The Four Pillars of Investing

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🎯 The Book in 3 Sentences

💡 Key Takeaways

Start saving early; save more; have 6-month expenses in the bank.
Spend at max 4% of your portfolio per year.
Own US, foreign, and REITs. You may further break the US into a large market, small market, large value, and small value.
Don’t worry about short-term losses.
Don’t be overconfident and don’t follow the herd.
Beware of forecasts made on the basis of historical patterns.
Even the most aggressive investors should not have more than 80% in stocks.
Bright political and economic outlook → low returns. Dark outlook → high returns.

✏ Top Quotes

With relatively little effort, you can design and assemble an investment portfolio that, because of its wide diversification and minimal expense, will prove superior to most professionally managed accounts.

Great intelligence and good luck are not required. The essential characteristics of the successful investor are the discipline and stamina to “stay the course”.

Investing is not a destination. It is an ongoing journey through its four continents—theory, history, psychology, and business. Bon voyage.

📝 Summary + Notes

Pillar One: The Theory of Investing

Chapter 1. No Guts, No Glory

Expect at least one, and perhaps two, very severe bear markets during your investing career.
Your short-term investing emotions must be recognized and dealt with.
High investment returns → substantial risk. Safe investments → low returns.
The history of the stock and bond markets shows that risk and reward are inextricably intertwined.
Do not expect safety without correspondingly low returns.
The longer a risky asset is held, the less the chance of a loss.

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Chapter 2. Measuring the Beast

The value of a stock is simply the present value of its future income stream.
The best time to invest is when the sky is black with clouds because investors discount future stock income at a high rate. This produces low stock prices, which, in turn, beget high future returns.
The returns of stocks and bonds will be similar over the coming decades. This means that even the most aggressive investors should not have more than 80% of their savings in stocks.

Chapter 3. The Market is Smarter than you are

There is absolutely no evidence that anyone can time the market or pick the correct stocks.
The gross (before expenses) return of the average money manager is the market return.
The expected net (after expenses) return of a money manager is the market return minus expenses.
The most reliable way of obtaining a satisfying return is to index.
Owning a small number of stocks is dangerous. This is a particularly foolish risk to take, since, on average, you are not compensated for it.

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Chapter 4. The Perfect Portfolio

Since you cannot successfully time the market or select individual stocks, asset allocation should be the major focus of your investment strategy, because it is the only factor affecting your investment risk and return that you can control.
Past portfolio performance is only weakly predictive of future portfolio behavior. It is a mistake to design your portfolio on the basis of the past decade or two.
Your exact asset allocation is a function of your tolerance for risk, complexity, and tracking error.
The most important asset allocation decision revolves around the overall split between risky assets (stocks) and riskless assets (short-term bonds, bills, CDs, and money market funds).
The primary diversifying stock assets are foreign equity and REITs (real estate investment trusts). The former should be less than 40% of your stock holdings, the latter less than 15%.
Exposure to small stocks, value stocks, and precious metals stocks is worthwhile, but not essential.

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Pillar Two: The History of Investing

Chapter 5. Tops: A History of Manias

The necessary conditions for a bubble are:

A major technological revolution or shift in financial practice.
Liquidity—i.e., easy credit.
Amnesia for the last bubble. This usually takes a generation.
Abandonment of time-honored methods of security valuation, usually caused by the takeover of the market by inexperienced investors.

Chapter 6. Bottoms: The Agony and the Opportunity

When prices fall dramatically, buy more.
Increase your stock allocation only by very small amounts—say by 5% after a fall of 25% in prices—so as to avoid running out of cash and risking complete demoralization in the event of a 1930s-style bear market

Pillar Three: The Psychology of Investing

Chapters 7 & 8. Misbehavior & Behavioral Therapy

Avoid the thundering herd. If you don’t, you’ll get trampled and dirty. Conventional wisdom is usually wrong.
Avoid overconfidence. You are most likely trading with investors who are more knowledgeable, faster, and better equipped than you. It is ludicrous to imagine that you can win this game by reading a newsletter or using a few simple selection strategies and trading rules.
Don’t be overly impressed with an asset’s performance over the past five or ten years. More likely than not, last decade’s loser will do quite well in the next.
Exciting investments are usually a bad deal. Seeking entertainment from your investments is liable to lead you to a poor house.
Try not to worry too much about short-term losses. Focus instead on avoiding poor long-term returns by diversifying as much as you can.
The market tends to overvalue growth stocks, resulting in low returns. Good companies are not necessarily good stocks.
Beware of forecasts made on the basis of historical patterns. These are usually the results of chance and are not likely to recur.
Focus on your whole portfolio, not the component parts. Calculate the whole portfolio’s return each year.

Pillar Four: The Business of Investing

Media is worthless. Pick carefully the sources from which you learn about investing.
Your broker and your mutual fund are not your friends.

Investment Strategy: Assembling the Four Pillars

Chapter 12. Will You Have Enough?

Manage all of your assets—personal savings, retirement accounts, emergency money, college accounts, and house savings—as one portfolio.
You or your spouse may live a lot longer than you think. You should plan on spending, at maximum, the expected real return of your portfolio each year—i.e., 3% to 4% of its value.
Even this assumption may not be conservative enough. Should you experience a prolonged period of poor returns early in your retirement, you may run out of money before the market can rebound.

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Start saving early.
Save more.
Don’t invest any money in stocks that you will need in less than five years.
Have available at least six months of living expenses in safe investment vehicles in a taxable account.

Chapter 13. Defining Your Mix

The major stock asset classes you should own are domestic, foreign, and REITs. You may further break the domestic portion into the “four corners”: large market, small market, large value, and small value.
Your overall stock/bond allocation is determined by your time horizon, risk tolerance, and tax structure. Since stock and bond returns may be quite similar in the future, you should hold at least 20% in bonds, no matter how risk tolerant you think you are.
The stock and bond asset classes you employ are primarily dictated by the percentage of your portfolio that is tax-sheltered.
The easiest asset structures to design are those where more than half of assets are tax-sheltered.
If you have less than 50% of your assets in sheltered vehicles, you should place value stocks and REITs in them. If you have room left over, you should break your foreign assets into regions (European, Pacific, and emerging markets) to benefit from rebalancing.
The present value of your Social Security and fixed pension payments should be factored into your asset allocation.

Chapter 14. Getting Started, Keeping It Going

Only if you are an experienced investor who already has significant stock exposure should you switch rapidly from your current investment plan to one that is index/asset-class based.
If you are a relatively inexperienced investor or do not have significant stock exposure, you should build it up slowly using a value-averaging approach.
Value averaging is a superb method of building up an equity position over time. This technique combines dollar cost averaging and rebalancing. Asset allocation in retirement is the mirror image of value averaging—you are rebalancing with withdrawals.
Rebalance your sheltered accounts once every few years.
Do not actively rebalance your taxable accounts except with mandatory withdrawals, distributions, and new savings.
Rebalancing provides many benefits, including higher returns and lower risk. But its biggest reward is that it keeps you in “good financial shape” by helping maintain a healthy disdain for conventional financial wisdom.