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Four Pillars, part 1

“The aim of retirement saving and investing is not to get rich, but rather to minimize the risk of dying poor.” Saving and investing for retirement is one of the most important things that we do. And there are no second chances. Yet surprisingly few—even in the finance industry!—take the time to understand the basics.

Bill Bernstein’s Four Pillars of Investing tells you what you need to know. He published the second edition this year. He, more than any other, has influenced how I think about personal investing.

This post is about Bernstein’s first pillar, the Theory of Investing. A few key principles:

1) “Risk and return are joined at the hip.” If you want to earn high returns, you’ll have to take large risks. Maybe those risks will materialize, maybe they won’t. Some believe that the reverse is true (it isn’t) – to earn higher returns, just take more risk. But if risk-taking were always rewarded, it wouldn’t be risky!

2) “Risk is not just about how much you lose, but also when you lose it.” Risk is “bad returns in bad times.” For example, corporate bonds may offer higher returns in good times but, in a financial crisis, they are likely to lose value. Owning a lot of employer stock is another example – this is usually okay. But if the company struggles, you could lose your job and your retirement savings at the same time.

3) Equities offer higher expected returns. But they don’t have to deliver them. Realized returns (what you actually get) can be far higher or far lower (they are risky after all, as I discuss more in Part 2).

4) Markets are efficient. This doesn’t mean they are perfect or right. But it does mean they are very hard to beat consistently. Even for talented and hardworking professional investors. “Of the tens of thousands of money managers…. only the tiniest handful have shown indisputable evidence of skill.”

5) Although global diversification doesn’t help much over short periods (since markets tend to move together in the short term), diversification shines over longer horizons. And it is longer horizons (a decade or more) that investors should be focused on (not the last one to three years).

6) Investing can only get you so far; you must also save enough. The goal should be to accumulate at least 20-25 years of residual living expenses (expenses after social security or pension payouts).

7) Investors should be especially wary of deep risks. These are rare but can result in long-lasting and permanent losses if they occur. The most likely deep risk for investors in developed markets is a long period of high inflation. The other deep risks are less likely but include confiscation and devastation.

What about asset allocation?

“A suboptimal allocation that you can execute is better than an optimal one you can’t.” That may mean holding a chunk of short-term U.S. Treasuries – if they help you stay the course (and maybe even buy more equities) when stock markets pull back 40% or 50%, they could end up your highest returning asset.

“[It is] best to keep your stocks and bonds in entirely separate mental accounts and to own only the safest fixed-income assets.” There are risky assets and there are risk-free assets. For fixed income, Bernstein recommends only those with a government guarantee (e.g., U.S. Treasuries) and shorter durations.

Human capital (future earnings) needs to be considered as well as financial capital. And the relationship between the two is critical. For example, an investment banker’s income (and maybe whether they have a job at all) depends on the performance of the stock market. A doctor with earnings that don’t vary with the stock market may be able to take more risk with their retirement portfolio.


Related posts: Part 2 (on financial history), Part 3 (on psychology), Part 4 (on the investing industry), Part 5 (closing thoughts).

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