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The Intelligent Investor

Guide to Investing
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"I took the one less traveled by,
And that has made all the difference." -Robert Frost

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Benjamin Begins...

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Graham's book, "The Intelligent Investor: The Definitive Book On Value Investing," widely acclaimed book on investing. Are you an intelligent investor?

1: The Investor and Inflation

For those of you who aren't aware of this book, look through amazon.com and search this book up. It's your first step towards investing more intelligently. The principles Benjamin Graham uses in his practices, and explains in his book, is a substantial part of Warren Buffet's investment strategies. Buffet in fact worked under Graham. In the book, Graham's main objective is to describe the 'emotional framework & analytical tools' required for financial success in investing. He makes it very clear that it's not a "How to Earn a Million Dollars" book and any get-rich books that claims they know the secret formula to earning easy money is just b/s as most of us know. Now let's get to it.

"Those who do not remember the past are condemned to repeat it" - Santayana

We need to look over historical patterns of financial markets to invest intelligently. It let's us know how various types of bonds and stocks have behaved under varying conditions.

There are no sure and easy paths to riches. Raskob, chairman of GM, claimed an investment of $3,600 could amount to $80,000 if invested in good common stocks. Truth be told, calculations of actual earning made in the Dow Jones Industrial Average would have given less that $9,000. (http://www.efficientfrontier.com/ef/197/raskob.htm).

"Technical approaches" where you look at charts and other mechanical means to determine when the best time is to sell or buy is utter fallacy. Shares go up, let's buy, plummets, quickly get rid of it. Sound business principles tell to act otherwise, so should investors. (http://viking.som.yale.edu/will/dow/dowpage.html)

Obvious growth in physical business does not translate into obvious profit for investors.

One example is the airline industry. It was easy to forecast that the volume of air traffic would increase enourmously. Despite expansions in revenue, a combination of technological problems and overexpansion of capacity made for disastrous profit figues in 1945, 1961 and 1970 (of some $200m).

The investor's worst enemy is himself.

Employ the habit of always asking, "How much?"

Value shares not too far above their tangible-asset value. (Tangible being anything that can be touched) Anything far above would be too dependent on fluctuations.

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2: The Investor and Inflation

Inflation has greatly influenced thinking on Wall Street. People on fixed income are clearly disadvantaged as purchasing power decreases with increasing costs. Holders of stocks therefore have a good incentive to keep their shares as the price of shares and advances in dividends may offset this effect on purchasing power.

CPI in the US: http://www.bls.gov/cpi/home.htm

CPI in Australia: ABS

There has been arguments that inflation's so small now that it may be Dead . See commission's report. Some experts feel that deflation is now the problem making holding bonds just as important in hedging risk.

3: A Century of Stock-Market History: The Level of Stock Prices in Early 1972

Graham discusses the possible dangers in a bull market, especially when stocks are overpriced.

An example can be seen when during 1995 to 1999, the market rose by at least 20% each year, which was unprecedented in American history, and caused much optimism.

Much stocks were bought in such enthusiasm and, unfortunately, many were disappointed when prices became 50% cheaper, according to Gallup. The US stock market peaked at $14.75 trillion in 2000 and dropped to $7.34 trillion in 2002.

One crucial point illustrated is that an investor must never attempt to forecast the future using past data and simply ignore all other (present) indicators. Zweig points in support to Rroelich, the chief investment strategist at Kemper Funds, who declared that "We see people discard all the right companies with all the right people with the right vision because their stock price is too high--that's the worst mistake an investor can make." His two favourite stocks, Cisco & Motorola, lost 70% by 2002 which lost investors billions of dollars. Of course, both these companies are doing better now. Regardless, caution needs to be exercised when prices are at such dangerously high prices.

Three factors are involved in determining stock market performance:

1) Real growth - company profits

2) Inflationary growth - general price rise

3) Speculative growth - the growth or decline here based on the public investor perception

Robert Shiller (who predicted the burst of the stock market bubble in the late 1990s, and warns about the emergence of a housing bubble after the dot-com bubble burst in 2000), a professor at Yale University, argues that when the price/earning ratio shoots above 20, market returns will usually be poor. Anything below 10 will most likely allow profitable gains. Go here to look at some of the data.

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4: General Portfolio Policy: The Defensive Investor

It is generally viewed as a sound principle that the higher the risk you're willing to take, the higher the rate of return you can aim for. Graham takes a different approach. The amount of return is dependant, rather, on the amount of "intelligent" effort an investor is willing and able to put it. The passive investor, who is intent on safety and freedom, would have the minimum return and the enterprising investor would realise the maximum return by "exercising maximum intelligence and skill". This is done through continuing research, selecting and monitoring a dynamic mix of stocks, bonds and mutual funds.

The defensive investor should aim for a simple 50-50 split between common stocks and bonds.

For any investor, one should invest no more than 75% in either common stocks or bonds (and thus no less than 25% in either).

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5: The Defensive Investor & Common Stocks

Graham points out that when prices of common stocks fell from the relatively high prices of 1946, this was associated with common stocks being highly unpredictable and thus "unsafe". On the contrary, when prices were on the rise in the following 20 years, confidence in common stocks was strong in the public mind. This is again true during the dot com bubble.

Graham argued in the first edition (1949) for common stocks (as opposed to bonds) that, first of all, they offered some protection against the erosion of the dollar as a result of inflation and, second, that they tend to have higher returns than bonds. He stresses that these advantages cannot override all prices paid -- ie. these advantages would be lost if one overpaid for the stock. It can then be deduced that during times of dangerously high stock prices, bonds would be the more attractive option. Zweig refers to the works of Elroy Dimson et al and says that $1 invested for 100 years would yield $198 without dividents and $16,797 with dividends. I can't find any particular study/source in the book to back that up (except the name of the professors) so I guess you'll just have to take his word for it!

Although the stocks at 1971 were rather high, Graham nevertheless emphasises that a portion of both stocks & bonds need to be held, as discussed previously.

Some ground rules for the common stock portion of your portfolio:

1. It should not be excessively diversified (10-30 stocks; morning star helps you see stocks across different industries)

2. Companies should be "blue chip" one

3. As such, it should have a solid history of paying dividends

 

Graham notes quite interestingly that "medical men have been notoriously unsuccessful in their security dealings" as significant attention needs to be paid to the matter (as well as a professional approach to the values of securities) which cannot usually be afforded by doctors who would quite rarely have the time to invest in investment education.

For the young bright people, though, there is much advantage to begin education in finance early & start experiencing & testing their judgements of price versus value for themselves. As younger capitalists would have "limited means" (ie. they don't have as much money), they can learn an invaluable lesson through trial & error by trading with the smallest of sums.

For those of you in Australia, you can register with asx.com.au to trade $50,000 (simulated, not real money of course) and whoever ends up with the highest value at the end of the game, wins AU $5,000. You can find out more here.

 

If you found this useful, please consider purchasing the book (search "Online Book Store" or just go to Amazon.com)

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