Investing success comes from rational decision-making and emotional control, not exceptional intelligence. A stock represents ownership in a business with fundamental value beyond its price, and you should buy from pessimists and sell to optimists.
Keep a margin of safety to avoid overpaying and incurring losses during downturns. The book covers Graham’s concepts of Mr. Market and Margin of Safety, advising both defensive and aggressive investors on investment principles and market behavior.
Let’s start by defining investment.
Investors vs. Speculators
Investors, according to Graham, are those who analyze investments and prioritize safety of principal and adequate return. Speculators, on the other hand, trade on market movements and ignore fundamental value.
Investors buy when the market is down, while speculators follow popular opinion. Investors use a dependable system for decision-making and prioritize the fundamental value of the stock, while speculators are swayed by emotions and optimistic estimates.
Don’t Believe the Active Trading Hype
Beware of brokerages that push low fees and easy trading. They profit from trades, not your gains, and may lure you into risky speculation. Excessive trading can hurt your returns – a study shows that the busiest traders lagged the market by 6.4% annually, while the least active kept pace.
Defensive vs. Aggressive Investors
Graham classifies intelligent investors into defensive and aggressive types based on their approach to investing. Defensive investors prefer simplicity and aim for average market returns, while aggressive investors seek higher returns through in-depth research.
Both approaches can be successful if aligned with the investor’s temperament and goals, while maintaining emotional control.
The Defensive Investor
Graham advises defensive investors to allocate 50% to stocks and 50% to bonds, with a 75-25 imbalance limit. This balance helps to manage risks and exposure to market conditions. A 100% stock portfolio can be challenging due to high fluctuations.
Graham advises against market timing and recommends dollar-cost averaging for investing lump sums. Splitting the sum into equal investments over time helps avoid emotional attachment to market fluctuations and the false belief in predicting the market.
Low-Cost Index Funds are the Default Option
Graham’s advice on selecting individual stocks and bonds is outdated. Nowadays, low-cost index funds like Vanguard offer easy diversification across assets. Graham eventually recommended index funds as the default choice for most investors, and even Warren Buffett agrees.
Choosing Individual Stocks
To choose your own stocks, Graham advises a defensive investor to look for high-quality companies at reasonable prices and use these seven criteria: size, strong financials, continuous dividends, positive earnings over 10 years, earnings growth of at least 33% in the past 10 years, a P/E ratio no more than 15 times past 3-year earnings, and a price-to-book value ratio no more than 150%.
However, many companies today have more intangible assets, so a higher price-to-book ratio may be acceptable. These criteria are strict and filter out most stocks, but this is intentional as most stocks are not suitable for the defensive investor. For most everyday investors, Graham recommended low-cost index funds.
The Aggressive Investor
Defensive investors seek low-effort results, while aggressive investors aim for high returns via research. But Graham warns against impulsivity, advising methodical valuation, patience, and calmness.
Expectations for the Aggressive Investor
Aggressive investors aim for better returns by methodically valuing potential investments and maintaining level-headedness. Graham advises that an additional 5% annual gain, before taxes, is necessary for the effort to be worthwhile.
However, beating the market is difficult and even most professional money managers cannot do so in the long term, after fees are deducted. Graham suggests aiming for modest and consistent returns instead of stratospheric ones.
Find Bargain Stocks
Graham’s strategy is to buy undervalued companies and purchase a dollar for less than its actual worth. This strategy works because of human psychology, which can cause irrational fluctuations in stock prices. When a company falls out of favor, its stock price drops below its actual value, making it a bargain.
A bargain stock is one that is priced below two-thirds of its value, which can happen when a large company faces a temporary setback or when an entire industry becomes unpopular.
Aggressive Investor Criteria
To filter stocks, start with statistical criteria like the defensive investor. But as an aggressive investor, you can be more flexible with your criteria, such as not requiring a minimum company size. To determine if a stock is a good investment, you must conduct your own analysis. Good and bad stocks don’t exist, only cheap and overpriced ones.
Market Fluctuations and Mr. Market
J.P. Morgan famously said that the market “will fluctuate.” While it’s impossible to predict when and how these fluctuations will occur, there are two important ways to respond to them.
First, prepare yourself mentally for potential declines and avoid emotional reactions. Second, watch patiently for opportunities that arise when the market overreacts to negative news about a company, which can lead to bargain buying opportunities.
You don’t have to trade and sell with the market. Market prices should only serve as indicators for whether a stock is over- or under-priced. Graham’s Mr. Market concept shows that following the whims of other traders is irrational.
You should maintain your rationality and transact only when it’s in your favor, using market prices to your advantage. Don’t blindly follow Mr. Market, but also don’t ignore him entirely. You have no obligation to trade with him.
Margin of Safety
Graham believed in the importance of margin of safety when making investments. This refers to the amount that can go wrong before the investment goes bad. By choosing investments with a larger margin of safety, you increase your chances of success.
For example, Graham’s criteria for interest coverage ratio, price to book value, and asset to liabilities ratio all incorporate margin of safety. A larger margin of safety means you don’t need to predict market downturns or be overly clever to succeed. Warren Buffett summed up the idea of value investing as “if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me.”