The Four Pillars of Investing

1. Risk and return are inseparable: Higher rewards require higher risks

Do not expect high returns without frightening risks, and if you desire safety, you must accept low returns.

Risk-return tradeoff. The fundamental principle of investing is that you cannot achieve high returns without accepting high risks. This applies across all asset classes and investment strategies. Stocks, particularly those of small or struggling companies, offer higher potential returns but come with greater volatility and risk of loss. Bonds, especially government bonds, provide more stability but lower long-term returns.

Historical evidence. Looking at market history, periods of high returns are often followed by significant drawdowns. For example, the tech boom of the late 1990s led to the dot-com crash in the early 2000s. Similarly, seemingly "safe" investments can become risky in certain economic conditions, as seen with bonds during periods of high inflation.

Implications for investors. Understanding this principle helps investors set realistic expectations and build portfolios aligned with their risk tolerance. It also highlights the importance of diversification to balance risk and return across different asset classes.

2. The market is smarter than you: Indexing beats active management

The market is brutally efficient and can be thought of as being smarter than even its wisest individual participants.

Efficient Market Hypothesis. This theory suggests that stock prices reflect all available information, making it extremely difficult for individual investors or even professional managers to consistently outperform the market. Numerous studies have shown that the majority of actively managed funds fail to beat their benchmark indexes over long periods.

Benefits of indexing:

• Lower costs: Index funds have much lower expense ratios than actively managed funds
• Broader diversification: Index funds typically hold a larger number of securities
• Tax efficiency: Lower turnover in index funds results in fewer taxable events
• Consistency: Index funds provide more reliable performance relative to their benchmarks

Evidence. Research by academics like Eugene Fama and practitioners like John Bogle has consistently demonstrated the superiority of index investing for most investors. Even legendary investors like Warren Buffett have advocated for index funds as the best choice for the average investor.

3. Asset allocation is the cornerstone of successful investing

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).

Importance of asset allocation. Studies have shown that asset allocation is responsible for the majority of a portfolio's long-term performance. It determines the overall risk and return characteristics of your investments more than individual security selection or market timing.

Key considerations:

• Risk tolerance: Your ability and willingness to withstand portfolio volatility
• Time horizon: Longer time horizons generally allow for more aggressive allocations
• Goals: Different financial objectives may require different asset allocations
• Market conditions: While not advocating market timing, extreme valuations may warrant slight adjustments

Implementation. Start with a core allocation to broad market index funds (e.g., total stock market, international stocks, and short-term bonds). Consider adding smaller allocations to asset classes like small-cap stocks, value stocks, or REITs for additional diversification, keeping in mind your overall risk tolerance and investment goals.

4. Understand market history to navigate future turbulence

You simply cannot learn enough about this topic. The more you know, the better you will be prepared for the shocks regularly hurled at investors by the capital markets.

Patterns repeat. While specific events don't recur exactly, market cycles of euphoria and panic have played out repeatedly throughout history. Understanding past bubbles and crashes can help investors maintain perspective during future market extremes.

Key historical lessons:

• Markets are cyclical: Periods of high returns are often followed by lower returns
• Innovations lead to speculation: New technologies often spark irrational exuberance (e.g., railroads, internet)
• Crises create opportunities: Some of the best long-term returns come from investing during times of panic
• Valuations matter: Extremely high or low market valuations tend to revert to historical averages over time

Practical application. Studying market history helps investors develop the emotional fortitude to stick to their investment plans during both bull and bear markets. It also fosters a healthy skepticism towards claims of "new paradigms" or "this time it's different" narratives.

5. Behavioral biases are your worst enemy in investing

You are your own worst enemy. It is likely that you are more confident of your ability to pick stocks and mutual fund managers than is realistic.

Common behavioral biases:

• Overconfidence: Believing you can outsmart the market
• Recency bias: Placing too much weight on recent events
• Loss aversion: Feeling losses more strongly than equivalent gains
• Herd mentality: Following the crowd instead of sticking to your plan
• Confirmation bias: Seeking information that confirms existing beliefs

Consequences of biases. These psychological tendencies often lead investors to buy high and sell low, chase performance, or make frequent changes to their portfolios. Such behavior typically results in underperformance compared to a simple buy-and-hold strategy with a well-diversified portfolio.

