Samson

So, a little bit of a curveball: just recently, I wrote that I seem to keep reading personal finance books not to get any new ideas or to tweak my strategy, just to reaffirm my path and maybe gain a deeper understanding of why passive investing works so well. I was expecting something similar when I picked up the new 2023 edition of "The Four Pillars of Investing" by the brilliant William Bernstein. While it certainly overlaps with a lot of my beliefs, particularly the virtues of index funds and long-term investing, it's causing me to significantly rethink some aspects of my investment plan, particularly as it comes to retirement. I'm not going to make changes any time soon, but it feels a little refreshing to have something new and concrete to play around with.

I'm pretty sure I first learned about Bernstein through the Boglehead universe, but my previous exposure to him was through his books on economic history, The Birth of Plenty and A Splendid Exchange. I've been meaning to dip my toes into his personal finance books, and Four Pillars seems to be the most popular and recently updated. In an unusual move for me, I picked up the Kindle edition; I almost always prefer reading paper copies, but have had a hard time locating a recent print edition at my library, and am trying to limit my personal print library to a few specific authors. It's been a while since I read a Kindle book, and from a tech perspective I do like how they work: you can easily zoom in on graphs and tables, and there's a good system of highlighting passages that automatically bookmarks them for future reference. (Thus, it's easy for me to find and repeat here my favorite sentence in the book: "Since Morningstar is located in Chicago and staffed by Cubs fans, they have a special affinity for losers.") As with other Kindle books I've read, there is a little clunkiness to this book which makes me wonder if it was generated from a pre-copyediting draft, with some ideas seeming to repeat in nearby paragraphs and the odd typo here or there. On the whole the prose felt a bit less polished than the other Bernstein books I've read, while still being good and entertaining.

I came into the book with a small amount of skepticism just based on the title; The Birth of Plenty seemed to also be about "four pillars", with multiple concepts shoved into the fourth pillar, and I was prepared for something similar here. This book's thesis is pretty uncontestable, though. The title stems from the idea that, in order to be a successful investor (that is, to make rather than lose money at investing), you need to understand four things: The theory of investing, the history of investing, the psychology of investing, and the business of investing. That's all pretty compelling, and I think I agree with him. It's also encouraging: it suggests that, while there is definitely a high degree of uncertainty, investing is not just a matter of luck, nor of extraordinary ability, and that by learning and absorbing some specific knowledge you'll significantly increase your success.

I'll run quickly through the four pillars, then the aspects that interested me the most, and finally what thoughts it's sparked for my own portfolio and investment strategy.

Understanding the theory of investing includes topics like how businesses generate money (non-zero-sum), the tradeoff between risk and reward (investors will demand a greater return in exchange for greater uncertainty), and the differences between stocks (equity) and bonds (debt). This section overlaps with books like "A Random Walk Down Wall Street". I've said in the past that it isn't necessary to understand the theory behind investing to invest well, and while that's technically true, in practice I think it is important for verifying that a given portfolio or strategy is important for your situation and stage of life, and for understanding what's happening when you see major declines in your portfolio.

The history of investing means being aware of the major bubbles and crashes in the past. That includes recent events, like the 2008 great financial crash, 2000 dot-com bust, 1970s inflation and so on; but also ones further back, like the bond bear marked from the 1940s-1980s, the confiscation of assets during the Communist revolutions, bubbles at least as far back as the South Sea and Tulip Mania bubbles. Bernstein makes an interesting point that the importance of understanding a profession's history varies depending on the profession: you can be a very successful surgeon or engineer without knowing much about the history of surgery or engineering; but diplomats and lawyers need a very solid understanding of their fields' histories. Airline pilots benefit greatly from reading about crash reports; from learning about the mistakes other pilots made, they can avoid repeating them. Financial markets have existed for centuries, while our personal investing lives only last several decades. It's important to avoid "recency bias", where we assume that the last few years' trends will continue indefinitely; understanding the different ways markets have behaved in the more distant past enables us to better understand the possible risks that could occur and prepare for them. It's also helpful to understand that booms and busts are inevitable, and that you're always better served by being "fearful when others are greedy and greedy when others are fearful". If you encounter your first market crash, and all the financial news is talking about how everything is terrible, and you sell out of your depressed holdings, then you'll do permanent damage to your portfolio; but if you realize that these crashes happen roughly every decade and always recover, then you'll see this as a buying opportunity, and do permanent good for your portfolio. And if you're facing your first bubble, and everyone is talking about how "the rules have changed!" and justifying historically high P/E ratios, then you'll feel FOMO and jump on the bandwagon, setting yourself up for disappointment; but if you understand that there's always a return to the mean, you'll stick with a more sustainable asset mix and be much better positioned when the bubble inevitably pops (as it has many times before you were born and will many more times after you pass).

