Tuesday, February 26, 2019

Book Review #39: Four Pillars of Investing: Author: William J Bernstein

Four Pillars of Investing: Lessons for building a winning portfolio written by William J Bernstein is one of the best books on investing that I have reviewed in my book series on 50 Finance Books.

This book gets that rarest of rare rating of 5/5

Published by: McGraw-Hill

ISBN: 978-0-07-175917-5 (ebook) / 978-0-07-174765-9 (Print)

Short URL: https://goo.gl/qd2vsY


As per Mr.Bernstein, any investor in the financial markets should know the scientific basis of investing which consist of four broad areas which he calls the four pillars of investing. The pillars are Investment Theory, History of financial markets,  Investor Psychology (Behavioural Finance) and Business (How the mutual fund industry works)

15 Chapters of the book are covered under five sections, four of which cover each of the four pillars and the final sections puts it all together and guides the investor on his investment journey. One has to understand each of the four pillars deeply before venturing into the world of investment. In the preface to the book, author says that the key principle used in this book are accessibility and enjoyment. To that end, he has kept the math simple.

The first four chapters under section one exposes the reader to Investment Theory. The fundamental principle of the financial markets is the relation between risk and return. Each chapter of book touches upon the relationship between the two. The iron clad relationship between the two is that the higher the risk,  higher the expected return, and lower the risk, lower will be the expected return. The book spans a few centuries to demonstrate the relationship between risk and return in various asset classes. While Interest rate risk (inflation risk) and credit risk are associated with bonds, the holders of stocks will face short-term risk, where prices of his stocks crash with the market correction and long-term trend, secular fall in the value of the portfolio. While investors excessively focus on the short-term risk, it is the long-term version that is more damaging to the investor's wealth.

At a broad level portfolio of an investor should contain a mix of risky assets (Stocks) and risk-free assets (bonds). The proportion of stocks versus bonds that he will carry is one of the critical decisions that an investor should make. The second critical decision is allocating the stocks at a more granular level into Domestic and Foreign Stocks. An investor could broaden his portfolio by adding REITs and Precious Metals. Each element in the mix will carry its special flavor of risk and return.

The reader will learn that the biggest risk will be the failure to diversify your investments across asset classes and that a portfolio can behave differently from its component parts. The start of the process is to decide on the elements that one is going to invest in and the proportion. This is a critical decision that is dependent on factors like the current age, age to retirement, short-term and long-term investment objectives, tolerance to risk and  'Tracking Error'  and the ability to handle investment complexity. After analyzing each factor, the investor decides on a target allocation and a review period. Investor should periodically compare the current asset allocation against target allocation and make adjustments by selling the better performing asset classes and buying worse performing asset classes. This is very difficult decision and investor may require professional help.

Investor will be keen to know the return that he can expect from the market. The Gordon equation calculates the long-term return as dividend yield + earnings yield. Author calculates the value for US markets as about 7% which is close to what the bonds offer. This means that the markets are currently at a high and will not give much of future returns. The suggestion is to invest more in bonds since they give similar long-term returns.

It is important to know that the market periodically goes through boom and bust cycles. An investor who understands the history will be able to benefit from excesses on both directions. The author cites the example of LTCM as an investor who did not know the history of capital markets. Despite their enviable credentials in the other three pillars of investing, they went bankrupt during the bubble of the late 90s.To take advantage of the boom and bust cycles, investor should understand the four reasons for a boom. There should be technology displacement which catalyzes the economy. More than the absolute value of change, it is the rate of change of technology that is important. In addition there should be generous credit availability. There should be investor amnesia of the wounds caused by the busts of the past and finally, for boom to take place, investor should forget all the time tested criteria of calculating the value. This is the irrational exuberant phase that would signal the start of the bust. A market crash will be characterized by extreme caution, credit tightening and 'business as usual' growth of technology.

Reading this part, I couldn't help but think that currently technology displacement is underway the world over. However credit is still tight and central banks are not ready to open their purse strings. So the boom is yet to start, but we can safely say that we are on the trajectory to the next boom. It makes sense to stay in the market at this point in time.

