Investment versus Speculation – The Intelligent Investor: Chapter 1

Results to Be expected by the Intelligent Investor

Summary

Investment: through thorough analysis promises safety of principle and an adequate return.

Anything else is speculation. The word investor is misused often when actually describing speculators. Risks are inherent and inseparable from profit opportunities and must be allowed for when making investment decisions. There is always a speculative factor in stock investing. The important task for an intelligent investor is to keep that speculative factor at a minimum and to be prepared, financially as well as psychologically, for negative results in the short and long term. Speculation can be done intelligently but, often it is not. There are three main signs of unintelligent speculating:

1. You believe you are investing when you are really speculating
2. Serious speculation instead of as a fun pastime when you lack proper knowledge and skill
3. Risking more money than you can afford to lose

Trading on margin is, by definition, speculating. Following the latest hot stock pick is speculating. If you must speculate, allocate a very small portion of your money for this purpose. Do not continue to add to these funds and do not mix these funds in your real investment portfolio.

The future of security prices is never predictable.

Results to be Expected by the Defensive Investor

The basic compromise policy for the defensive investor is to have a significant portion of investment funds in stocks and bonds. The simplest choice in allocating assets is a 50-50 proportion between stocks and bonds. The allocation can be adjusted but bond allocation should never be less than 25% or greater than 75%. In 1972, Graham states that the defensive investor should be able to rely on a 3.5% dividend return on stocks and an average annual appreciation of about 4% for a combined return of 7.5%. This is an example of the “Gordon equation” which says that the stock market’s future return is the sum of the current dividend yield and the expected earnings growth.

Remember, the defensive investor cannot hope for better than average results. The defensive investor cannot expect to beat the market.
Results to be Expected by the Enterprising Investor

Being an enterprising or aggressive investor does not imply stock trading. Trading does not fit the definition of an Investment as seen above. In order to have a chance to experience better than average results, the enterprising investor must follow policies that are

1. sound and promising
2. unpopular on Wall Street

Market prices do not always reflect the true value of a stock and therefore, the enterprising investor does have opportunities to purchase undervalued securities that will lead to better than average returns.

Commentary by Zweig

3 elements to Investing

1. Analyze and understand a company and the soundness of its business before buying its stock
2. Deliberately protect yourself against losses
3. Aspire to adequate, not extraordinary, performance

An investor calculates what a stock is worth based on the value of its business. Only invest if you are comfortable owning a stock if you have no way to know its daily market price.

In investing, you cannot lose in the end as long as you play by the rules. Investors make money for themselves while speculators make money for their brokers. 10% of your overall wealth is the absolute maximum amount to be used in speculation.

Introduction: What This Book Expects to Accomplish – The Intelligent Investor

Summary

Graham begins by stating the purpose of this book: to provide guidance in terms of solid principles and attitudes in investing. The focus of the book is not security analysis. He stresses that much attention will be paid to the history of financial markets as an intelligent investor needs to know how stocks and bonds have behaved in the past. Some of those conditions are bound to repeat themselves and an investor who is equipped with this historical knowledge will have an advantage.

“Those who do not remember the past are condemned to repeat it” – Santayana

Graham also intends to emphasize the difference between an investor and a speculator. He touches on the fact that many speculators are traders and use a technical approach (i.e. charts) to determine when to buy and sell. He points out that buying when the market is going up and selling when it goes down is a fundamental mistake. Using sound business principles, the idea is to buy low and sell high. You cannot make money following the market.

Regardless of the current market conditions, investors must be prepared to experience significant losses (as well as rises) in their portfolio. Graham notes that he historically recommends at least 25% of an investor’s portfolio be in equities. He leans more towards a 50-50 split between stocks and bonds.

Graham explains the two types of investors he is going to covering in this book.

1. Defensive Investor
   • Avoids serious mistakes and losses
   • Has more freedom from effort, annoyance, and decision making
2. Enterprising Investor
   • Devotes time and care to the selection of investments that are fundamentally sound and more likely to generate better returns

Graham points out two fundamental principles an intelligent investor must be aware of:

1. Obvious prospects for growth does not necessarily mean obvious profits for investors
2. There is no thoroughly dependable way to select the most promising companies in the most promising industries

Intelligent investors should develop a habit of quantifying the price of an investment and to be able to distinguish if it is cheap enough to buy or expensive enough to sell. One of requirement he recommends is that investors limit themselves to securities that are not priced above their tangible-asset value. While there are some opportunities in growth stocks that trade well above this value, they are very sensitive to market fluctuations.

Graham finishes the introduction by reiterating that investing is hard work. By bringing just a little extra knowledge may cause you to perform under the market. Even the so-called expert fund managers have extreme difficulties in beating the market. The key is to build a simple and diversified portfolio that does not require expert assistance and based on the margin-of-safety principle.

“There are no sure and easy paths to riches on Wall Street or anywhere else”. – Graham, from the Introduction

Commentary by Zweig

This book will not teach you how to beat the market. Instead it will teach you:

1. How you can minimize unrecoverable losses
2. How you can maximize gains
3. How you can control the self-defeating behavior that ruins most investors

Once you lose 95% of your money, you have to gain 1900% just to get back where you started. How often can you buy a stock at $30 and sell at $600?

Intelligent investing requires patience, discipline, and an eagerness to learn. You must be able to control your emotions and think independently. Intelligent investing owes more to character than brain power.

The most significant losses in investing come when the buyer forgot to ask the important question: how much?

Stocks become more risky as their prices rise and vice versa. An intelligent investor dreads a bull market and welcomes a bear market because that is when stocks are on sale.

Other Notes

Dollar-Cost Averaging: regular monthly purchases of stock regardless of the market conditions

The Intelligent Investor by Benjamin Graham

The Intelligent Investor is considered the seminal work on value investing. Benjamin Graham was a Wall Street mastermind, professor at Columbia, and teacher and mentor to the Oracle of Omaha Warren Buffett.

Graham released several editions of this book with the last published in 1973. I am reading a revised edition of the 1973 version with commentaries on every chapter by Jason Zweig. I believe this is a useful and welcome addition to the book as, obviously, a lot has happened in the markets since ‘73.

Warren Buffett says of The Intelligent Investor: “By far the best book on investing ever written”. Enough said.

 

Contents

• Introduction: What This Book Expects to Accomplish

1. Investment versus Speculation: Results to be Expected by the Intelligent Investor
2. The Investor and Inflation
3. A Century of Stock Market History: The Level of Stock Market Prices in Early 1972
4. General Portfolio Policy: The Defensive Investor
5. The Defensive Investor and Common Stocks
6. Portfolio Policy for the Enterprising Investor: Negative Approach
7. Portfolio Policy for the Enterprising Investor: The Positive Side
8. The Investor and Market Fluctuations
9. Investing in Investment Funds
10. The Investor and His Advisers
11. Security Analysis for the Lay Investor: General Approach
12. Things to Consider About Per-Share Earnings
13. A Comparison of Four Listed Companies
14. Stock Selection for the Defensive Investor
15. Stock Selection for the Enterprising Investor
16. Convertible Issues and Warrants
17. Four Extremely Instructive Case Histories
18. A Comparison of Eight Pairs of Companies
19. Shareholders and Managements: Dividend Policy
20. “Margin of Safety” as the Central Concept of Investment