By Phil Town of Rule One Investing

William Bernstein is the author of several investing books including, “Four Pillars of Investing”, which was originally published in 2002. In the book, Bernstein touches on a lot of investing principles, including Classical Portfolio Theory. Here’s what the book says on the back cover:

Four Pillars Of Investing portfolio theory
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“Since its initial publication, The Four Pillars of Investing has become a staple for the independent-minded investor looking to make better-informed investment decisions. Written by noted financial expert and neurologist William Bernstein, this time-honored investing guide provides the knowledge and tools for achieving long-term profitability. Bernstein bridges the four fundamental topics successful investors use to generate exceptional profits on a consistent basis:

 

  • The Theory of Investing: “Do not expect high returns without risks.” 
  • The History of Investing: “About once every generation, the markets go barking mad. If you are unprepared, you are sure to fail.”
  • The Psychology of Investing: “Identify the era’s conventional wisdom and assume that it is wrong. More often than not, it is.”
  • The Business of Investing: “The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks.”

 

From the essential soundness of classic portfolio theory through the inherent wisdom of investing in multiple asset classes, The Four Pillars of Investing provides a distinctive blend of market history, investing theory, and behavioral finance to help you become a successful, self-sufficient investor.”

Classical portfolio theory is the same as Bernstein’s ‘The Theory of Investing’ – that there is a clear correlation between risk and return.  In other words, if you want a higher return you’re going to have to take more risk to get it.  The problem with this classical portfolio theory is that it isn’t true from two different perspectives.  First, it isn’t true that you have to take a higher risk to get a higher reward.  We see this all of the time in flea markets, used car lots and grocery stores.  People sell things they own for less than those things are worth everywhere in every market and they pay too much in every market as well.  They do so because people are not coldly rational computers but rather emotional herd dwellers who are driven by herd behavior to make irrational decisions in times of stress.

The twin emotions of fear and greed are operating wherever people make a market and, while most of the time people price their goods rationally, they will, when driven by greed or fear, occasionally price their goods emotionally.  The key word is ‘occasionally’, a word that makes it seem that irrational pricing is rare.  It is not.  It happens almost daily in the stock market but not in the entire market.  It happens where the fear or greed is strongest; it happens to the most fearful buyer or seller or the most greedy buyer or seller.  And they make the market price.

For example, the classic pricing error occurs when there is great fear and great greed mixed in the same market.  When the Macondo well blew up in the Gulf of Mexico, the price of the well owner’s stock, BP, went down steadily from $60 to $27.  At that point, the only thing that the buyers and the sellers could agree on is that $27 is the wrong price, not the right one, as it should be according to the tenant of Modern Portfolio Theory (MPT) that says that the price of the stock is the same as the value of the business.  According to MPT $27 is the value of BP (per share).  But the truth of pricing BP in this case is that it is a war between those who believe the company is going bankrupt and, therefore, the value of the stock should be $0 and those who believe the company will recover and the value of the stock should be $60.  While $27 was equilibrium for a couple of days, it didn’t represent agreement in the market.  It represented a truce between two completely opposite and irreconcilable views of the future of BP.

His first pillar contention that classical and modern portfolio theory is correct (that price and value are the same thing and that you must take more risk to get a higher reward) is immediately refuted in his second and third pillars; that the market gets crazy (meaning price and value are NOT the same thing), and that the conventional wisdom is wrong (that you must take more risk to get a higher return – see Pillar #1).

What does this mean for you? It means there are opportunities to get returns in any market, depending on how much research you’re willing to do and the current events taking place. So, don’t be afraid to hope in and do your due diligence to see if a company could potentially be underpriced, then snag it up.
About Phil Town – Phil Town is the founder of Rule One Investing, hedge fund manager, two-time NY Times best-selling author, ex-Grand Canyon river guide and a former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence. You can follow him on Facebook, Twitter, and YouTube.