• William Bernstein
  • May 25, 2019
    Read, recorded or researched
The title is apt. All new investors should read this book. Written in the wake of the 08/09 crisis, it’s enjoyable to read and drenches theory in real-world practicalities. Bernstein covers all the investment essentials, from equity analysis through portfolio construction to behavioural finance and risk.

The Best Points

The Investor's Manifesto

Chapter 1

  • Throughout history, there’ve been providers and consumers of capital. Capital has taken two forms, broadly, loans (incl. bonds) and equity. Equity has a lower legal standing and so is riskier, meaning it needs a higher expected long-term return to attract investors.
  • During times of social, political and military turbulence, both stock and bond prices fall heavily. Most often, this sets the stage for high future returns. Example of Venetian prestiti bonds. But sometimes the losses can be permanent and total. Example, the Russian stock market prior to WW1 was booming then shut down. So too, Cairo, Bombay, Shanghai. All markets which were once-vigorous but became defunct.

Chapter 2

  • You can only earn higher returns by taking on more risk.
  • To calculate the expected return from bonds, start with the coupon yield and subtract the annual rate of loss resulting from default and bankruptcy (generally around 1-2% for highly rated companies)
  • For equities, use the Gordon growth equation. Add the dividend rate to the growth rate. (Valuations even themselves out)
  • The Gordon growth rate often sends very different signals compared with historical returns. On this point, financial history is very clear, always favour expected returns calculated by the GGM. No matter how long a period historical returns cover.
  • Houses aren’t investments. An investment is the deferral of current consumption for future consumption. A home is money spent today. And history shows house prices don’t rise much, 1% annually maybe. Most people are better off renting.
  • No investor should have an all stock portfolio. For two reasons. First, no one can stomach a 50% fall in their portfolio. Especially those who think they can (think of the difference between crashing a flight simulator and real life. Second, pascal’s wager. The consequence of being all in and having your money wiped away is so much worse than not earning a percent or two more each year because market anarchy never arrived. This is the heart of the investment process: the goal isn’t to further your odds of getting rich, it’s to simultaneously allow for a comfortable retirement and to minimise the odds of dying poor.
  • In the long run, the advantages of the indexed and passive approaches over traditional stock picking are nearly insurmountable. The quip that indexing dooms you to mediocrity is true only if mediocrity is defined as beating 60 to 80% of the competition in the long run. The one legitimate criticism of it is that it’ll never hit a home run. But that’s not the nature of investing. You don’t invest to become rich, you invest to avoid a miserable retirement.
  • Making sure you pay low fees for bonds is paramount. The results are overwhelming that passive > active here.

Chapter 4

  • Our emotions define us as humans but kill us financially. Fear and greed.
  • Man is the primate that tells stories. We’re hardwired to understand events in narrative form.
  • We should estimate future business activities and cash flows, then discount them to find what they’re worth to us today. But we don’t. We get caught in stories.
  • Learn to automatically mistrust simple narrative explanations of complex economic or financial events.
  • Not only do humans like to tell stories, we want to be amused by them.
  • And we react to fear badly, no where worse than investing. Details a study done to compare people who have damaged Amygdalae (fear centre) with normal people. It’s a coin toss experiment, but showed that once normal people lost a round they were far less likely to carry on, even though the risk premium was there and odds in their favour.
  • Because fear arises from our fast moving limbic system, fear is also a short term phenomenon. That’s why we care so much about short term losses. But in the market up and down days are pretty much even. Up months are only slightly more frequent than down months. Only when you look at markets less than once a year are the good times outweigh the bad more than two-to-one (the loss aversion calc.)
  • We’re pattern seeking primates, constantly fooled by randomness.

Chapter 6

  • Building your portfolio. Need to start early. One dollar not saved at 25, is two at 35 and four at 45.
  • In retirement, buy a fixed annuity. Or take 2% of your portfolio to be safe. 5% is big trouble.
  • Value averaging is a great way to save monthly – rather than buy £100 each month if the market falls you buy more to reach your target amount and if rises you don’t need to add as much.
  • Bonds – general rule, “keep it short, and keep it high quality”. The bond portion serves three purposes: an insurance policy, in case of a deflationary or inflationary meltdown; a source of dry powder when equities fall; and to help you sleep at night. Because inflation is the biggest threat to any bond portfolio, strive to keep duration below 5 years
  • Rebalancing – elephant in the room is taxes. Excess returns of rebalancing aren’t big, no bigger than 1% a year, which is much smaller than CGT. So purely from a return perspective you should never sell stocks to rebalance in a taxable account.
  • But every now and again, you’ll need to rebalance to manage risk.
  • Suggestion: rebalance about once every few years. More than once a year is too much. In a taxable portfolio, even less.
  • How can we know that rebalancing is a good thing, in general. Because it can work against you. You have to establish that mean reversion exists, but even that’s difficult to prove. Momentum governs short term, supposedly mean reversion takes place in long term. But quality data only goes back to 1925, so if you want to look at mean reversion over 5 year time horizons, there are only 16 independent periods to assess. It’s not kosher to look at overlapping periods.
  • Problems with threshold rebalancing:
  • Because of the lognormal distribution of asset class returns, a 20% relative rise in price is more likely than a 20% relative fall. In lognormal terms, a 20% rise counterbalances a 16.67% fall.
  • Some asset classes are more volatile than others.
  • Thresholds need to be portfolio specific – i.e if you have stocks and bonds in the portfolio, will need to address these separately.