Human psychology is the most difficult to handle for an investor. Unless he is careful, he will go into euphoria and despair along with the markets and commit investment mistakes. To be a successful investor in equity market, one should develop a set of personality traits. It is easy to make mistakes like following the herd, being overconfident in one's abilities, assuming that a great company is a great stock, assuming that what happened recently will continue to happen etc. The behavioural traits become pronounced during a short-term down turn of the market. The winner in the market is the one who can stay calm through the market panic and take calm and deliberate actions.

There are  three businesses that impact an investor, Brokerage, Mutual Funds and Financial Media. These are selfish entities whose only goal is survival. They do not care for the returns that an investor will achieve by using their services. The first two businesses adds cost of transactions to the investor thereby lowering his returns. In the age of mobile and TV, finance media plays abnormal role on the investor's choices. While they may appear neutral, it is very important to realize that most of the time the media works in tandem with the other two businesses. If the investor do not understand the working of these businesses, he or she will be taken to the cleaners.

Once one master the four pillars, he / she is ready to venture into the area of investing. Since one is investing to meet future consumption requirements, it is very important to have clarity of those objectives before one ventures into the journey. Different investment goals will call for different asset allocation approaches. It is important to use the real interest rate in all these calculations. Ensure to put in enough of safety net while doing the calculations. Once you calculate the goal, it is important to identify the asset allocations between Total Market Funds, Large Value, Large Growth, Small Value and Small Growth stocks, foreign market assets, REITs, precious metals and bonds. Author advises conservative approach to investment where safety of the capital is paramount.

Finally the most valuable part of the book is the reading list which will augment the knowledge of the reader about the four pillars and will make better investors.

The simple and powerful message of the book is this. "With relatively little effort, you can design and assemble an investment portfolio that, because of its wide diversification and minimal expense, will prove superior to most professionally managed portfolios. One just have to stay the course.

That is one heck of an inspiring message.


The first four chapters of the book cover four aspects of Pillar one, the theory of Investing. They cover the relationship between risk and return, how to estimate the return, the interplay between investors and themselves and the chapter 4 discusses the mechanics of portfolio design.

To understand the relationship between risk and return, Chapter One traverses across centuries starting from early Venice through the UK and the US. When the market is viewed across centuries, the relationship between risk and return is highly predictable. High returns always entail high risk.

Over the long-term stocks have given exceptional returns. For example Sensex which traded at 100 in 1980 is currently trading at 36000, a 36000% increase in just about 39 years. This doesn't mean that an individual investor will make such returns. There are a few reasons for that. One, he will withdraw from his savings for personal consumption. Even a small reduction in the invested amount can lower the final return significantly due to the power of compounding. Two, the above calculation do not consider taxes and transactions costs that will further lower the investor's return. Three, in these 39 years, there were at least three correction, the HarshadMehta correction in 1992, Dot com bubble in 2000 and the US Sub-prime crisis in 2008. Many investors would have had their hands burnt during the corrections, exited the market at a loss never to return again to the market. Yet another reason why in individual investor do not make the market returns is that if the investor had invested during the market peaks, they would not make similar returns. For example, if the investor had invested when the  Sensex was 22000 in early 2008 would have seen meagre returns on his investment in the last 10 years. So the timing do matter.

Chapter One makes five key points.

One, risk and return are closely intertwined. Higher the expected return, higher the risk that one has to take. For instance, you will make money in bonds only if you buy them at a low price. But that low price is always accompanied by high interest rate and corresponding uncertainty.

Two, the economic stability of a country can be traced by its interest rate chart. Higher the stability, lower and stable the interest rates. Any spikes in interest rate signifies a state of political and economic turmoil. high interest rates and economic and political uncertainty go hand in hand. In fact you can call an interest rate chart as a nations 'Fever chart'. High interest rate is always accompanied by uncertainty and low asset prices. Paradoxically that is the best time to invest.