I think this may be the pillar where Bernstein raises the really helpful distinction between what he calls "shallow risk" and "deep risk". "Shallow risk" is part of the normal ups and downs we expect from investing in equities and can be endured simply by riding it out. In 2008 stocks fell by half, which felt terrible at the time, but they bounced back within two years, so everyone who stayed the course did well (and, if they continued buying during the dip, even came out ahead); this falls under "shallow risk". "Deep risks" are the less likely but more devastating possibilities that you can't just ride out and that can permanently damage your financial life. Bernstein identifies four of these: from most likely to least likely, they are inflation, confiscation, destruction, and deflation. Inflationary periods, like 1920s Germany, 1930s-1940s US and UK, or more recent episodes in Chile, can utterly devastate financial security. (As in previous works, Bernstein serves as a kind of mirror to Thomas Piketty in offering an opposite viewpoint of the same phenomenon: Piketty notes how these inflationary periods helped reduce inequality between the very rich and everyone else, and allowed governments to more easily retire their debts, while Bernstein focuses on the perspective of those who were fortunate enough to assemble small or large fortunes and then saw them decimated.) By "Confiscation", he means both the wholesale seizure of assets like happened in Russia and China after the Communist revolution, and various "land reform" actions in the developing world, but also extremely high taxation. (Again, a great mirror to Piketty here!) "Devastation" refers to the physical loss of value, usually through war or natural disaster; not so much your dollar bills burning up or gold melting, but more the loss of value in existing companies due to destruction of productive capacity or markets. Finally, deflation can also wreak havoc, not just on individual portfolios but on entire economies: fortunately, deflation is extremely unlikely to occur in our era of central banking and fiat currency, so it's the least of our concerns.

Inflation is the most likely "deep risk", and fortunately also the easiest to prepare for. For retirees, Social Security is indexed to inflation, so maximizing your Social Security benefit by delaying retiring until 70 is the best thing to do, even if it means selling some assets to delay the time until you start collecting. It's also easy to buy TIPS, Treasury Inflation Protected Securities, which are bonds that automatically rise in value based on inflation. You can have some minor protection against inflation by holding commodities (Bernstein likes commodity-producing stocks rather than futures), value stocks, and to a lesser extent real estate. (Interestingly, historically gold has not been a great hedge against inflation; there are exceptions like the 1970s, but it tends to not keep its value very well.) The worst possible thing would be to be locked into long-term nominal bonds, which was exactly the situation that wiped out so many fortunes in the early 1900s (and more recently brought down Silicon Valley Bank).

The other "deep risks" probably aren't worth preparing for; they're highly unlikely and harder to prevent, and if they do hit then protecting your portfolio will likely not be your top concern. Still, it is helpful to remember that most countries have faced these problems at some point in the past. You could protect against confiscation or destruction by holding a portion of your assets outside the country; but this does incur significant cost and government scrutiny, and would you really be willing to flee your country if it came down to it? In the rare event deflation occurs, holding a large amount of cash should see you through; Bernstein recommends doing this anyways for unrelated reasons (keeping "dry powder" to be able to buy on market dips).

Moving on to the third pillar: given that any investor's lifetime will have at least a few major up and down markets, it's really important to understand our own emotions and thought process. Bernstein doesn't present this as a moral judgment, more a description of the physical, biological, evolutionary reasons why we think and act the way that we do, and why that leads us into trouble. We adapted to make split-second decisions, to focus on danger, to listen to stories over data. All of those things helped our ancestors escape saber-toothed tigers, but those exact same instincts can cause people to make impulsive decisions that can set back their retirement by a decade or more. Much like with history, just understanding what's going on and how it works can help prepare us to act wisely in times of crisis.

The final pillar is the business of investing, understanding the various people you may encounter along your journey (stockbrokers, investment advisors), types of investments (mutual funds, ETFs), what incentives people have, what types of things to look for and avoid. This is the area that overlaps most strongly with the writings of John Bogle and the various Bogle-adjacent writers I tend to favor. For better or worse, you're best off ignoring the vast majority of "news" and services, and sticking with simple indexed funds and ETFs from low-cost brokerages.

