“I read the first edition in 1950, when I was nineteen. I thought that it was by far the best book about investing ever written. I still think it is.” – Warren Buffet.
Benjamin Graham’s The Intelligent Investor
There are literally (no pun intended) hundreds of books that have been written about becoming a better investor. This one, The Intelligent Investor, is practically the granddaddy of them all.
First published in 1949, Graham’s book has maintained its prominence. Early on, because it was the first book of its kind to recommend “value investing” and later, because Warren Buffett had endorsed it in flowery and flattering prose.
Well, I’m no Warren Buffett, but here are my thoughts after re-reading the Fourth Revised edition (copyright 1973) of this investment classic.
In an earlier post, I questioned whether one could “play” the market better. Graham established the intellectual framework for critical thinking about investments and recognized the importance of maintaining some emotional discipline, especially when stock prices dropped too low or rose too high, due to either extreme pessimism or optimism.
He took a prudent approach, by clearly distinguishing between investment and speculation. “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
He emphasized the impossibility of knowing what the future holds and mentioned, more than once, the difficulty (some would say impossibility) of achieving higher returns than the average. His answer was to include a healthy amount of bonds in a portfolio, up to what would now be considered an astounding 75%.
Forecasts, Timing the Market and Financial Advisors
In a quote that warms my heart, Graham said, “It is absurd to think that the general public can ever make money out of market forecasts.”
Graham questioned whether or not anything could be accomplished by trying to “time the market.”
It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities. On the whole, it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value.
Most of that quote is dead on, although I disagree with the last phrase, because it can lead to the market timing that he advises against.
In discussing the role of seeking financial advice, Graham was pragmatic about what investors could reasonably expect from their financial advisor, “Perhaps their chief value to their clients lies in shielding them from costly mistakes.”
Although Graham was a visionary and a sage, some of his conclusions are, in my opinion, no longer correct. These will be discussed in future posts.
Please visit Wikipedia for more information on Benjamin Graham’s background and views.
“The key question is what asset allocation allows you to sleep at night.” Burton Malkiel.
An earlier post discussed the controversy related to the new Pension Benefit Guaranty Corporation’s (PBGC) Investment Policy. The relationship between Risk and Return were covered.
Discussing Risk and Return
When working with clients, I have them first complete an online Risk Tolerance Questionnaire, consisting of 25 questions. Their responses to those questions and the final score give me an indication of their experience and preferences in making investing decisions. The feedback from the questionnaire also acts as a basis for discussion of risks and returns and the inherent trade-offs.
Part of the process is to look at past returns for various portfolios. I typically go over returns from 1970 through 2007, because we have good data for various asset classes. I also like to emphasize the 13 “Bear” markets we have experienced since World War II.
What has happened in the past may or may not, necessarily, be indicative of future portfolio returns, so this approach is certainly not perfect. But in my opinion, looking at past performance history is the best we have to go by.
On the other hand, the Pension Benefit Guaranty Corporation’s (PBGC) consultant used estimated future returns to predict portfolio performance. Certainly a lot depends on the assumptions used, and some have rightly questioned those assumptions.
Determining Risk Tolerance
In his book The Only Guide To A Winning Investment Strategy You’ll Ever Need Larry Swedroe spells out the various issues in determining your risk tolerance.
The first step is to determine your willingness to accept risk. Do you have the discipline and courage to stick with an investment strategy when the going gets tough? Swedroe calls this the “stomach acid test.”
For example, suppose you decide on an aggressive portfolio, with a high percentage of stocks. Then a market decline causes your stomach to create excess acid, giving you agita, and causing you to lose sleep. If this chain of events results in your decision to sell your stocks or stock mutual funds, then you’ve overestimated your tolerance for risk.
Swedroe believes investors’ ability to take risk is “determined by three things: The investment horizon, the stability of their earned income, and the need for liquidity.”
The need to take risk is the final factor, “The need to take risk is determined by the rate of return required to achieve the investor’s financial objectives.”
Frankly, this last consideration – the need to take risk – seems to have greatly influenced the PBGC’s revised Investment Policy. They have a huge deficit. While an individual might simply decide to save a bit more or retire a little later, the PBGC’s situation is much more complicated.
Creating an Investment Policy Statement
Education, discussion, and introspection are all critical parts of the consultative process between me and a client. Finally, after much consideration, the client agrees on the basic asset allocation decision of their portfolio — how much should they invest in stocks and how much in fixed income or lower risk investments?
Once that decision is made, their job is over. Then it’s my task to come up with a globally diversified portfolio, representative of their allocation. I then present a “picture” of how this portfolio would have behaved in the past, ensuring that the client is aware that past performance is not an indicator of future performance, and we sign off on the agreement.
The final product is an Investment Policy Statement (IPS) which is a roadmap for the client and me, and which explains the expectations and responsibilities of each party.