Then why don't many people invest? The reason is that they don't know when the tide will turn. If it takes long time for situation to reverse they will be stuck in a poor investment for a long time.

Three, you can make money in stocks or bonds only if you invest when the prices are low. However, the prices are low because of some negative factors. Investing while prices are low is difficult due to the inherent risk and uncertainty.

Author makes a difference between growth and value stocks. Growth stocks are where the growth an the good news are fully priced in the stock. If you buy it you do not make any higher than normal return. Value stocks are those whose price is significantly lower than its intrinsic value. They are going through some temporary uncertainties and downturn and the prices are depressed. If the situation improves, these stocks can provide super-normal returns. The risks are also high in their case.

In general, higher the historical returns, lower the future returns. Lower the historical returns, higher the future returns.As a corollary, higher the historical returns, higher the potential risk and lower the historical returns, lower the future risk.

Four, in stock market, an individual encounters two types of risks, short term and long term. Short term risks is that the prices will fall in the near term. The Short term risk is immediate and in your face. The long term risk is that the value of your investment will deplete over  the long term. This is a more serious risk, but since it is incremental and long-term, it is not in the investor's radar.

The fifth point is that if a country is economically stable, the lower the chances of your making high returns in your investment. Interest rate is high and market fully captures the optimism and stability. If things continue to be stable, the returns will grow with the growth in stable earnings. In case of any potential instability, the markets will fall sharply

Chapter Two discusses the calculation of value and return. Two formulae were discussed. One is the Dividend Discount Model (DDM) propounded by Irwing Fisher which is used to calculate the intrinsic value  and Gordon Equation used to calculate the expected return.

As per the DDM method, the value is Current Dividend / (Discount rate - Dividend Growth rate). Discount rate is the return expected by the investor. It will be low in times of stability and high in times of instability. Rearranging the terms in the above equation, we get Gordon Equation which says that long term return = Dividend Yield + Dividend Growth rate. It will be fascinating to do the above calculation to see the fair value of Nifty at various discount rates as per DDM and the long term return embedded in Nifty as per Gordon Equation.

Author says that as per Gordon’s equation, the long term return in US stock market is paltry 6.5%. I don’t think Nifty will be any different.

A deep bear market is the best situation for a young man who is starting to invest. A bull market will be the best case scenario for a person at the cusp of retirement.

Chapter Three explores various approaches to investing in stock market and decides that index investing is the best approach. Investing in mutual funds (MFs) have hidden costs beyond the obvious one that is the expense ratios. In addition, MFs also charge four hidden costs on the investor. One is the transaction costs, which is the brokerage and transaction taxes. Second is the capital gains taxes, both Short-Term and Long-Term. The third is the bid-ask spread that the mutual funds have to pay to the market maker who helps them transact high volume of shares. Fourth is the research costs that they have to pay to buy equity research reports from third parties. All these costs will lower the returns for an average investor.

Another point against mutual funds is that none of the funds have beaten the index consistently over a long period of time. While the winners are rare, the losers, those fund managers who underperform the index is very predictable.

So high costs that lower returns for the investor, coupled with lack of consistent high level performance leads to only one conclusion, investing in Active Mutual Funds is a waste of time.

Market also continue to penalize successful MF manager in a peculiar way. More successful an MF manager is, the higher is his Assets Under Management (AUM). This phenomenon called 'Asset Bloat' causes high 'Impact Costs' that lower their performance. When they buy, the market comes to know and then the market joins the process raising the price progressively. While they sell, market also sells thus lowering the price progressively. So higher purchase price coupled with lower selling price (Impact costs) lowers the return for the shareholders.

So the question arises, why can't I invest in stocks directly. While it conceptually good, author points out that out of a universe of about 4000 stocks, only about 200 has given consistently high returns over the long-term. So if you did not own these stocks in your portfolio, you would end up incurring long-term losses.

To avoid the situation, you end up increasing the number of stocks in your portfolio and diversify. The end point of diversification is nothing but the index fund!

