Preview from William Bernstein's
Now Available from McGraw-Hill INTRODUCTION
I didn’t start out my professional life in finance; my original training was in the sciences, and later, in medicine. Practicing physicians, among whom I still count myself, have a richly deserved reputation as miserable investors. The conventional explanations for this are that our practices are so demanding that we don’t have the time to do it properly, or that we’re too egotistical to take professional advice.
In fact, neither is the case. Learning how to invest properly doesn’t take an inordinate effort, and I don’t find most of my colleagues overly egotistical. Medical practice is a profoundly humbling experience to anyone with a breath of intellectual honesty; the best doctors soon come to the conclusion that the more they see, the less they know. The same, not surprisingly, is often true in finance.
The real reason that physicians are rotten investors is that it never occurs to them that finance is a science, just like medicine. Day-to-day medical practice is profoundly scientific, informed by a vast amount of underlying research; nowadays almost no drug or surgical treatment is adopted without rigorous trials comparing it to other accepted treatments or placebo. In short, most physicians would not commence a treatment for so much as a cold without a good deal of experimental and statistical evidence in back of it.
The most important work is reported in prestigious peer-reviewed periodicals such as The New England Journal of Medicine and Lancet. The key term here is "peer reviewed." Nothing appears in these high-level periodicals without being vetted first by the top experts in the field—requests for multiple extensive revisions are routine. Your own physician hopefully reads these top-echelon publications on a regular basis for data relevant to his practice.
Unfortunately, when doctors put on their investing hats, they completely forget their scientific training. There is, in fact, a rich and informative scientific literature about what works and what doesn’t in finance; it is routinely ignored. Instead of depending on the Journal of Finance (the investing equivalent of the New England Journal of Medicine), they get their advice from USA Today or worse, from their stock broker.
Of course, I’m only picking on my colleagues for fun—in this regard doctors are no different from lawyers, retail clerks, or anyone else. In fact, what’s truly scandalous is that even most finance professionals are unaware of the scientific basis of investing. The scientific basis of investing consists of four broad areas, the Four Pillars of this book.
Pillar One: Theory
The most fundamental characteristic of any investment is that its return and risk go hand in hand. As all too many have learned in the past few years, a market that doubles rapidly is just as likely to halve rapidly, and a stock that appreciates 900 percent is just as likely to fall 90 percent. Or that when a broker calls suggesting that the price of a particular stock will rocket, what he’s really telling you is that he is not overly impressed with your intelligence. Otherwise, you would realize that if he actually knew that the price was going to increase, he would not tell it to you or even his own mother. Instead, he would quit his job, borrow to the hilt, purchase as much of the stock as he could, and then go to the beach.
The first, and most important, part of the book will survey the awesome body of theory and data relevant to everyday investing. Don’t be daunted by this; my primary mission is to present this body of theory and data in terms that you will find both understandable and entertaining. We’ll find out that:
Whether you invest in stocks, bonds, or for that matter real estate or any other kind of capital asset, you are rewarded mainly for your exposure to only one thing—risk. We’ll learn just how to measure that risk and explore the interplay of risk and investment return.
Over the long haul, it is not that hard to measure the probable return of different kinds of stocks and bonds; a bad job of this is usually managed by even well-respected experts.
Almost all the differences in the performances of money managers can be ascribed to luck and not to skill; you are most certainly not rewarded for trying to pick the best-performing stocks, mutual funds, stock brokers, or hedge funds.
The biggest risk of all is failure to diversify properly.
It’s the behavior of your portfolio as a whole, and not the assets in it, that matters most. We’ll also learn that a portfolio can behave in ways radically different than its component parts, and that this can be used to your advantage. The science of mixing different asset classes into an effective blend is called "portfolio theory" and occupies center court in the grand tournament of investing.
Pillar Two: History
It is a fact that, from time to time, the markets and investing public go barking mad. Of course, the madness is obvious only in retrospect. But a study of previous manias and crashes will give you at least a fighting chance of recognizing when asset prices have become absurdly expensive and risky and when they have become too depressed and cheap to pass up. The simplest way of separating the managers who would be suckered into the dot-com mania from those who would not, would have been to administer a brief quiz on the 1929 crash.
Finance, unfortunately, is not a "hard science." It is instead a social science. The difference is this: a bridge, electrical circuit, or an aircraft should always respond in exactly the same way to a given set of circumstances. What separates the "hard" sciences of physics, engineering, electronics, or aeronautics from the "social" sciences is that in finance (or sociology, politics, and education) apparently similar systems will behave very differently over time.
Put a different way, a physician, physicist, or chemist who is unaware of their discipline's history does not suffer greatly from the lack thereof; the investor who is unaware of financial history is irretrievably handicapped. For this reason, an understanding of financial history provides an additional dimension of expertise. In this section, we'll study the history of finance through the widest possible lens by examining:
Just what the centuries of recorded financial history tell us about the short-term and long-term behavior of various financial assets.
How, from time to time, the investing public becomes almost psychotically euphoric, and at other times, toxically depressed.
- How modern investment technology has exposed investors to new risks.