Of course, designing the initial portfolio is merely a small part of the process. Asset location, monitoring the portfolio, periodic rebalancing and perhaps tax loss harvesting are other important parts of the process. So is revisiting the IPS when the client’s circumstances or goals change. And ongoing comprehensive financial planning is included for most clients.
Actually, follow-up is one area in which the PBGC has been criticized. In a later post, we’ll discuss the follow-up (or lack thereof) issue, PBGC’s more aggressive Investment Policy and whether this is appropriate for them.
“We have two classes of forecasters: those who don’t know — and those who don’t know they don’t know.” – John Kenneth Galbraith
Politics and the Stock Market
Forget about the issues, the upcoming presidential debates, or even voter turnout. Why even bother to vote, when the stock market can tell us who will win?
An article posted today on the CNBC website, ”Who’s the Next President? The Stock Market Says…” gives us an “analysis” of the upcoming presidential election. The article’s writer bases his analysis on the Stock Trader’s Almanac and Standard & Poor’s, publications that are more commonly used to make predictions and comment on stock market trends. It’s a very entertaining article, but has no informative value in helping you to become a more successful investor. The following quote is very revealing:
“Presidential election years are usually good for stocks, no matter which party wins, while the market’s performance in the three months prior to the November vote is a reliable indicator of which candidate wins.”
Well, so far 2008 has not exactly been a banner year for the stock market, so the first part of that quote has been shot full of holes. But consider this, suppose that you had taken this “prediction” to heart and invested 100% of your capital in stocks in January, instead of following your well thought out investment plan? Where would you be now?
The tail end of that quote tells us who the likely winner will be in the presidential election, depending on whether the stock market is up or down over the next couple of months. This is a very limited view of what economic factors may influence voter behavior — the rate of inflation, the unemployment rate, not to mention the popularity of the present administration, surely all play a part. Certainly using just one indicator – the stock market – is misleading at best.
The article also attempts to give some guidance on how well the stock market will perform, depending on who actually wins in November.
Try to make sense of any of the analysis, if you can, whether you are a short-term trader or a long-term investor. But, please, don’t take anything in this article too seriously. These type of forecasts work, unless they don’t. It is all just “noise.”
And, please, do vote.
“To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading off one goal against another.” – Gregory Mankiw.
A recent New York Times article by Floyd Norris about the Pension Benefit Guaranty Corporation’s (PBGC) revised investment policy goes in depth into a controversy – how can they increase expected returns and at the same time lower risk? The discussion is relevant to individual investors.
The old PBGC policy called for an allocation of 25% in equities and 75% in U.S. Treasury bonds, an allocation typical of an insurance company. The PBGC’s report specifically recognizes that there has been an “opportunity cost” in being too conservative, which is why they have revisited their strategy. Their new allocation will be 45% equities, 45% bonds and 10% “alternative investments” meaning private equity funds and real estate (but not commodity funds or hedge funds). This approach is much more in line with what a typical individual investor or pension plan might use.
The controversy is that they claim that they will both increase expected returns and lower risk at the same time. Some disagree with this assessment and also whether the new approach is appropriate for an entity that insures failed pension plans.
We will cover the controversy in a later post. For now, let’s see how the issues apply to you.
Return and Risk
To earn higher returns, you must take on the risk of ownership of companies and real estate. Safer investments have lower expected returns. The typical tradeoff is between equities (stocks) and fixed income (bonds and cash equivalents). The higher proportion of stocks you have in a portfolio, the higher your expected return. (Note the word expected.)
But the larger percentage of stocks, the more your portfolio will fluctuate. And if we ever have another Great Depression, you can be sure that stocks will have very bad results. So if you want safety, put your money in insured CDs or U.S. Treasury securities. But realize that your returns will be low, possibly negative after taxes and inflation. If you hope to get higher returns than inflation, you have to invest some money in stocks and accept the possibility of being disappointed.
Just as the PBGC did, when deciding on an investment strategy, you must determine how much risk you should take. Considerations include individual circumstances, the willingness, ability, and need to accept short-term fluctuations to achieve better long term results. But what do we mean by risk?
One way investors view risk is the chance they might lose money. This is certainly valid for an individual stock. But what about an entire portfolio?
For a collection of investments, one accepted way to measure risk is the standard deviation of the portfolio. Standard deviation can be thought of as the volatility of a portfolio, how much it fluctuates. In general, a portfolio will fluctuate less if the components do not move together, and therefore risk (as defined) is lower. This is why proper diversification is so important.
Having many Large Cap Growth Stocks will not yield proper diversification, but adding other asset classes that are not correlated with Large Cap Growth Stocks will. Certainly fixed income investments reduce a portfolio’s expected volatility, especially U.S. Treasury bonds or Treasury Inflation-Protected Securities.