There we go again.

In summary, the best option for an investor is to invest in Index fund.

Chapter Four, the final chapter in Section One,  explains the process of portfolio creation in a methodical manner. There are some suggestions for portfolio creation that is given in the book. First suggestion is that you should track all your assets and liabilities in the same place. This will give us an opportunity to understand our real financial position and help us make the right investment decision.

Second suggestion is that as an investor, understanding yourself is the key to successful investing. An investor has to invest her tolerance towards risk, complexity and tracking error. She has to understand her risk tolerance before commencing her investment journey. She has to decide on her investment goals and plan her asset allocation  in line with the risk profile. Most investors get it ass backwards. They first set ambitious goals and take excessive risks to meet their goals. And once the inevitable market correction occurs, they can’t handle the loss and abandon the process altogether.

With multitude of investment options available, the investment process can be as complex or as simple as one wants it to be. It is very important to understand the language before we venture in the esoteric products like derivatives. By sticking to stuff you know and understand well, you can easily ensure good returns.

When your portfolio consists of different asset classes, it is natural that at any given time, some asset classes may underperform.compared to another. This is called ‘Tracking error’ and this is where most of the investors make mistakes. They invariably make the mistake of selling the worst performing asset class and buying the better performing asset class. This is a mistake. Why?

This brings me to the key message in the book. “High historical returns means low future returns. Low historical returns means high future returns. Stated in terms of risk, high historical returns means high future risk and low historical returns means low future risk”

Investment is easy. We just need to follow our instincts and buy when prices are low.

One more point on tracking error. It is not just the novice investor who make the mistake of buying the over performing asset class in favor of underperforming one. Many investment advisers do it. ‘Invest in ABC MF since this has 5 star rating as per Value Research’, most of us have heard this spiel. Nothing could be farther from the truth. ABC fund is having a high rating because of its past performance. As we have seen many times in this book, that is a predictor of a bad future performance. The best strategy for an investor should be to choose the funds that are trailing at 1 and 2 star rating. Their NAVs would have been beaten down and they would be available at good valuations.

We covered consolidated portfolio and investor profile so far. The third suggestion is to have a planned allocation between various asset classes in your portfolio and periodically review and rebalance it to the original proportion. Some asset classes would have gone up and exceeded the proportion and others would have lagged. So you sell the better performing asset class and buy the poorly performing asset class.

Counter intuitive? Welcome to the world of investing.

There are three aspects to portfolio allocation. The first one is to decide on allocation between risky (stocks) and riskless (bonds) asset classes. This Stock-Bond ratio is the most important asset allocation decision and should be made considering your risk tolerance level and your age. If your risk tolerance is high, have a higher proportion of stocks. If it is low, have a lower proportion of stocks in your portfolio. In any case never go 100% stocks whatever be your risk tolerance. Author suggests a maximum of 75% of your portfolio to be allocated to stocks.

In case of bonds, author suggests to restrict oneself to buying bonds of shorter duration of less than 10 years. A bond with a longer duration is highly susceptible to the vagaries of inflation and uncertainties.

Author recommends that those who are starting their investment journey at a young age must start conservatively. This goes against the conventional wisdom that says that one should invest predominantly in stocks at an early age since they have the lifetime to make for any losses. Author disagrees. A high proportion in stocks and when faced with a severe correction in their early years, the chances of an investor abandoning his investment process is very high (this happened to a person I know in the early 90s)

One final point about stocks to bond ratio. Author plots the performance of portfolios of various Stock - Bond mix and show how they have performed well over long-term (return) as well as when stock markets went through a long bout of correction (risk). It shows that while all stock portfolio has performed very well over long-term, it has significantly underperformed the all bond portfolio (by 40%) in times of correction. This is the aspect of risk that one has to keep in mind when investing in stocks.

