds they snap they are doing great.  Maybe one day they’ll figure out what they are paying for, nothing.

Sadly the 10th chapter examines loaded mutual funds.  These funds unfortunately have higher fees and cost a lot more over the long run.  The amount you pay obviously compounds over time.  So where’s the problem?  Many 401k plans only have loaded funds.  Why?  Because they are getting deals to inexpensively administer the 401k plans for the company, but for the employees it sucks.  I can sympathsize.  DH’s 401k has terrible choices and last year they finally revamped and added some non-loaded funds!  But if the choice is not investing versus investing in a 401k, invest anyway. It’s better than not saving for retirment.

FInally the book say the media plays a role in the business of investing.  It influences what we know and learn about investing.  The media can play both a helpful and hurtful role in your investment strategy.  The chapter reccomends some books to read to understand more about investing.

I’m going to try to hurry through the last part of the book because this is becoming a way too long book review.  It’s a great book but very long and one that should be read.

The last part of the book examines assembling the 4 pillars of investing. The first part asks the question have you saved enough to retire?  It’s suggested you don’t withdraw more than 3-4% of your portfolio, and start saving eary.  One suggestion is that all money needed within 5 years should be kept in cash.  The 13th chapter talks about defining your mix.  It gives examples of people in different savings situations and what might be best for each situation.  It also emphasizes that the portfolio for each situation of course varies based on your risk tolerance and potential time horizon.  Meaning if things go badly will you work longer?

 The final chapters just talks about getting into the habit of saving and investing.  Don’t bother to time to market but rather keep dollar cost averaging.  Plan a long term strategy and stick to it.  Don’t try to beat the market but be happy with your diversification and secure in your knowledge that you are in for the long run.  It also talks about rebalancing in retirement.

So that’s the long wrap up about the book. It is an excellent book and deserves to be read even if you don’t win it.  I suggest checking both this book and the asset allocator out and skimming it at a minimum.  This book helps understand the how and why we invest like we do.

Hope you enjoyed the review.  Again leave a comment to try and win this book.  I will draw next Wednesday 9/17/2008 after I host my festival of frugality.