Another example is Real Estate Investment Trusts, and some advisors believe commodities offer diversification benefit. Strangely enough, a small amount of Emerging Market stocks could lower portfolio volatility, even though Emerging Market stocks are themselves quite volatile. It all depends on the correlation between an added asset and the existing portfolio.
Another Definition of Risk
Standard deviation is one definition of risk, but there are others. It is not an easy task to capture so much in one concept or number. The world is uncertain and therefore so are future returns of various investments.
Not meeting a goal is another important definition of risk. For the PBGC that means not having enough assets to meet its benefit obligations. For you it might mean not having enough assets to fund your retirement living expenses. Perhaps your individual situation is such that you will have to shoulder risk (short term volatility) in order to have enough money to retire in 20 years. Playing it safe will just not do for you. So as with many financial planning issues, it depends on your individual circumstances.
How this get applied is discussed in the next post.
“If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.” – Benjamin Graham.
“Is this a good time to invest?” Inevitably, whenever I’ve met someone for the first time and she learns that I’m a financial advisor and investment manager that is one of the two questions I am asked. Sometimes, often depending on the state of the economy, that question may be raised even before the “how do you do” pleasantries. And if it’s not that particular question, it’s the other perennial favorite, “What do you think of the market?”
My answer to the first question is, “Yes. It’s always a good time to invest, but it depends.” By that, I mean that I have no way to predict whether the market will go up or down or even sideways in the short term. But, over the long term, I am utterly convinced that investors in the equity or stock market will be well rewarded.
By “it depends” I’m not being obscure or hedging my bets. The fact is, only your individual circumstances can determine whether a long-term investment in the stock market makes sense. Your portfolio makeup should be based on your individual goals, and your willingness, ability, and the degree to which you need to take risk. Entry into the equity market should not be dependent on a prediction of the short-term direction of equity prices.
Predicting Stock Prices
No one can accurately and consistently predict the short term direction of the stock, bond, oil or any other market, for that matter. But that doesn’t stop them from trying to, whether as a professional or merely as a hobbyist. The fact is, being an economist, mutual fund manager, market strategist or stock broker doesn’t confer clairvoyance.
Yet, within almost every issue of The Wall Street Journal, Barron’s, The New York Times or Money Magazine there is at least one article discussing recent stock market occurrences, both good and bad, and why that trend will or won’t continue. Frequently, so-called experts will be called upon for a quote, one from either side of an issue. One will say something like, “The dollar is definitely in a strong upward trend,” while the other remarks, “The dollar’s strength is expected to be short-lived.”
These contradictory opinions make perfect sense. In every transaction, there is always a buyer and a seller. Each market participant believes that his or her decision is the right one. The market sorts out these thousands and thousands of opinions and arrives at a price that reflects the best accumulated knowledge at that time. As facts and factors change, and as opinions change, then stock prices change.
The real question is, “Can anyone predict these changes on a regular basis?” My answer is, “No.”
“Experience is the toughest kind of teacher — it gives you the test first and the lesson afterwords. Perhaps, by learning a bit of history, you can assimilate the lesson vicariously without bearing the costs.” – Burton Malkiel
I’ve been an ardent reader and believer in “How-To” books since, as a teenager, I read The Education of a Poker Player by Herbert Yardley. It was one of the first books published which addressed poker from a mathematical perspective. What an eye-opener, because it proved (to me, at least) that there is a huge difference between a professional with a well thought out strategy and someone who merely played poker by relying on hunches and the appearance of Lady Luck.
About the same time, I also read How to Play Winning Checkers by Millard Hopper. While not exactly an investment book, it was useful nonetheless, especially if you were willing to practice until you had your winning strategy down pat.
Based on personal experience, it is definitely possible to improve your game by reading “How-To” books.
The concept of learning how to win at a game gives rise to these two real world investment questions: Can someone actually “play” the stock market? Is investing just a “game” or is it something else entirely?
My perspective on this goes back decades (all right, a lot of decades) to when in high school, I first started reading books on the basics and fundamentals of finance and investing. I was intrigued enough to include the biographies of several very successful financiers such as J.P. Morgan, Bernard Baruch, the Rothschilds, etc. Of the many books I read on investing, these three titles stood out among the rest:
I had no idea that these books would one day be considered investment classics. At the time, I read them because the titles attracted me. I read them passionately, often nodding my head in agreement, or shaking my head in wonder at the collective brilliance. And after all these many years, they all continue to be available for sale, albeit in new and updated editions.
Now, there may be selective memory at work, but I cannot remember the titles of any of the other books, the ones which, apparently, did not become classics, merely used book store fodder.
How many and which books about investing should you read? Obviously, that depends on what you have already read, where you are starting, and what your investment goals are. For a beginning investor, though, a good book to start with would be Mutual Funds For Dummies by Eric Tyson.
For more advanced investors, there are several books you might consider, which I’ll discuss in future posts. Stay tuned.