My notes from reading The Intelligent Investor, ‘the definitive book on value investing,’ written by Benjamin Graham, commentary by Jason Zweig.
I don’t know about anyone else, but I find that if I read a non-fiction book, I end up forgetting most of it pretty quickly. This trait is not ideal when one’s job involves reading the latest scientific literature in order to come up with new ideas and advances! However, I’ve found that, if I make notes as I go along, my attention and memory are both vastly improved. In fact, I don’t even necessarily always need to reread the notes; the very act of writing helps to imprint it into my memory.
So, I thought I’d give it a go with this book. And now that I’ve finished it and am looking over my notes, I thought why not tidy it up and stick it on the blog. It further helps me (ensuring that my notes are intelligible for when I come back to look at them several months/years later) and it might interest some readers.
The Intelligent Investor
The Intelligent Investor, written by Benjamin Graham, has been praised by Warren Buffet himself as the best book about investing ever written. It was first published in 1949, and has been revised by Graham several times since; the fourth version was published in 1973 with a preface and appendices by Warren Buffet. The latest revision, with commentaries and new footnotes added by Jason Zweig, was published in 2003, and it is this version that I picked up.
In Jason Zweig’s own words, “The Intelligent Investor is the first book ever to describe, for individual investors, the emotional framework and analytical tools that are essential to financial success.”
One quote that I liked at the beginning of the book was that Ben hoped to do “something foolish, something creative and something generous” every day. Words to live by!
What, according to Graham, makes an intelligent investor?
Being patient, disciplined and eager to learn. Being able to harness your emotions and think for yourself.
Graham’s core investing principles:
- A stock is an ownership interest in an actual business, with an underlying value that does not depend on its share price.
- The market is a pendulum, swinging from too optimistic (making stocks too expensive) to too pessimistic (making them too cheap).
- The higher the price you pay, the lower your return will be.
- There’s always the risk of being wrong. So don’t pay too much (margin of safety) to minimise the amount that you lose.
- How your investments behave is much less important than how you behave.
Two important things to bear in mind:
- Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
- The experts do not have dependable ways of selecting the most promising companies in the most promising industries.
A creditable (though unspectacular) result can be achieved by the lay investor with minimum effort and capability. However, improving on this return is extremely difficult. You would think that it’s easy to “beat the average” but the number of people who manage it is surprisingly small.
‘The intelligent investor realises that stocks become more risky as their price rises, and less risky as their prices fall.’ (Obviously a bit of an exaggeration, but is another take on something that Graham frequently comes back to – don’t overpay for stocks).
Investment vs speculation
“An investment operation is one which, upon thorough analysis promises safety of principal and adequate return. Operations not meeting these requirements are speculative.”
“There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: 1) speculating when you think you are investing; 2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill; and 3) risking more money in speculation than you can afford to lose”
“Never mingle your speculative and investment operations in the same account, nor in any part of your thinking”
Investors judge the market price by established standards of value, while speculators base their standards of value upon the market price. Invest in a stock only if you would be comfortable owning it if you had no way of knowing its daily share price.
“Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars’ worth of groceries. Today, a five-year-old can do it.” – Henry Youngman
Inflation erodes purchasing power over time.
The stock market has done poorly when inflation has risen roughly 50% of the time (it lost money in 8 out of 14 years when inflation rose above 6%).
Branch out beyond stocks to hedge against inflation:
- REITs – Real Estate Investment Trusts
- TIPS – Treasury Inflation Protected Securities (US gov bonds)
Stock market prices
Stock market performance depends on three factors:
- Real growth (the rise of the companies’ earnings and dividends)
- Inflationary growth (general rise in prices)
- Speculative growth or decline (change in the public’s appetite for stocks)
In the long run, you can reasonably expect stocks to average roughly a 6% return, (or 4% after inflation). Calculated by:
1.5 to 2 % (yearly growth in corporate earnings per share)
+ 2.4% (inflation)
+ 1.9% (dividend yield on stocks)
= 5.8 to 6.3%
This can be driven temporarily higher (or lower) by a greedy (or fearful) stock-buying public.