Having decided on the Stock to Bond ratio, the next step is to determine your exposure to foreign stocks. Foreign stocks provide two advantages. Due to their negative correlation with the country stocks, they provide a downside cushion while providing an upside cap. In addition, the foreign stocks are also a hedge against inflation. The critical element in this allocation decision is the tolerance to tracking error. It is possible that domestic market performs significantly better and there will be a tendency to violate the asset allocation discipline. After all it is difficult to sell Nifty if it is going up everyday and buy a DAX which is being impacted by Brexit!. Author recommends that less than 40% of your stock portfolio should be allocated to foreign stocks.

The final part of the allocation decision is between large cap versus small cap and growth versus value stocks. It is recommended to have a part of your portfolio in growth stocks and part in value stocks. In value stocks author prefers Large value stocks to small value stocks.

While author warns against sectoral themes, you don’t know when the sector will vanish, There are two sectors that author recommends (hesitantly). One is REITs due to their negative correlation with broader market and the other is stocks of precious metal companies. The latter is interesting. The stock of precious metal companies have no correlation with broader market. Their share prices are linked to the highly volatile global commodity markets. If you have these stocks in your portfolio, the global volatility combined with the discipline of portfolio rebalancing will ensure that you get about 3 to 5% higher returns than normal.!

That is it. Very good chapter, with huge insights.

Chapter 5 and 6 under Section 2 discusses the history of Stock Markets. Chapter five discusses that bubbles and Chapter 6 discusses the busts. The history of financial markets is an interplay of bubbles and busts. Starting from the ‘Diving Company’ bubble in the early 17th century, the chapter covers the South Sea bubble, the Canal Transport Bubble, the bubble that preceded the great crash of 1929, the bubble between 1960 and 1972 and finally the dot com bubble of 2000

The bubbles are caused due to four factors. One, technology displacement, where a new technology attains a critical mass and displaces an older one. For example, in the canal transportation bubble, it was the construction of a canal that eased the transportation between distant cities that started the bubble.The 1929 bubble was initiated by a slew of new technologies including air travel and electricity. The 1960 bubble was started by developments in Electronics etc. This is supported by easy availability of cheap credit which spurs innovation and investment. There has to be a gap of 30 years between the bubbles as Societal Memory about the earlier debacle  fades. Fourth element is the ‘irrational exuberance’ when the investing public forgets everything they know about valuation and the price takes a path of its own delinked from the intrinsic value.. This happens in the last stages of a bubble and is normally led by uninformed investors.

The chapter also makes some critical points. One, more than the absolute status of Technology, it is the rate of growth in the pace of technology that cause the bubble. Two, more than the inventor or the creator of a new technology, it is the user of the technology who benefits most from it. Author sites the example of Edison. While Edison invented light bulb, it was Mr.Morgan who lent money to Edison and who later sold his stake to Westinghouse that benefited the most from this invention. Another example is the construction of the first canal. While the person who constructed it got benefits, it is the businesses that used the Canal to transport their goods and services, who got the maximum benefit out of the construction. 

The chapter also made me think about the current state of India / Global  markets. There is not doubt that a technology displacement is under way. AI, IoT, Robotics etc are attaining a critical mass.

However, globally cheaper credit is not yet available. Credit availability is a critical ingredient in starting the bubble. Third, it is only about 10 years since the last bubble and the painful memories of that crash are still in public memory. Four, irrational exuberance is yet to set in. It will happen in the end stages of the bubble.

So we are not yet looking at a bubble.

But what is clear is that the market will continue to go up for the next few years till there is a crash. So despite all the short term negativity, it is important to stay invested in the market and use these corrections to invest more in the market. Also the approach should be very disciplined, the lessons learned in chapter 4 about portfolio rebalancing should be followed rigorously.

Two, IT and Banks will lead the next bubble. It is important to have a higher allocation to these sectors.

Three, new technology will drive the change. Scout for companies that are doing cutting edge research in these areas.

Four, keep abreast with the new technology. Understand AI, IoT and other new technologies in much more detail...

