Issues relating to beginner stock investing are what matter most. There’s an 80/20 rule that applies in learning how to invest successfully — 20 percent of what there is to learn about investing provides 80 percent of the benefits of the educational effort.
Get the fundamentals right, and it is likely that you will be at least a reasonably successful investor, even if you never manage to get fully up to speed on a lot of the finer points of successful investing. Fail to develop a sure grasp of the investing basics, and the effort you direct to learning the fine points will likely not help much.
Chapter Two of the William Bernstein book The Four Pillars of Investing is my favorite chapter of any investing book I have ever read. There are two reasons. One, it addresses the investing basics, the things you must understand if you are to have much hope of becoming a successful long-term buy-and-hold investor. Two, it describes investing realities that few of the best-informed experts understand. It addresses the fundamental questions, but in a fresh way.
Understand the insights put forward in those 30 pages, and you will be a better-informed investor that 80 percent of those who write about investing topics for a living. That’s my take, anyway.
The first shocking claim about beginner stock investing made by William Bernstein in Chapter Two of his book The Four Pillars of Investing is that long-term market timing works.
Most investors of today believe that timing the market is not possible. The historical stock-return data does not support this belief. The historical stock-return data shows that timing does work.
How is it that so many investors have been misled on this most important of investing basics?
There are a number of factors at work. The most important is that many investment advisors fail to point out the critical distinction between short-term market timing (predicting what will happen to stock prices in three months or six months or one year or three years) and long-term market timing (predicting what will happen to stock prices in 20 years or 30 years or 40 years).
Changes in valuations affect the probabilities of various return scenarios. But the laws of probability are generally not able to assert themselves in short periods of time. It’s a counter-intuitive phenomenon, but it is a far easier task to predict what your return on the purchase of shares in an index fund will be in 30 years than it is to say what your return will be in 30 days.
In trying to come to terms with this most important of investing basics, consider what happens when a gambler pulls the lever of a slot machine in a gambling casino. Can the house be sure of being ahead at the end of 10 pulls of the lever? It cannot. Ten pulls does not provide enough time for the laws of probability to assert themselves. But the house can be virtually certain of being ahead at the end of 10,000 pulls.
The same rule applies with investing in index funds. Investors following the Valuation-Informed Indexing approach can do poorly in the short term. But the odds are in their favor in the long term.
Practice Valuation-Informed Indexing, and you put yourself in a position substantially equivalent to the house in a gambling casino. Is it possible that you will end up wishing that you had ignored valuations? It’s possible. Anything is theoretically possible. Is it likely that that is going to happen? It’s not terribly likely, if stocks perform in the future anything at all in the way in which they have always performed in the past.
William Bernstein spills the beans on this most important of investing basics on Page 66 of his book The Four Pillars of Investing. He says: “The worst possible time to invest is when the skies are clearest” because widespread confidence in stocks as an investment class “produces high stock prices, which result in low future returns.”
My sense from other chapters of the Bernstein book, and from comments he has made elsewhere, is that Bernstein believes that investors should make only modest adjustments to their portfolio allocations in response to changes in valuation levels. I do not agree. I believe that Bernstein’s own analysis of the historical stock-return data (discussed below) justifies a strategy of making significant changes in portfolio allocations in response to changes in stock valuation levels.
The second shocking claim about beginner stock investing made by William Bernstein in Chapter Two of his book The Four Pillars of Investing is that the return you will obtain on your stock investment can be known in advance.
“Which would you rather know: the market return for the next six months, or for the next 30 years? I don’t know about you, but I’d much rather know the latter. And, within a reasonable margin of error, you can.” So says William Bernstein.
Yikes! And Double Yikes!
Is William Bernstein really saying that it is possible to know (within a reasonable margin of error) how your stock index-fund shares will have performed three decades down the road on the day you purchase them? Yup.
