Book Summary of The Intelligent Investor by Benjamin Graham

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.

Dollar-Cost Averaging

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Graham’s advice on selecting individual stocks and bonds is outdated.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.

Mr. Market

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.”

Book Summary of The Essays of Warren Buffett

A collection of Buffett’s yearly reports to Berkshire Hathaway shareholders is available as The Essays of Warren Buffett. In addition to his commercial savvy, Buffett, CEO of Berkshire Hathaway, is renowned for his success across a variety of sectors and his reputation as a teacher.

He views shareholders as partners and uses his annual report to educate them on Berkshire’s operations and his investment decisions. Buffett’s essays provide valuable insights into his investment philosophy and principles, which contrast with typical Wall Street culture. He also sheds light on the ethical landscape of the wider business world. Though his ideas on investing are easy to understand, they are difficult to put into practice.

This guide covers Buffett’s writings on investment practices and the inner workings of high finance. The part on investments looks at Buffett’s suggestions, his critiques of flawed economic theories, and the kinds of investments to steer clear of.

The book illustrates Buffett’s beliefs by contrasting Berkshire Hathaway’s values with the conventional culture and principles of Wall Street corporations. It also presents the ideas of other financial experts, both in agreement with and in opposition to Buffett’s philosophy. The guide places Buffett’s career and essays in their historical context and evaluates how well his ideas hold up in modern investment.

How to Invest

Buffett’s most valuable insights for both casual and professional investors relate to his ideas on the dos and don’ts of the stock market. His fundamental philosophy is that owning a stock means owning a piece of a real-world business. He advises investors to identify and invest in well-run businesses that are undervalued, and to hold onto their stocks indefinitely as long as the business continues to be well-managed and profitable.

This strategy goes against the widely held belief on Wall Street that stock prices and company valuations are generally unrelated. Buffett warns against trading based on the market’s mood swings, instead endorsing long-term investments as the best way to maximize returns. Buffett doesn’t make forecasts, unlike other traders who can foresee the future with accuracy; instead, he concentrates on buying good companies at bargain prices.

Best Practices

Individual investors might benefit from Warren Buffett’s writings, which primarily provide an explanation of his investing approaches for Berkshire Hathaway shareholders. One of his main points is to invest in industries that you understand and have knowledge about, which can give you an advantage in identifying companies with good future prospects. In order to profit from the market’s rising momentum, he also stresses the significance of understanding the value of market volatility and investing in straightforward index funds.

Buffett emphasizes the idea of purchasing stocks as a form of business ownership rather than just a short-term investment, and advises investors to concentrate on businesses that effectively utilize capital to generate consistent profits, particularly in sectors where future prospects are straightforward to predict.Buffett’s strategy is based on “hedgehog thinking,” which entails concentrating on one’s “circle of competence,” or area of expertise, to make wise investment decisions.

The Upside of Volatility

Warren Buffett believes that market volatility is good for investors, as it offers great deals when the market’s behavior is irrational. While high stock prices may be pleasing to owners, investors want stock prices to be low. Buffett recommends investing in industries that you understand, and if you don’t have time or resources for thorough research, he suggests putting your money into a simple S&P index fund.

This way, gains will match the overall market with minimal loss to brokerage trading fees, rather than trying to “beat the market” through day trading or individual stock picking.

Mindful Investing

Benjamin Graham, the mentor of Warren Buffett, distinguishes between thoughtful investors who make rational decisions and speculators who are driven by emotions and irrational optimism. For those who want to make money simply and safely without much effort, low-cost index funds are recommended.

Yet diligent but aggressive investors like Buffett devote their time and efforts to well-researched investments, turning investing into a full-time career. On the other hand, Ramit Sethi recommends starting with retirement accounts, such as your employer’s 401(k), if available, then opening a Roth IRA. Sethi also advises automating payments into your investment accounts, exploring index and mutual funds, and gradually learning about other types of equities.