Chapter Six is a small chapter that deals with how market crashes happen and how investor should handle it. Causes of Crashes are reverse of what caused the boom. Investors get disillusioned with the technology. They feel that rate of growth of new technology has plateaued. This is almost always accompanied by inflation, high interest rates and credit squeeze. Also the crash wipes out the notional wealth of many people and they become dejected and sell and exit the markets. This further depresses the already depressed markets. Finally, investors become so careful that they forget the valuation math. Great companies become available at throwaway prices.

What should an investor do in these circumstances? One, he should not panic and exit the markets. Two, they should maintain a strict discipline of portfolio allocation. Author suggests to invest 5% of your money in the market for every 25% fall in the market, so that you have money available to take advantage of the market bottom. Three, investors should be able to calculate the value of investment themselves. Investors must look for earnings yield, dividend yield, PE Multiple and calculate the Expected Return as per Gordon Equation. This will give them a sense of the value left in the market. Four, do not underestimate the courage that it takes to stay the course during these tough times. Investor should realize that Bear Markets cannot be avoided and stay calm.

Remember, there are no intrinsically good or bad stocks. Any stock is good at a price low enough. When the market crashes, many more stocks become investment worthy.

Are there any advantages of busts? It depends on how you handle the aftermath. Many investors would have lost money and there will be demands to find and punish scapegoats. The experience of how UK and US handled market crashes is very educative. After the South Sea bubble was bust, UK went for knee jerk reaction. General market transactions, that ensure liquidity in the market, were banned and the market tanked further due to the lack of liquidity. Further, such actions permanently weakened the stock market.

On the other hand, US, after the 1929 melt down, learned the right lessons and strengthened the market activity by introducing path breaking reforms which strengthened the market over the long term. Institutions like SEC were formed during that time.

In this section, author accomplishes four things. One, reader gets an appreciation that booms and bust are a part of the market cycle. It informs us about the psychology of people and nations. Two, from time to time market can become irrationally exuberant or morose. That is just the nature of the beast. Three, boom bust cycle depends on the behaviour of people. As long as people do not change fundamentally, these cycles will continue. Four, at the time of great optimism the future returns are the lowest and at time of great pessimism, the future returns are the highest.

Section 3 consists of two chapters. Chapter Seven deals with investor psychology. It discusses the following biases of a retail investor.

Following the herd: If everyone feels that stocks are the best investments it means that a) everyone has bought them and b) there is no one else left to buy them. So by following the herd an investor hardly makes any returns.

Overconfidence: People tend to think that their investing skills are above average. There are intriguing reasons for overconfidence. The more complex the task, the more confident we are about our ability to accomplish it, the longer the feedback loop or the delay between out actions and results, greater is our overconfidence. The delay between action and result is called Calibration. If the delay is less, the more calibrated we are and less confident. Overconfidence comes in many flavors. The first is the illusion that ewe can pick stocks by following a few simple rules. Many investors also believe that they can time the market. This is the second flavor of overconfidence.

Overconfidence is associated with two investor errors. One is 'Compartmentalization' of success and failure. We only remember our successes aka survivorship bias. Second error is ascribing our success to our skill and failures to bad luck.

Recency Effect: The assumptions that immediate past is predictive of a long-term future. We tend to overemphasize the short term data and under emphasize the long-term data. The problem with recency effect is that it comes to the completely wrong conclusion. (like my Put Option buying!!). Asset classes mean revert and the recent winner is a future loser.

Need for excitement. People gravitate to low probability / high pay-off bets in search of the potential '100 Bagger'. and pile up unnecessary risks.

Focusing on short-term risk at the expense of long-term risk: This leads to 'Myopic Loss Aversion' where you avoid short term losses but end up incurring serious long-term losses.

Great Company / Great Stock fantasy: Growth is ephemeral. The growth premium of great companies exist for just a few years.

Searching for patterns where non exist:

Loss aversion / Regret avoidance: We are less likely to sell off the winners than losers. We do not like acknowledging that we made mistake.

Seeking expensive and exotic investment options: This is a problem faced by the ultra rich. Everyone wants a piece of their wealth pie and try to sell them expensive and exotic investment products.