Very few professional investment advisors know this. I’ve been telling people for years about the shocking claims re the investing basics put forward in Bernstein’s book, and you would be amazed at how many smart people just don’t know that it is possible to know in advance (within a reasonable margin of error) how an index fund will perform over the long term. Few of the investment advice pros understand this today, although it is obviously one of the most important of investing basics.
Think for a moment how much more attractive it makes the stock investing class to be able to know in advance how your stocks will perform in the long term. The major disadvantage of owning stocks is their volatility. The apparent unpredictability of stock prices makes it hard to use them in your investment planning since you need to be able to count on a specified return from your investments to be able to plan to live off your investment earnings in some future day.
William Bernstein is offering you some very reassuring words in his description of the true investing basics. Stock returns are not nearly so unpredictable as you probably now believe them to be.
There’s a catch. Valuation-Informed Indexers obtain predictable long-term stock returns only if they stick to a buy-and-hold strategy through the ups and downs of stock prices. It is essential to adjust your stock allocation to a level that you are sure you can stick with through a bear market if you hope to transform this apparently volatile stock investment class into one providing you with reasonably predictable long-term returns.
The third shocking claim about the beginner stock investing made by William Bernstein in Chapter Two of his book The Four Pillars of Investing is that, were the Dow Industrial Average once again to sink to valuation levels that it has touched twice before, the DOW would drop from its high of close to 12,000 (reached at the top of the recent price bubble) down to DOW 1,400.
This one knocked my socks off the first time I saw it.
I’ve read Chapter Two of The Four Pillars of Investing six times, and it still knocks my socks off to see that DOW 1400 number appearing in cold hard print on Page 53 of this invaluable investing guide.
Please understand that by no stretch is William Bernstein saying that he believes we will ever again see DOW 1,400. By not stretch do I believe that we will. Still, the reality is that that is the number you get (actually, the number would be a bit higher today because of the effects of earnings growth and inflation that have taken place since the book was published in early 2002) if you assume that investors will demand a discount rate of 15 percent, as they did on two separate occasions during the 20th Century. So theoretically it could happen. Or at least it is possible that a drop in stock prices much deeper than most of us now imagine possible could take place.
This is one of the investing basics that I like to bring up with people as often as possible.
Not because I am anti-stock. Stock are my favorite asset class. I love stocks.
I bring it up because I want people to be afraid of stocks.
Preachers often stress the importance of being a God-fearing person. They don’t mean to suggest that you should not love God. They mean that you should be sure to develop a healthy respect for His power. That’s how I feel about stocks. I am a stock-fearing investor.
I think of investing in stocks as being in some ways comparable to riding the waves of the Atlantic Ocean. I love body-surfing. I’ve talked about it enough to cause my two boys to love it. But I often warn them to be careful, especially when the surf is rough. The ocean is fun but, if you don’t respect its power, it can be truly dangerous. Stock investing is fun too, but stock investing too can be terribly dangerous. You need to keep in mind at all times how rough the current can suddenly become.
We are at high valuations today (this article was written in January 2006). The surf is rough. Be careful out there.
Dow 1400.
It’s one of the investing basics I don’t want you to forget.
The fourth shocking claim about beginner stock investing made by William Bernstein in Chapter Two of his book The Four Pillars of Investing is that the safe withdrawal rate methodology used in many media accounts to advise investors how much they can afford to invest in stocks is “highly misleading.”
You have probably read a good number of media accounts that refer in some way to the “safe withdrawal rate” for those who invest heavily in stocks. Most media accounts dealing with the safe withdrawal rate issue are terribly flawed. Most accounts cite studies using an approach to safe withdrawal rate analysis known as “the conventional methodology.” This approach has been discredited in recent years. I hope that the Financial Freedom Community will be taking steps in coming days to bring financial reporters up to speed on the exciting discoveries we made during The Great Safe Withdrawal Rate Debate.