Economic Nonsense

Buffett’s financial ideas may seem like common sense, but they often contradict the views of many financial professionals. He concedes that there are several topics where his opinions and those of other investors diverge, such as the efficacy of diversified portfolios, efficient market theory, and the importance of financial advisors.

Efficient Market Theory

Deeper study is unimportant according to the Efficient Market Theory (EMT), which contends that because financial markets are naturally intelligent and logical, stock prices always represent the true worth of their respective enterprises. According to Buffett, study into a firm shows its underlying value, and stock swings are generally worthless until they present possibilities.

He finds it frustrating that EMT is still taught in business schools despite being discredited. EMT’s underlying implication that investors are rational actors was challenged by psychologists Daniel Kahneman and Amos Tversky, who proved that humans are fundamentally irrational, undermining much of the economic research of their day.

Diversification

Buffett challenges the idea that diversification of a portfolio protects against risk, which he believes originates from academic models that equate risk with volatility. Instead, he defines risk as the odds of suffering financial harm and recommends investing in a few safe bets such as companies with good management and excellent long-term economics.

Although Berkshire Hathaway’s diversified holdings may appear to contradict this approach, most of its investments are in majority shares in the businesses it owns, committing a significant amount of capital, and Buffett’s personal holdings are not diversified. Nassim Nicholas Taleb, a mathematician, endorses this strategy in his book Skin in the Game, where he makes the case for focused investing rather than diversification.

Financial Advisers

Buffett criticizes the culture of brokers and advisers who create and sell complex financial products, encourage frequent trades, and obfuscate market clarity to convince investors of their need for their services. These professionals skim off the top in the form of service fees and transfer wealth away from investors. Although they claim to outperform the overall market, the vast majority of them fail.

Buffett’s portfolio has outperformed the S&P 500 by 3,000% since transitioning Berkshire Hathaway into a holding company. Brokers and advisers feed off fear and optimism in the market, incentivizing them to recommend more trades and products even when it would be wiser for investors to let their money sit in an index fund with minimal fees. Advisers bear none of the risk as their clients’ fortunes rise or fall.

What to Avoid

Buffett favors equities but discusses other forms of investment and explains why they’re problematic. He advises against investing in ineffective goods like jewelry, collectibles, and gold since they are only worth what others are willing to pay for them. He also cautions against trash bonds, which are issued by failing businesses and carry a significant default risk. Investing in money market funds and bonds may seem safe, but their interest doesn’t keep pace with inflation, causing money invested in them to lose value over time.

Despite diversification minimizing risk, investing in junk bonds is like buying a lot of lottery tickets. Junk bonds exacerbate financial crises, and the market for them was particularly active in the 1980s until a series of defaults in 1989 led to a downturn in the stock market and the bankruptcy of investment firm Drexel Burnham.

Financial Derivatives

Derivatives are complex financial products that are essentially bets on how a portion of the market will behave. They are instruments of pure speculation and their value depends entirely on the financial strength of the parties involved. While both parties to the wager can assert that their derivatives yield genuine earnings up until the derivative actually comes due, Warren Buffett contends that derivatives are tools of deception. Derivative contracts are designed to be so complex that their true risks and false earnings claims are hard for portfolio auditors to spot.

Buffett also emphasizes the importance of avoiding borrowing money to invest, as it can lead to financial ruin. Debt is often sugar-coated as “leverage,” but eventually, all debts come due, and if your investments have dropped in value, you won’t be able to pay off your debts. It is important to be debt-free before investing.

How to Run an Investment Business

In the article, Warren Buffett’s opinions on Berkshire Hathaway’s internal operations are discussed. Buffett thinks Berkshire Hathaway distinguishes itself from other investment firms via openness, sane investing, and delivering wealth for shareholders. Buffett, on the other hand, criticizes the shortcomings of Wall Street’s business practices, including their use of financial derivatives, dubious accounting practices, and expensive acquisitions.