No more than 75% and no less than 25% stocks, with a consequent inverse of bonds.
More stocks when they are cheap, less stocks when they are expensive.
Are you a defensive or an enterprising investor?
- Defensive/passive – chief emphasis on avoidance of serious loss. Also has freedom from effort and the need to make frequent decisions.
- Enterprising/aggressive – willing to devote time and care to the selection of securities that are both sound and better than average.
Common saying is that rate of return is dependent on the degree of risk that an investor is willing to deal with. Not so, says Graham. It is dependent on the amount of intelligent effort the investor is willing and able to put in.
Minimum return goes to the passive investor. Maximum return to the alert and enterprising investor.
Have a fixed ratio of stocks vs bonds, and then rebalance every 6 months. Will help to avoid buying high and selling low.
Consider a 50:50 ratio – A truly conservative investor will be satisfied with the gains on half their portfolio in a rising market, and may derive solace in a severe decline from how much better off they are than their more adventuresome friends.
The active approach is intellectually and physically demanding, the passive one is emotionally so (need to hold your nerve during a crash / bear market).
Graham avoids the rule of thumb that says that you should have 100 minus your age in stocks (‘what if you are 80 but intending to pass it all on to your offspring? What if you are 20 and want to buy a house?’)
Only change your allocation as your life circumstances change. Don’t buy more stocks because the market has gone up, or sell because it’s gone down. This approach replaces guesswork with discipline.
Stock picking rules:
- Adequate, but not excessive, diversification. Min 10, max 30, companies.
- Each company should be large, prominent and conservatively financed.
- A long record of dividend payments.
- Impose a limit on the price you are willing to pay in relation to its average earnings over the past seven years.
Zweig say that an index portfolio can require virtually no monitoring or maintenance whatsoever. They are a defensive investors dream come true. (This is good, because this is exactly what I’ve done!)
Avoid junk bonds, foreign bonds, IPOs, day trading.
- in low markets and sell in high markets.
- growth stocks.
- bargain issues e.g. a large company that is currently unpopular.
- ‘special situations.’
The choice is between being a defensive/passive or enterprising/active investor. There is no intermediate.
Aggressive investor requires considerable knowledge of security values – it will essentially be a business enterprise.
The majority should adopt the defensive approach. They will not have the time, determination or intelligence required.
The investor will be prepared for them financially and psychologically. But do not become a speculator.
Two ways to deal with them
- Timing – anticipating the action of the market.
- Pricing – buy stocks when they are below ‘fair value’ and sell when the price is above.
Graham states that if the investor places his emphasis on timing, he is likely to end up a speculator, and with a speculator’s financial results.
The true investor should never be forced to sell their shares, and is free to disregard the current price quotation of the market.
Imagine you own a share of a business, costing you £1000. One of your partners, named Mr Market tells you every day what he thinks your interest is worth. Would a prudent investor let Mr Market determine what value they perceive the business to be? Only if you wish to buy or sell at that price. Otherwise, better to form your own opinion on the value of your holding, based on full reports from the company.
The most realistic distinction between the investor and the speculator is found in their attitude towards stock market movements:
- Speculator – primary interest lies in anticipating and profiting from market fluctuations.
- Investor – primary interest lies in acquiring and holding suitable securities and suitable prices.
If you have a portfolio of sound stocks, you should expect the price to fluctuate, and should not be concerned by large declines or excited by large increases. Never buy a stock because it has gone up, and never sell because it has gone down.
Ultimately, you cannot control the market. Focus on what you can control:
- Brokerage costs – trade rarely, patiently and cheaply
- Ownership costs – minimise annual expenses
- Your expectations – don’t forecast wild returns
- Your risk – diversify, rebalance
- Tax – use tax shelters, lower capital gains tax liability
- Your own behaviour
Ignore financial TV, market columnists, etc. Investing is not about beating others at their game, but about controlling yourself at your game, and preventing yourself from becoming your own worst enemy.
Psychologists Daniel Kahneman and Amos Tversky have shown that the pain of financial loss is more than twice as intense as the pleasure of an equivalent gain.