Why are the conventional methodology studies so wildly off the mark? William Bernstein explains on Page 43 of his book The Four Pillars of Investing. “The historical returns we studied in the last chapter are invaluable, but these data can, at times, be misleading,” he says. He returns to the point and makes it in stronger terms on Page 73, in which he uses the phrase “highly misleading” to describe the results of analyses using historical data but making no adjustment for changes in valuation levels.
The conventional methodology studies use historical data but make no adjustments for changes in valuation levels. The authors of these studies get a failing grade in “Investing Basics 101.” Please promise me that you will never take the results of any such study seriously in planning your investing strategies (it is of course fine to make use of the findings re the historical returns sequences set forth in these studies, which, as Bernstein notes, offer “invaluable” insights).
The false safe withdrawal rate claims frequently put forward in media accounts today are likely to cause hundreds of thousands of busted retirements in days to come, presuming that stocks perform in the future somewhat in the way in which they always have in the past. I cannot make use of my “Yikes! Double Yikes!” observation here because it is not right to make light of a reality so painful to contemplate. Please tell as many of your friends as possible about the investing basics that William Bernstein knows about but that most investing writers do not, and save them from suffering busted retirements due to reliance on demonstrably false (but frequently cited) safe withdrawal rate claims.
The fifth shocking claim about beginner stock investing made by William Bernstein in Chapter Two of his book The Four Pillars of Investing is that the safe withdrawal rate for high-stock-allocation portfolios dropped to 2 percent at the top of the recent price bubble.
Bernstein not only tells us that the conventional safe-withdrawal-rate numbers are shockingly off the mark from those you get by making an analytically valid examination of the historical stock-return data. He tells us what the true safe withdrawal rate was at the top of the recent bubble. It was 2 percent (or a bit less than that), not the 4 percent you often hear in media accounts written by reporters who are not aware of the important recent advances in our understanding of the safe withdrawal rate concept. Bernstein explains his calculation on Page 234 of his book (that’s from Chapter 12), but he refers the reader back to Chapter Two for his explanation of why the 4 percent number is so wildly off the mark.
Bernstein’s finding that the safe withdrawal rate for a high-stock-allocation was 2 percent at the top of the bubble sounds right to me, going on what I know about the results generated by other analytically valid safe withdrawal rate studies. However, it seems to me to point to an inconsistency in Bernstein’s views on the timing question. As noted above, Bernstein appears to favor only modest efforts at long-term timing. Yet his own safe withdrawal rate analysis shows that changes in valuations have a dramatic effect on the value proposition offered by stocks.
The sixth shocking claim about beginner stock investing made by William Bernstein in Chapter Two of his book The Four Pillars of Investing is that middle-class investors have a history of investing too heavily in stocks during bull markets.
We have been discussing the investing basics. I have described five claims about the investing basics put forward by William Bernstein that I think can fairly be described as shocking. There is a question that you should be wanting to ask me after having read this far into this article. You should be wanting to know: “How the heck could so many smart people get so far off the track in their understanding of the investing basics?”
Bernstein answers that one on Page 57 of his book. Our guide to the investing basics explains that: “Once every 30 years or so, investors tire of valuing stocks by these old-fashioned techniques and engage in orgies of unthinking speculation. Invariably, Fisher and Graham’s lesson — not to overpay for stocks — is relearned in excruciating slow motion in the years following the inevitable market crash.”
He is talking about us.
We are the ones engaging in the orgy of unthinking speculation. We are the ones arguing that the investing basics have been overturned and that we have entered a new world where changes in valuations no longer will have an effect on the safe withdrawal rate. We are the ones trying to persuade ourselves that it is possible for stocks to go up, up, up, and then never again need to come down, down, down.
It doesn’t work like that.
Bernstein is right. The fundamental rules apply. The investing basics hold, as time goes by.
Investing is a highly emotional endeavor, It always has been thus and it always will be thus. Just wait until we are all hearing media reports that get the safe withdrawal rate as wrong on the down side as today’s bull-market-influenced reports get it wrong on the up side. That’s when stocks will be an amazing long-term buy again.
