Benjamin Graham begins chapter one of "Intelligent Investor" by promising to outline the issues to be discussed in the rest of the book. He says he wants to start with his concept of a portfolio policy for non-professional investors (who can be either defensive or aggressive investors).
Once again, he reminds us of the distinction between investment and speculation. The key distinction? An investment involves thorough analysis aimed at preserving principal and generating adequate returns. Without safety and adequate returns, it is a speculative operation. An investor is not simply someone who buys and sells securities, an investor is someone who studies his or her securities and selects them based on a proper plan.
Fun money
Not that Graham is entirely against speculating. He argues it can be fascinating and fun, while you are ahead of the game. And those who want to try it should invest only a small portion (the smaller, the better) of their portfolios, in separate funds.
Keep the speculative factor within minor limits
Graham also wants us to know about the difference between investment and speculation in the case of common stocks. To some extent, he says, some degree of speculation is inherent in any stock purchase.
“In most periods the investor must recognize the existence of a speculative factor in his common-stock holdings," he writes. "It is his task to keep this component within minor limits, and to be prepared financially and psychologically for adverse results that may be of short or long duration.”
Why? There are “substantial” possibilities for both profit and loss, and someone must assume the risk. Investors should recognize there is intelligent speculation as well as intelligent investing.
Defensive investors
Graham then spends some time discussing what returns an intelligent defensive investor might expect in the mid-1970s. When he published this final edition in 1973, both bonds and common stocks offered reasonable returns, and he reviews portfolio allocation in such an environment. He concludes a simple 50-50 split between bonds and stocks as a starting point. Beyond that, he believes that either one might represent between 25% and 50% of a portfolio. 2018 readers are welcome to scratch their heads about the future of bond-stock allocations.
Defensive stocks
As to which stocks should go into a defensive investor’s stock allocation, Graham says he has no particular favorites. He also does not expect stock selection by defensive investors to make a material difference, saying, “we are skeptical of the ability of defensive investors generally to get better than average results”. Further, he notes he is also skeptical of the efforts of experts who manage large funds.
Still, defensive investors should avoid new offerings and “hot” issues, the types of investments associated with quick profits. So the defensive investor must focus on “the shares of important companies with a long record of profitable operations and in strong financial condition.”
To this he adds supplementary concepts for defensive investors: shares of well-established investment funds; common trust funds/commingled funds and dollar-cost averaging. The latter recommendation was also mentioned in the introduction, where readers were warned dollar-cost averaging was no guarantee of future wealth. The difference, it appears, is between the mindless application of a formula without a plan and that done within the context of a well developed investment plan.
Aggressive investors
Graham now turns his attention to the aggressive investor, someone who expects to earn better results than defensive investors. The key for this group, he says, is in starting with a clear conception about the courses of action that could lead to success and those that would not.
Three courses which are not likely to lead to success are trading in the market, short-term selectivity and long-term selectivity. He defines short-term selectivity as buying stock when a favorable event is expected, such as an upcoming report with increased earnings. Long-term selectivity refers to companies that are expected to generate high earnings power at some time in the future (this includes drug, computer and electronics companies developing new processes or products).
Developing these points further, Graham warns aggressive investors about short-term and long-term opportunities by pointing to human fallibility and the nature of investing competition.
Aggressive investor policies
Thus, Graham comes to this conclusion: “To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.”
What are such sound and promising policies? He gives us a few possibilities:
- Speculative stock movements: prices swing like a pendulum, and often swing too far in either direction.
- Stocks may be undervalued because the market's lack of interest or some irrational sentiment.
- The misadventures of other investors, “We can go further and assert that in an astonishingly large proportion of the trading in common stocks, those engaged therein don’t appear to know—in polite terms—one part of their anatomy from another.”
- Special situations, which may appear promising, but big problems may well lie in the shadows.
- Bargain issues: securities selling for less than their net current assets. Graham says a “good part” of his operations have focused on this area of opportunity. However, during his time in the market, bargain issues could not always be found.
Commentary
In his commentary on chapter one, Jason Zweig doubles down on Graham's distinction between investing and speculating. He calls investing a “unique kind of casino,” one in which you will not lose in the end as long as you stick by the rules that put the odds in your favor. He writes, “People who invest make money for themselves; people who speculate make money for their brokers.”
A word of warning for anyone who believes Graham may be too cautious: it comes from Zweig's commentary to Graham's introduction. Hedge fund manager and broadcast personality Jim Cramer said in February 2000 that internet stocks “are the only ones worth owning right now.” Cramer predicted they would consistently go up in good and bad times. And he took a swipe at Graham for added emphasis, “You have to throw out all of the matrices and formulas and texts that existed before the Web…. If we used any of what Graham and Dodd teach us, we wouldn’t have a dime under management.” A bold claim--and a costly one, too; by the end of 2002, a portfolio spread equally across Cramer's picks would be worth 94% less. A $10,000 “investment” would be worth just $597.44 almost three years later.
A couple of personal takes from chapter one:
- Again, the reader gets occasional thoughts about buying stocks, but most frequently Graham is laying a foundation for an intelligent investment policy. To start that process, he must emphasize the difference between investing and speculating. To some, that might be too much emphasis, but Graham would no doubt insist it is so often forgotten or rationalized away that he must keep making the case (see the Cramer quotes above).
- Remember Graham’s definitions: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
- There is also the continuing distinction between defensive and aggressive (enterprising) investors. As readers, we need to figure out where, on an imaginary spectrum, we roost. There is one way ahead for defensive investors, and another way for aggressive investors (but no way for speculators).
- A brief but meaningful reference to “bargain issues,” a strategy now at the heart of modern (to us) value investing.
Although this is only chapter one of 20, following the advice in just this chapter could well improve the returns of almost any investor.
(This review is based on the 1973 revised edition of “The Intelligent Investor”; republished in 2003 with commentary by Jason Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series (beginning with 'The Intelligent Investor: A Guide for Beginners), as well as other articles about Graham, go here.)