I should note that, while Bernstein does emphasize "simple", he is definitely not as simple as the vast majority of Bogleheads that I am familiar with. As one extreme, the late John Bogle favored just holding two funds, the Total (US) Stock Market and the Total (US) Bond Market. Vanguard's core portfolio recommendation today has four parts (Total US Stock, Total US Bond, Total International Stock and a currency-hedged Total International Bond). I think Burton Malkiel recommended including an REIT fund as well. Anyways, Bernstein seems to believe that there's nothing wrong with a simple portfolio, but he does believe you can reasonably outperform with a much more granular approach. He gives several examples of increasing complexity, with the most complex including something like ten holdings, including funds tilted towards value stocks, towards small-caps, direct exposure to commodity producers, separate holdings for various international regions (Europe, Pacific, and emerging), real estate and more. He gives some solid justification for these, mostly building off the "history" pillar: going back for several centuries, value stocks have tended to outperform growth stocks; for the last 20+ years, growth have outperformed value stocks, and while we cannot predict the future and certainly can't anticipate when any shift would occur, previous experience strongly suggests that value stocks are overdue for a relative increase in valuation.

After the four pillars, Bernstein spends a chapter or two walking through specific advice he has. Open up an account at either Fidelity, Vanguard or Schwab. Take your time to think through your investment needs, develop a strategy, and then implement it. He repeatedly says that being able to stick with a sub-optimal strategy is significantly better than alternating between optimized strategies. If you're young, start with a lower equity allocation until you encounter your first real bear market and get a real-life sense for what your actual risk tolerance is: having years of lower gains at the start of your career is much better than getting spooked and withdrawing after a crash.

Doubling back to earlier in the book: One of my big take-aways is rethinking just what is meant when people talk about "risk". It's common for a questionnaire or survey to ask about your risk tolerance, which I tend to think of as a matter of emotion or courage: how badly would your stomach hurt if the market drop? As Bernstein looks at it, though, it's more of a mathematical description of the odds of achieving an outcome. If someone has an investment portfolio of $750k and wants real inflation-adjusted returns of $50k per year over the next 30 years, then that portfolio has moderate risk: it can probably provide the desired outcome, but if the market crashes in the early years and has a slow recovery, then it may fail. If someone else has a portfolio of $5m and also wants real returns of $50k per year over 30 years, then there is virtually no risk: no matter what the market does, you'll be able to achieve your goal. Looking at it this way, risk is more a matter of reality than of opinion, which I like.

While reading this book, I thought a lot about a great collection of videos I watched last year from the Bogleheads conference about retirement funding: This one from Dana Anspach:

And a round-table discussion on retirement:

As I mentioned in my writeup on "How to Make Your Money Last", this is actually an area I haven't thought much about: I've been focusing on accumulating and felt pretty good about my acumen, but realized I haven't given much thought at all to how the draw-down phase will go. I think these videos were the first time I started to think about the goal of retirement planning being to "minimize the odds of failure" versus "maximizing returns". Bernstein goes into this topic with even more depth, including some very helpful hypothetical situations and a look at historical results.

My biggest new take-away from this book has to do with the transition from a volatile investment portfolio to a stable income portfolio. Throughout our working lives, we're ideally saving money for retirement. As we approach middle age, the size of our portfolio may be substantial, and will swell during boom times and crash during busts. Once we start seriously thinking of retirement, we can start putting specific numbers together: how much would we want to receive today to live how we want to live? We can guarantee an inflation-adjusted income in the future by buying TIPS today. If, say, you're planning to retire at 65, and delay Social Security until 70, want to plan for income until you're 95, need $50k to live comfortably this year, and expect to get $40k per year from Social Security, then you can buy $50k worth of TIPS that mature the years you turn 65-70, and $10k of TIPS that mature the years you turn 70-95. This is a "TIPS Ladder", kind of similar to a CD ladder or a bond ladder, but intended for consumption rather than rolling. (He also calls it a LMP, "Liability Matching Portfolio", which is a portfolio calibrated to precisely meet anticipated spending needs rather than to maximize returns. It's probably most accurate to say that it's a LMP that primarily relies on TIPS and Social Security.)

In Bernstein's view, once you get to a point where you can buy that ladder, you should do it, which will then lock in and guarantee the stability of your future retirement. If you delay, the risk is that a market crash (like 1987, 2000, 2008, 2020, etc.) may destroy the real value of your portfolio just as you need it.

This whole approach is very different from my working assumptions to date, which have more followed the idea of a "glide path" that gradually shifts from equities to fixed-income as you age. Bernstein's argument is powerful, though: from looking at specific years and sequences, there are many cohorts that COULD have retired at, say, age 55, but once they reached 56, they had to continue working until 68 to regain their position. His phrase is something like "once the market has given you what you need, you don't need to keep playing: you've won."

Importantly, this is not about market timing: you aren't trying to "get out at the peak" or predict when a crash is coming. It's all about the present value of your funds and your predetermined calculations for what you need. Maybe the market will double after you exit: that's okay! You've got what you need for retirement.