Chapter Eight guides an investor in navigating these emotional and behavioral pitfalls in investing. The points in this chapter are the opposite of points made in chapter 7. The suggestions are.

Identify the seasons conventional wisdom and assume that it is wrong. Realize that asset classes that are highly unpopular now are the ones with the highest future returns. In India, currently is it Infra and Real Estate.

Do not be overconfident: Understand that smarter people are sitting on the other side of the trade.

Ignore the recent data: It is a much better idea to buy the last decades worst performing assets.

Dare to be boring: A superior portfolio must be intrinsically boring.

Focus on long-term risks: Myopic loss aversion makes you focus on the short term risks at the cost of long-term risks. To do this check your portfolio as infrequently as possible. Also hold enough cash to take advantage of market crashes.

There are no great companies: Remember Ben Graham's advice. There are no 'good' or 'bad' companies. At a given price any company can be a 'good' or 'bad' investment. Suggestion is to be overweight on value stocks in your portfolio.

Enjoy the randomness in the market: Market behaves randomly.  Do not look for patterns

Beware of mental accounting: Do not compartmentalize your asset classes, take a portfolio view.

If you are super rich, remember they are out to get you: Go simple, invest in Indexes.

Section 4 of the book consists of Chapters 9, 10 and 11. These chapters cover three businesses that impact an investor's wealth, Brokerages, Mutual Funds and the Press.

Chapter Nine talks about the brokerage business. While the author do not spare any of the three businesses from fleecing an investor, he reserves most of his ire at the brokerage business. To become a broker, you do not need any special qualification. You can become a broker just by passing a simple examination.Brokerages have no fiduciary responsibility towards their clients. This is a business with huge divergence between the interest of the business and the customer. Investor seeks to minimize turnover, fees and commissions and broker wants to maximize all the three. Any dispute between the customer and the broker have to be resolved by the brokers trade association, thereby stacking the deck against the customer. Finally most of the brokerages are full service brokerages who do underwriting, market making, broking, equity research and analysis. In addition to increasing the costs for the ultimate customers, most of the recommendations from them are in favor of companies who are their large customers for business other than broking.

The key lesson from this chapter is that you should not have any links with a full service brokerage business.

Chapter Ten deals with the business of Mutual Fund. Like we discussed earlier, any mutual fund transaction involves four costs vis management costs (expense ratios), transaction costs and taxes, research costs and bid-ask spreads. In addition we also have 'Impact costs'. however the business of mutual fund is less vicious than that of the brokerages. The credit for reducing mutual fund costs go to John Bogle who transformed the business by making the investors the owners of the fund they are investing in. This aligned the interest of everyone involved in the transaction.

Author suggests that load fund and variable annuities (so called pension funds) should be avoided at all costs. Investor should also be aware of the excessive marketing of a single high performing fund  under the company's fund portfolio. This phenomenon known as 'Gunning the fund' could mean that only that specific fund in the portfolio of the company is performing well.

The chapter closes by discussion ETFs. The advantage of ETF is that they are cheaper than an open ended mutual fund since they do not have to services their shareholders. ETF can be tax efficient (since they mirror the index and do not do any transactions) and they are traded through the day. however, like buying a stock, you have to pay spread and a commission. Another concern in this institutional stability. ETF can be a great way of assets allocations that we discussed earlier.

Chapter Eleven is dedicated to the financial press. Simple message of the book is not to read too many finance papers or watch business news channels. Most of them have a symbiotic relationship with Mutual Funds, brokerages and companies that issued the stock and much of their content is sponsored by the businesses. Author suggest to read at the minimum tow books, 'Random walk down the wall street' and Common sense on Mutual Funds'.

If not the press, who should we listen to.? Listen to the market. When you buy the market, you are hiring the aggregate judgment of most brilliant and well informed minds in the market.

Do not sweat. Stay on the index.

There are many more books listed. These are mentioned elsewhere.

