“The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between” by William Bernstein

In a nutshell

Must read book for investors; Bernstein calls it the way he sees it. He starts off with the observation that only a very small minority of investors will succeed at managing their own investments (this by the way makes me wonder why am I authoring a website of DIY investors?) because they lack the four essential requirements for success: interest, mathematical inclination, understanding of financial history and emotional discipline to execute strategy. Nevertheless, he then proceeds to fill his short (<200 page) book with valuable advice. It’s an easy read, which could pay you a lifetime of dividends; it might even help save you from eating cat food in retirement.

The book is full of gems:

-history of investment: loan capital (with gradually decreasing return over time), equity/stock capital (higher risk and therefore usually carries a risk premium), capital markets (allowing trading of financial assets); history teaches that risk and return are intertwined, only long term returns (>10 years) matter, and historical returns are not suitable for future planning

-investment is defined as deferral of current consumption in favor of future consumption

-U.S. economy historically grew at 3%/year, corporate profits also grew at 3%/year however dividends grew at 1.36%/year

-Expected return (equity) =  Dividend Yield + dividend growth rate (r= D/P + g); actually the return needs to also factor in changes in valuation, Real Return= Yield + real growth rate +annual change in valuation.

-a home is not an investment but a form of consumption; real prices have typically been constant or at most grew at 0.5-1.0%/year max. To do a thorough analysis of house buying you need to factor in imputed rent (dividend on the house, 5% in his example), reduced by taxes, maintenance and insurance (Bernstein uses 3% for these expenses, could be much higher at times) leaving 2% after tax return; then compare to long term return from other assets. His rule of thumb for buy vs. rent is 150 x monthly rental value and he says never to pay for house more than 15 years of rent (180x monthly rental value). And vacation home makes no economic sense at all according his calculations, so rent instead.

-portfolio withdrawal rate rules of thumb during retirement: 2% survives all but catastrophe, 3% probably safe, 4% taking a real chance, and if you need >5% consider annuitizing. (He doesn’t say but I suspect he means these numbers to refer to inflation adjusted withdrawals from original value of the portfolio.)

-only Vanguard, created by John Bogle, has the most investor friendly ownership structure in that it is owned by its customers; Vanguard is also the one that was the creator of low cost index funds. (Private ownership is worse and the worst is public ownership)

-costs associated with investing (the headwinds that must be overcome) are: management expense ratio + commissions + bid/ask spread + impact cost (price impact of a large fund buying large quantities of a stock) + taxes (on capital gains, interest, and dividends)

-asset allocation is a two step process: first the overall stock (vs. bond) allocation, and second the allocation among the stock asset classes; asset location is also an important consideration: for all tax-sheltered portfolios any asset class OK, for all taxable accounts, municipals are preferred on bond side and domestic and large foreign stocks for the stock allocation

-stocks are not safer over the long run, however young investors should own more stock since they can apply their regular savings in depressed markets; also for the young the bond-like human capital (HC) is much greater than financial capital (FC), whereas for the retired crowd HC=0 thus can’t buy cheap stock.

-his risk tolerance definition in its simplest form, based on how you behaved the last two years is: low, moderate, high and very high depending on whether you sold, held steady, bought more or bought more and hoped for even lower prices to buy even more during the recent crisis.

-on stock allocation  he starts with (100- age) % for average risk tolerance and then adjusts it +/-10-20% for  higher and lower risk tolerant individuals.

-within the stock asset class, start with the FTSE (market cap weighted) All World Index (e.g. Vanguard’s implementation), but it is better to adjust (for Americans) for lower foreign allocation (30% of equity) due to: currency risk (if living in the US you are spending US$), foreign stocks more expensive/riskier, it is cheaper to buy components separately. Additional refinements discussed are due to the extra historical return from value and small cap stocks (1-2%) and separation of foreign content in developed and emerging markets.

-he keeps emphasizing that “portfolio is the thing” and rebalancing (every 2-3 years or so) is essential (if not for return enhancement, then for risk control).

-he has an excellent chapter on behavioral finance, explaining  how our behavior is our worst enemy and how reflection takes time and effort, whereas reflexion (action driven by our base instincts) is automatic and choosing the latter costs us dearly.

-“Muggers and worse” is one of the chapters I enjoyed the most; he calls them the way he sees them: “the prudent investor treats almost the entirety of the financial industrial landscape as an urban combat zone”. He argues that a combination of incompetence, motivation to make money and “agency conflict” are at the root of the raw deal that investors get from the industry. A key reason why the public is not as well protected when doing business with the brokerage industry as when we go to a doctor, lawyer or accountant is because brokers are not fiduciaries like other professionals. Bernstein says that you’ll do fine if you “act on the assumption that every broker, insurance salesman, mutual fund sales person and financial advisor is a hardened criminal”.

-explains the difference between “indexed” (tracking a public index) and “passively managed” fund (a private index as DFA which also is focused more on value and small cap stocks)

-savings rate if you start at age 25 should be 10% a year, but if you start at 45 it is almost 50%!

-explains difference between Dollar Cost Averaging (investing the same amount per period into an asset class each month) and Value Averaging (specified target amount at specified times in the future allocated to each asset class)

-Variable Annuities (e.g. GMWBs) come wrapped in enormous fees and are offered by insurance companies that as a group constitute the worst players in the financial business” (how is that for an endorsement of the insurance industry). To top it all off, the recent problems of insurance companies put in question their ability to survive the required 20-50 years that typically are the horizon for their products. If you have to annuitize, you should delay as late as possible (insurance company survival is lesser issue, perhaps eventually government will guarantee annuities or even sell an actuarially fair annuity- now that’s an annuity that I would consider!)

-the best annuity is Social Security, especially if you can wait until 70 to start receiving it!

-Bernstein finishes off with a lament for the “traditional (DB) pension” which provided secure income (not in Canada, but at least in the U.S. and U.K. where government guarantees about the first $55K of annual private sector pension) and a dignified retirement” which has been replaced by “investment mess pottage: poorly designed, overly expensive, miserably performing DC plans…the nation is only slowly waking up to the enormity of the situation.