Once you do have this locked-in TIPS ladder, you can continue working and retire on schedule. If you have extra money beyond what you need, you can do what you want with it, which may be something like 100% invested in equities: since this isn't money you need, you're really investing for the benefit of your heirs, and can take advantage of their longer time horizon. He refers to this as an "RP", or "Risk Portfolio", which is a separate bucket from the LMP. (Of course, you could always sell equities to fund "wants", like first-class tickets or a fancy new car; if the market does poorly, maybe you fly coach and get a used Corolla. Again, it's fine, your needs are all covered by TIPS and Social Security.)

I've been aware of TIPS for as long as I've been investing, but have never bought any, and hadn't previously looked into how to buy them. From the book I found the fantastic website tipsladder.com; like many of the best sites it looks like it was designed in the 1990s. I've also started exploring purchase options on my brokerage, and learning a little about auctions.

There are still some fundamental questions I need to work through - most importantly, when would I want to retire? But by eliminating the major unknown variables of future inflation and future market returns, it becomes possible to run through some scenarios. It's super-encouraging to be able to see specific numbers, like "It would cost me $X to buy inflation-adjustment payments of $Y/year from age Z until I turn 70". I can compare $X to my current portfolio to see how much on track I am. I can also do some simple comparisons, like buying vs. renting or carrying a mortgage vs. paying off early: I can adjust the monthly costs that I'd need in retirement, and see if I'd still have the funds available to buy the ladder to fund it.

For comparison, what I've been vaguely considering up until now is basically saving as much as I can in a diversified portfolio (US and international stocks and bonds) and following the "4% rule" - withdrawing 4% of the principal value (including dividends) in my first year of retirement, then adjusting each following year based on inflation, probably adopting some bumpers to limit withdrawals in years with significant market declines and allow higher withdrawals after a hot streak. There are some major differences between these approaches. A big one is that, since a TIPS ladder is to fund spending, when it's done, you're just out of money; with a portfolio of stocks and bonds, the 4% rule supposedly covers the worst-case outcome, but in most cases you'd be left with significant assets after that time to leave to heirs. Another one is that the 4% rule was based on historical studies from the late 1800s through the 1990s, and there's no guarantee that the future will have the same kinds of returns, but it's much more likely that the US government will honor its obligations.

It is kind of gut-dropping to contemplate selling a massive chunk of the assets I've been assembling over my working life and drastically shifting from equities into TIPS. I'm not sure yet if I'll do it. If I do, it would probably be gradual - I might dollar-cost-average over a year, or make a longer-term plan to fill in a ladder through auctions.

But, if I am going to do it, I don't want to wait too long before pulling the trigger. Again, the goal isn't to time the market, but it does seem like mid-2024 is a relatively good time to dial down equities, capture the historic gains we've been seeing and lock in the relatively appealing interest rates.

Once again, though, this comes back to just when I think I might retire. I probably still have a couple of decades of gumption to keep working if I want to / need to, and with that kind of horizon, I probably am better off maximizing equities. BUT this is the sort of thing I should ideally be planning, say, a decade or so out, so I can make shifts when they make sense without being forced to make changes at the last minute with an unfavorable market. I dunno. Which probably means that inertia will keep me on my current course - not necessarily the worst thing!

It is kind of funny to think back to the very early investing posts I made on this blog. At that time I was buying CDs instead of bond funds exactly because of the low bond yield. After the 2008 crash I kept waiting for bond rates to rise, belatedly realized that they hadn't and might not for some time, and eventually switched over, mostly because owning an indexed bond fund is a lot easier to manage over the long term than maintaining a rolling CD ladder. Bernstein is actually pretty positive in this book about CDs, and I may be seriously looking at CDs for cases where TIPS don't work.

Okay, this has felt like even more of a shaggy dog story than most of my posts - for what it's worth, though, this is probably less than half of the thoughts I'd had about a TIPS ladder, let alone the follow-up research I've been doing. I may or may not post again when I come up with a clearer plan for how to proceed.

For now, I'll wrap up to say that the new edition of "The Four Pillars of Investing" is probably the most thought-provoking investing book I've read since "A Random Walk Down Wall Street". It's clear, cogent, actionable, occasionally daring. I wouldn't necessarily recommend this to a new investor; it helps to already have a deep understanding of the conventional wisdom around passive investing to realize the significance of Bernstein's suggestions. It's probably best suited for "enthusiastic amateurs" like me: people who realize that their investments won't make them rich and aren't chasing for unrealistic returns, who enjoy understanding the dynamics of finance, and would consider putting in a lot more effort for a few basis points of results.