The final section of the book, Section Five, covers four chapters. Chapter Twelve tries to answer the question how much should you save. Since the ultimate objective of saving is to spend, the author flips the question around and says that answer to that question will depend on the pattern of your future consumption -when and how you spend your savings, is the single most important factor determining your asset allocation.  on your various investment goals. The goals could be retirement, buying a house, children's education, saving for emergencies. These needs will determine your asset allocation among various asset classes.

Author says that you should track all your investments in a single portfolio.  It will help simplify your financial management and increase your chances of success.

Much of the Chapter is dedicated to Retirement planning. He gives a simple formula to identify how much money you have to save today to ensure smooth retirement. You start by identifying how much 'real' money you want to spend per year. Let us say that you want to spend about 12 Lakhs per year. Keeping the current average tax rate of 33% in India, you must save 12/.67 = 18 Lakhs per year. Assuming a real rate of interest of 4%, you will require about 18/0.04 = 4.5 Crore at retirement. From there you can back calculate on how much money you will need to save per month to meet this target. Please note that long term average real interest rates in India have been about 6.09%, so 4% in our calculation provides sufficient factor of safety.

The state of the market behaves in opposite ways for retirees and young savers. Starting on a weak market is brutal on retirees as a combination of low returns and mandatory withdrawals will devastate their portfolio. On the other hand, a weak market is godsend for young savers since they can get more bang for their buck in such a market.

In summary, to retire comfortably, you have to save a lot and start saving early. Every decade you delay will double the amount you need to save per month to meet the same goals.

For other goals like Emergencies, you should not put money at risk that will be needed within the next five years. This is applicable for your house savings also. Put the money in short term bonds instead of equity.

Chapter Thirteen discusses portfolio allocation between asset classes. Author says that at least 20% of your portfolio should be in bonds with less than 10 years of maturity. Of the remaining, based on the parameters like risk profile, tracking error tolerance, asset class preference and age, one can spread one's investment among Total Market Index Funds, Large growth, Large Value, Small Growth, Small Value (all in domestic market) stocks, foreign market and REITs. Author recommends against investing in Growth stocks due to reasons mentioned earlier.

The author makes an interesting point. If you are working in a company in Cyclical Industry, like Auto, your investment should be in value stocks. If you are working in a 'defensive' industry like health-care or food, you should stock on Value stocks. In summary, do not invest in the company that you work for.

Chapter Fourteen discusses the execution of the portfolio plan. For an experienced investor, author suggests to quickly transition to the target asset allocation, considering the tax impact. Novice should take a more measured approach. One of the best ways to do this is through Value Averaging. In this approach, you plan for a specific portfolio value every month for example. Let us say that you want your portfolio value to be 100 in the first month, 200 in the second month, 300 in the third etc, reaching 1200 by year end. You invest 100 in equity in the first month. In the second month, based on the value of your portfolio, you invest sufficient amount to make your portfolio value as 200. For example, if your portfolio is 120 at the end of first month, invest 80 in the second month. If your portfolio has fallen to 70 in the first month, invest 130 in the second month and so on. While it sounds complicated, it is simple to execute and is better than an SIP.

The final section of the chapter talks about portfolio rebalancing. It is very important to rebalance your portfolio in regular intervals, author suggests every two years, to ensure that you come back to the original asset allocation. In this case you will sell off the winners and buy more of the losers. Buying losers is very difficult emotionally, but that is where discipline matters. When you are rebalancing in retirement the suggestion is to live off stocks in good years and of bonds in bad years.

Author says that most of the investors are capable of investing competently, however they struggle with executing the rebalancing plan. In case you are seeking professional help ensure that the fees are reasonable and the advisor use passive / index fund approach where feasible.

Chapter Fifteen rounds off the lessons of the book. It ends with a powerful and simple message. "With relatively little effort, you can design and assemble an investment portfolio that, because of its wide diversification and minimal expense, will prove superior to most professionally managed portfolios. One just have to stay the course.

That is one heck of an inspiring message.

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