An option for the defensive investor as a cost-effective way to diversify a portfolio with minimal effort.
Don’t expect market-beating results. The average fund does not pick stocks well enough to overcome the costs of researching and trading them. High returns may indicate speculative or even fraudulent behaviour. Speculation is no better than gambling. Be wary of high fees, excessive trading, and volatility. Past performance is not an indicator of future success – high past returns are unlikely to continue.
May help the investor to avoid making any mistakes. Very unlikely to help the investor beat the average market performance.
Nick Murray – ‘you hire a financial adviser, not to manage money, but to manage you’.
A financial adviser is a line of defence between you and your worst impulses. They should have systems in place that will help you control them:
- A comprehensive financial plan – how will you earn, save, spend, borrow and invest.
- An investment policy statement – your fundamental approach to investing.
- An asset allocation plan.
These financial building blocks should be created mutually.
The chief criterion for corporate bonds is the number of times that total interest charges have been covered by available earnings for some years (at least seven) in the past.
Bonds and interest rates are inversely dependent on each other – if interest rate rises, bond prices fall, although a short-term bond falls less than a long-term. On the other hand, if interest rate falls, bond prices rise. And a long-term bond outperforms a shorter one. Can split the difference by buying intermediate bonds maturing in 5-10 years.
Five key elements to consider:
- The company’s general long-term prospects
- The quality of its management
- Its financial strength and capital structure
- The dividend record.
- Its current dividend rate.
When you buy a stock, you become an owner of that company.
Margin of safety
The margin of safety is the ‘secret of sound investment.’
- Don’t pay too much for an investment.
- Diversify. You might pick the next Microsoft… Or you might pick the next Enron. Better safe than sorry!
- Watch your behaviour.
The investor’s worst enemy is likely to be himself. More money has been made and kept by ‘ordinary people’ who were temperamentally well suited for investing than by those who lacked this quality, even though they had extensive knowledge of finance, accounting, etc.
Treat investing as a business:
- Know what you’re doing
- Don’t let anyone else run your business, unless you can supervise them or you trust them implicitly.
- Don’t invest unless it has a fair chance to yield a reasonable profit
- Have faith in your knowledge and experience
To achieve satisfactory investment result is easier than most people realise; to achieve superior results is harder than it looks.
My main takeaways
Honestly, active investing sounds like hard work! I’m definitely a defensive investor – all of my investments are in passive global index trackers. I can see eventually allowing myself to use up to 10% of my investments to dabble in some stock picking, but the vast majority will stay in index trackers.
Based on Graham’s stock/bond ratio rule-of-thumb, I’m thinking about adding in some bonds (probably either a global bond index fund, hedged to GBP, or just equal parts UK and US bonds) so I can re-balance in future crashes, but I may also just leave continue to invest in 100% equities for now.
Behaviour is frequently mentioned throughout the book. If you can manage your own behaviour, then you should be set.
My opinion on the book
This is an thought-provoking read, but not for the beginner! I think I’d sooner recommend ‘Investing Demystified‘ by Lars Kroijer for the beginner, and reserve this for someone who is keen to learn more.
Sometimes, the book shows its age. Graham references companies that I’ve never heard of, situations that occurred almost a century ago, and sometimes speaks in a very academic style. Thankfully, Jason Zweig does a fantastic job in his commentaries to summarise the preceding chapter and update it for the modern audience.
It is very interesting to see that advice from the 40’s still holds up today. Although a lot of the information contained within is now very well known, it’s fascinating to think that this was probably ground breaking when it first came out.
Overall, if you’re the type of person who enjoys reading money/FIRE/investing blogs, or someone who wants to try more than ‘just’ index investing, then this is a worthwhile read.
Over to you
Hopefully some readers have found this useful, and perhaps are inspired to give it a read themselves.
Are there any other finance / investing books that you might recommend? (For what it’s worth, I have read Smarter Investing, The Richest Man in Babylon, Investing Demystified, Reset, and The Millionaire Next Door).
As always, thanks for reading.