The seventh shocking claim about beginner stock investing made by William Bernstein in Chapter Two of his book The Four Pillars of Investing is that valuations can be assessed with a reasonable level of accuracy through use of the Gordon Equation.
There are some who acknowledge that valuations are important, but who argue that there are no tools available to those wanting to practice Valuation-Informed Indexing to make use of to determine when valuations are too high. It’s not so, according to Bernstein.
”The Gordon Equation is as close to being a physical law, like gravity or planetary motion. as we will ever encounter in finance,” he says on Page 54. He concludes Chapter Two by noting that “the ability to estimate future stock and bond returns is perhaps the most critical of investment skills” and that “we’ve reviewed a theoretical model that allows us to compute the ‘expected returns’ of the major asset classes on an objective, mathematical basis.”
It is possible to determine valuation levels with a reasonable degree of accuracy. That’s another of the investing basics that many of the pros of today don’t know about, but that careful readers of “The Four Pillars of Investing” have taken to heart.
The eighth shocking claim about the beginner stock investing made by William Bernstein in Chapter Two of his book The Four Pillars of Investing is that the intrinsic value of a stock investment cannot be assessed with reasonable accuracy.
Bernstein says in his book that it is not possible to know the “intrinsic value’ of a stock purchase. I think he is wrong about that and that his own statements on how to determine the long-term value of a stock index-fund purchase show why. I included this claim of Bernstein’s in this article to put you on notice that not all readers of The Four Pillars of Investing have come to the same conclusions about the statements he makes in Chapter Two as I have.
Even Bernstein does not appear to have come to the same conclusions about his own statements as I have!
My only explanation of this exceedingly odd phenomenon is that some of the claims re the investing basics put forward in Chapter Two really are shocking. They are very much at odds with the conventional investing wisdom of today, a set of beliefs that I refer to as the Stocks-for-the-Long-Run Investing Paradigm. It may take some time for people (including Bernstein himself!) to come to accept the implications that follow from a searching consideration of the claims re the investing basics put forward by Bernstein in Chapter Two of his book.
I describe this particular claim as “shocking” not because it is contrary to the conventional wisdom of today, but because it appears to me to be contrary to the other shocking claims re the investing basics made in Chapter Two of the book. It is a claim that is shocking because of the context in which it appears.
Check out William Bernstein’s web site to watch the development of his thinking on the investing basics in days to come.
The ninth shocking claim about beginner stock investing made by William Bernstein in Chapter Two of his book The Four Pillars of Investing is that the valuation level that applies at the time a stock purchase is made affects the long-term return earned on that investment as a matter of “mathematical certainty.”
Bernstein doesn’t just say that valuations affect long-term returns. He says they do so as a matter of “mathematical certainty.”
That’s an awfully strong claim for a writer as careful as Bernstein to put into print. Is he right to state things so strongly?
Yup.
Changes in valuation levels always affect the long-term return provided by an investment asset. There can be no exceptions to this rule.
Say that three virtually identical houses in the same neighborhood go up for sale on the same day. The fair market value of these houses is $100,000. The buyer of the first house pays $50,000. The buyer of the second house pays $100,000. The buyer of the third pays $200,000.
Can we say as a matter of “mathematical certainty” which of the three buyers will be ahead at the end of 30 years? We can. The buyer who paid $50,000 is going to be ahead.
We don’t know how much the prices of the houses will change in 30 years or in what direction. But we know for certain that the buyer who paid $50,000 will have done better than the other two. There is no imaginable scenario in which a buyer who pays less than fair value for an asset does not do better than a buyer who pays fair value or more than fair value.
It works that way with stocks too. Those who follow a Valuation-Informed Indexing approach put themselves in a position to obtain better returns for their investing dollars over the long term. There are many uncertainties in investing. But valuations always matter.
That’s so as a matter of “mathematical uncertainty.” That’s one of the investing basics that many of today’s investing pros don’t understand. Thanks to William Bernstein, you now do.