Overcoming biases. Awareness is the first step in combating these tendencies. Develop a written investment plan and commit to following it. Automate your investing process where possible, and limit how often you check your portfolio. Consider working with a fee-only financial advisor who can provide an objective perspective and help you stay the course.

6. Keep costs low and diversify broadly for long-term success

Harness the power of the market by owning all of it—that is, by indexing.

Impact of costs. Investment costs, including expense ratios, transaction fees, and taxes, directly reduce your returns. Over long periods, even small differences in costs can have a significant impact on your wealth. Low-cost index funds provide a way to capture market returns while minimizing expenses.

Benefits of broad diversification:

• Reduces company-specific risk
• Captures returns from different market segments
• Smooths overall portfolio volatility
• Increases the reliability of outcomes over time

Implementation strategies:

• Use total market index funds as core holdings
• Consider adding targeted exposure to small-cap and value stocks
• Include international stocks for global diversification
• Utilize low-cost ETFs or index mutual funds
• Minimize portfolio turnover to reduce transaction costs and tax impact

7. Rebalancing is key to maintaining your desired risk profile

Rebalancing forces you to buy low and sell high.

Purpose of rebalancing. As different assets in your portfolio perform differently over time, your asset allocation will drift from its target. Rebalancing involves selling assets that have become overweighted and buying those that have become underweighted, effectively "buying low and selling high."

Benefits of rebalancing:

• Maintains your intended risk level
• Potentially increases returns over time
• Forces disciplined, contrarian behavior
• Provides opportunities to reassess your strategy

Rebalancing strategies:

• Time-based: Rebalance on a set schedule (e.g., annually)
• Threshold-based: Rebalance when allocations drift beyond predetermined ranges
• Combination: Use both time and threshold triggers
• Consider tax implications: Utilize new contributions or rebalance within tax-advantaged accounts when possible

8. Invest for the long term and ignore short-term market noise

The key point is this: the fundamental return of the stock market—the sum of dividends and dividend growth—is somewhat predictable, but only in the very long term. The short-term return of the market is purely speculative and cannot be predicted.

Focus on fundamentals. In the short term, stock prices are driven by factors like sentiment, news, and speculation. Over longer periods, returns are determined by underlying business performance, earnings growth, and dividends.

Dangers of short-term thinking:

• Increased trading costs and taxes
• Higher likelihood of buying high and selling low
• Missing out on long-term compounding of returns
• Emotional stress from market volatility

Strategies for long-term success:

• Develop a sound investment plan aligned with your goals
• Automate regular contributions to your portfolio
• Resist the urge to react to market headlines or short-term fluctuations
• Focus on your overall financial progress rather than day-to-day market movements

9. Beware of financial industry conflicts of interest

The rub here is that your broker has an incentive to keep those expenses—the nearly exclusive source of his income—as high as possible.

Misaligned incentives. Many financial professionals, including brokers and some advisors, are compensated through commissions or fees based on the products they sell. This can lead to recommendations that are not in the best interest of the investor.

Common conflicts to watch for:

• High-fee mutual funds or annuities
• Frequent trading recommendations
• Proprietary investment products
• Complex investment strategies with opaque fee structures

Protecting yourself:

• Seek fee-only financial advisors who have a fiduciary duty to act in your best interest
• Understand how your advisor or broker is compensated
• Ask questions about any recommended investments or strategies
• Prioritize low-cost, broadly diversified index funds as core holdings

10. Develop a sound investment plan and stick to it

At the end of the day, you can never be completely certain that your retirement will be a financial success. Further, you are faced with a tradeoff between the amount of your nest egg you can spend each year and the probability of success—the less you spend, the more likely you are to succeed.

Elements of a sound plan:

• Clear financial goals and time horizons
• Realistic assessment of risk tolerance
• Appropriate asset allocation strategy
• Low-cost, diversified investment selections
• Regular savings and investment contributions
• Periodic rebalancing and review

Importance of discipline. The biggest threat to long-term investing success is often an investor's own behavior. Emotionally-driven decisions to abandon a well-thought-out plan during market turbulence can be extremely costly.

Strategies for staying the course:

• Write down your investment plan and rationale
• Educate yourself about market history and investing principles
• Avoid constantly checking your portfolio or following market news
• Work with a trusted advisor who can provide objective guidance
• Focus on your progress towards long-term goals rather than short-term performance

2010 Postscript

Last updated: August 20, 2024