Pillar Three: Psychology
Most of what we fondly call "human nature" becomes a deadly quicksand of maladaptive behavior when allowed to roam free in the investment arena. A small example: people tend to be attracted to financial choices that carry low probabilities of high payoffs. In spite of the fact that the average payoff of a lottery ticket is only 50 cents on the dollar, millions "invest" in it. While this is a relatively minor foible for most, it becomes far more menacing as an investment strategy. One of the quickest ways to the poorhouse is to make finding the next Microsoft your primary investing goal.
Only recently have academics and practitioners begun the serious study of how the individual investor's state of mind affects his or her decision making; we'll survey the fascinating area of "behavioral finance." You’ll learn how to avoid the most common behavioral mistakes and to confront your own dysfunctional investment behavior. You will find out, for example, that most investors:
- Tend to become grossly overconfident.
- Systematically pay too much for certain classes of stocks.
- Trade too much, at great cost.
- Regularly make irrational buy and sell decisions.
Pillar Four: Business
Investors tend to be almost touchingly naïve about stock brokers and mutual fund companies: brokers are not your friends, and the interests of the fund companies are highly divergent from yours. You are in fact locked in a financial life-and-death struggle with the investment industry; losing that battle puts you at increased risk of running short of assets far sooner than you'd like. The more you know about the industry’s priorities and how it operates, the more likely it is that you will be able to thwart it.
The brokerage and mutual fund businesses form a financial colossus that bestrides modern financial, and increasingly, social, and political life. (If you doubt this, just turn on your television and time the interval between advertisements for financial services.) In the book’s penultimate section, then, we’ll examine how the modern financial services industry is designed solely to serve itself, and how it:
Exists almost entirely for one purpose: the extraction of fees and commissions from the investing public, and that in fact, we are all locked in a constant zero-sum battle with this behemoth.
Operates at a level of educational, moral, and ethical imperatives that would be inconceivable in any other profession. A small example: by law, bankers, lawyers, and accountants all have a fiduciary responsibility towards their clients. Not so stock brokers.
Only after you've mastered these four areas can you formulate an overall investment strategy. Only after you’ve formulated a program that focuses on asset classes and the behavior of asset-class mixtures will you have any chance for overall success. A deficiency in any of the Four Pillars will torpedo this program with brutal dispatch.
Here are a couple of examples of how a failure to master the Four Pillars can bring grief to even the most sophisticated investors:
Big time players: The principals of Long Term Capital Management, the firm that in 1998 almost single handedly crippled the world financial system with their highly leveraged speculation, had no trouble with Pillar One—investment theory—as they were in many cases its Nobel-Prize-winning inventors. Their appreciation of Pillars Three and Four—psychology and the investment business—was also top drawer. Unfortunately, despite their corporate name, none of them had a working knowledge of Pillar Two—the long-term history of the capital markets. Focusing narrowly on only several years of financial data, they forgot the fact that occasionally, markets come completely off the rails, often in ways never before seen. A working knowledge of western financial history would have warned them that their investment strategy carried with it the near-certainty of self-destruction.
Small investors: On the other hand, the average investor most often comes to grief because of deficiencies in Pillars One and Three—theory and psychology. They usually fail to understand the everyday working relationship between risk and reward and routinely fail to stay the course when things get rough.
The above two examples are caricatures: the failure modes of individual investors are as varied as their personalities. In this tome, I want to provide you with these invaluable tools—the Four Pillars—to avoid the kinds of failures I've listed above. I also want to expose you to the wondrous clockwork and history of the capital markets, which are deserving of attention in their own right.
Arguably the most substantive domestic issue facing the republic is the fate of Social Security, with privatization the most frequently mentioned option. For the first time in history, a familiarity with the behavior of the financial markets has become a prerequisite for competent citizenship, apart from its obvious pecuniary value.
Building on the Four Pillars
In the book’s last section, we’ll show how mastery of the Four Pillars can result in a coherent strategy that will enable you to accomplish investing’s primary aims: achieving and maintaining financial independence and sleeping well at night. The essential mechanics of operating an efficient investment portfolio will be covered:
- Calculating how much you’ll need to save and when you can retire.
- The process of allocating your assets among various classes of stocks and bonds.
- Which mutual funds and securities to employ.
- How to get off of dead center and build your portfolio.
- How to maintain and adjust your portfolio over the long haul.
Although I hope that I’ve conveyed my enthusiasm for financial theory, history, psychology, and strategy, I’ll freely admit that I’ve been dealt the short straw in the subject scintillation department—this book, after all, is not a bodice-ripper or a spy thriller. There is no arguing with the fact that some areas of finance can be damnably opaque, even to cognoscenti. This book, then, should be consumed in small bites, perhaps ten or twenty pages at a time, preferably first thing in the morning.
Lastly, while I’ve tried to make this work as comprehensive and readable as possible, no one book can claim to be an all-encompassing source of investment instruction. At best, what is offered here is a study guide—a financial tour d’horizon, if you will. Personal finance, like most important aspects of life, is a never-ending quest. The competent investor never stops learning. As such, the most valuable section is the last part of Chapter Eleven, which will guide you through the subsequent legs of the eternal journey towards financial self-sufficiency.