Buffett believes that CEOs lack true accountability, and many are rewarded for mediocrity. By withholding funds from investors, boards and CEOs frequently fudge profit figures, and if the business collapses, they flee with golden parachute payouts. Buffett is particularly skeptical of giving stock options to CEOs as pay since he thinks that doing so is a genuine expenditure that is unrelated to the success of the CEO. Yet CEOs frequently bargain for stock options, which have none of the risk that shareholders have but nonetheless yield the same benefits. Buffett lobbied for a change in accounting rules to list stock options as an expense, but he lost.

The Trouble With Stock Options

Stock options might encourage CEOs to take dangerous actions to increase the value of the stock, even when such actions could cause the stock price to fall and harm shareholders. Notwithstanding this problem, many companies continue to give stock options to CEOs as a strategy to increase remuneration, even when there is no connection between CEO pay and a company’s success.

In a recent study, over 70% of CEO pay comes from stock awards and options, 20% from bonuses, and less than 10% from their actual salary. Yet according to a 2021 Harvard Business Review research, stock options are only useful when CEOs may otherwise misappropriate business resources for their own benefit.

Takeovers, Debt, and Danger

Buffett’s investment strategy involves buying interests in companies he admires, but other corporations often engage in buyouts and takeovers that harm shareholders. CEOs and acquisitions managers often prioritize corporate growth without adding meaningful value, resulting in paying too high a price for another company and issuing new stock, which reduces the value of existing shareholders’ stock.

Instead of issuing new stock, bonds can be used to raise quick capital without impacting stock value, but investors should be cautious of bonds issued by companies in financial trouble. Leveraged buyouts, in which one business borrows money to acquire another, hurt whole industries and jeopardize the livelihoods of workers. Derivatives are used to hedge against debt risk, but they can pose a danger to the larger economy if a wave of defaults occurs, potentially causing the economy to collapse.

The Financial and Social Cost of Leveraged Buyouts

Leveraged buyouts transfer the burden of debt onto the company being bought, not the acquiring company. This means that if the loan defaults, the bought company goes bankrupt, not the buyer. Elon Musk’s purchase of Twitter is an example of this, as he put $33 billion of his own money into the purchase, but Twitter was left with $13 billion in debt.

The potential consequences of Twitter’s insolvency highlight the societal impact of corporate insolvency, as it could affect the information landscape and cost thousands of jobs. This illustrates Buffett’s thesis regarding the risks associated with leveraged buyouts.

The Berkshire Way

The article discusses Warren Buffett’s unique approach to running his holding company, Berkshire Hathaway, and the business philosophies that guide his decisions as CEO. Buffett favors boosting Berkshire Hathaway’s overall value per share over merely the number of its assets, in contrast to typical Wall Street practices. He values transparency and accountability to shareholders, providing them with comprehensive information about the company’s financial and managerial standing.

He thinks that a company with a reasonable price will draw long-term investors who respect and embrace Berkshire Hathaway’s culture. Buffett views his investors as partners and requires board members to own at least $4 million in Berkshire stock outright to avoid conflicts of interest. CEO compensation is judged on performance and real returns generated, not just the company’s stock price.

Growing the Berkshire Family of Businesses

Warren Buffett’s favorite part of his job is acquiring new businesses. In his youth, he looked for mid-range businesses available for cheap, but with Berkshire, he seeks out high-quality companies that he can buy for fair prices. For every opportunity that arises, he compares the potential value of an acquisition to other, more conservative ways to invest.

Buffett doesn’t intervene much with his new businesses’ operations after Berkshire owns a majority share. As long as an acquisition can provide even a small return on investment, Berkshire don’t ever sells it off, understanding that a mid-tier company is still a crucial source of revenue for its employees and their families. Buffett’s investment philosophies dictate that Berkshire never takes on debt to buy new businesses. Instead, it has a ready pool of capital from its numerous subsidiaries available for acquisitions. This owner-centric philosophy, which Buffett claims he deliberately fostered so that it will last long when he is gone, is at the core of Berkshire Hathaway’s culture.