Wednesday, January 27, 2010

The Four Pillars of Investing Part 4

This is a multi part series dedicated to the review of  William Bernstein's book The Four Pillars of Investing.
The Four Pillars of Investing: Lessons for Building a Winning PortfolioNumbered Page references are from the hardcover edition.

Value = Bad Companies = higher risk = higher return
Small or Emerging Markets = higher risk = higher return

Pillar Three - The Psychology of Investing

Chapter 7 and Chapter 8 – Our Behaviors and how to combat them.
Richard Thaler and friend were contemplating driving across Rochester, New York, in a blinding snowstorm to see a basketball game. They wisely elected not to. His companion remarked, “But if we had bought the tickets already, we’d go.” To which Thaler replied, “True – and interesting.” Interesting because according to economic theory, whether or not the tickets have already been  purchased should not influence the decision to brave a snowstorm to see a ball game.
It is like throwing good money after bad.  Richard Thaler helped found the field of Behavioral Finance. Is there any other kind?
The problem with investing is yourself and these bad traits.
•    Human beings are very social. So be ready to invest as the contrarian.
•    We are too overconfident that we could beat paid experts in the field, and money managers who routinely do not outperform the market. You are trading with/against the money managers. You cannot time the market. The news and hype has already been priced in.  So tell yourself regularly that the market is smarter than you and there are plenty others better equipped than you. Obtain market average - Just do it cheaper and more efficiently.
•    The next major error is using the immediate past as an indicator to future returns.  The best asset classes for five years tend to be the worst performers in the following five years and vice versa.  So recognize this and forget the last ten years of performance.
•    Why don’t we index – it is boring. Gambling is more fun. And we like to brag about who and what we invest in and with. The exciting funds are probably at the top ready to go down. So be dull and index.
•    Focusing on the wrong risk. Worrying too much about the short term than the long term. Myopic risk aversion.  So check on your portfolio less often – think of your house and how you hold onto it without knowing how the price might be swinging. And/Or hold lots of cash and take advantage of short term drops in prices.
•    Finding the next Wal-Mart. Great company/Great stock fallacy. Better to stick with slow and steady growing than trying to bet on an explosive, advertised stock which will fall out of favor soon enough anyways. So be dull and index.
•    There are no patterns. The markets are random. Look long enough and find a historical pattern, but it does not work applying it forward. So be dull and index.
•    Poor accounting. Calculate your return on investment and do not bury your failures or they tear down overall performance, and the overall return is all that matters. And don’t be a “whale” feeding your money to your managers through fees and expenses.

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