WS: INTELLIGENT INVESTOR III

INTELLIGENT INVESTOR III

The basic characteristics of an investment portfolio are usually determined by the position and characteristics of the owner. At one extreme we have savings banks and life insurance companies, which tend to stick with AAA-rated bonds and large blue-chip stocks. At the other extreme we have the well-to-do experienced businesspeople, who will include any kind of bond or stock in their portfolio provided they consider them an attractive purchase.

It is an old and sound principle that those who cannot afford to take risks should be content with a relatively low return on their investments. From this we have developed the common notion that investment returns will be proportional to the level of risk one accepts.

Ben Graham's view is different. The rate of return sought should be dependent, he suggests, on the amount of intelligent effort the investor is willing and able to bring to bear on their task. The minimum return goes to a passive investor, who wants both safety and freedom from concern. The maximum return would be realized by the alert and enterprisiing investor who exercises maximum intelligence and skill. In many cases there may be less real risk associated with buying a 'bargain stock' offering the chance of a large profit than with a conventional high-grade bond yielding 5%.

The Problem of Bond-Stock Allocation

Ben Graham advised an intelligent defensive investor to divide his funds between high-grade bonds and high-grade stocks. He suggested never having less than 25% or more than 75% of your funds in stocks, and the inverse range (75% to 25%) in bonds. This implies, of course, on average having about 50% of each asset class in your portfolio. The stock portion of your portfolio would be raised when they appear to be 'bargain priced' and decreasing the stock portion when they appear 'dangerously high'.

Graham notes that such advice is easy to dish out but difficult to execute-- not the least because it goes against our very human nature, a nature which produces excesses in bull markets and bear markets alike. It is almost a contradiction in terms to suggest as a feasible policy for the average stockowner that he lighten his holdings when the market advances beyond a certain point and add to them after a corresponsing decline. It is because the average man operates, and apparently must operate, in opposite fashion that we have had the great advances and collapses of the past; and-- Graham believes, as I do-- we are likely to have in the future.

Although it sounds simplistic, Graham was convinced that his 50-50 stock/bond portfolio approach made good sense for a defensive investor. It is extremely simple; it aims unquestionably in the right direction; it gives the follower the feeling that they are at least making some moves in response to market developments; most important of all, it will restrain one from being drawn more and more into stocks as the market rises to more and more dangerous bubble heights. The defensive investor will be satisfied with gains from half his portfolio in a rising market, and take solace from doing much better than his more venturesome friends during a severe decline.


Can You Be Brave, Or Will You Cave?

In his commentary on Graham's writing, Jason Zweig notes that Graham never mentions age as a factor in portfolio allocation. That sets his advice firmly against the winds of conventional wisdom-- which holds that how much investing risk you ought to take depends on how old you are. A traditional rule of thumb was to subtract your age from 100 and invest that percentage of your assets in stocks, with the rest in bonds or cash. (A 28-year-old would put 72% in stocks; and 81-year-old just 19%.) Like everything else, these assumptions got overheated in the 1990s. By 1999, a popular book argued that if you were younger than 30 you should put 95% of your money in stocks-- even if you had only a "moderate" tolerance for risk!

Unless you've allowed the proponents of this advice to subtract 100 from your IQ, you should be able to tell that something is wrong here. Why should your age determine how much risk you can take? An 89-year-old with $3 million, an ample pension, and a gaggle of grandchildren would be foolish to move most of her money into bonds. She already has plenty of income, and her grandchildren (who will eventually inherit her stocks) have decades of investing ahead of them. On the other hand, a 25-year-old who is saving for his wedding and a house down payment would be out of his mind to put all his money in stocks. If the stock market takes an (always unexpected) nosedive, he will have no income to cover his downside-- or his backside.

What's more, no matter how young you are, you might suddenly need to yank your money out of stocks not 40 years from now, but 40 minutes from now. Without a whiff of warning, you could lose your job, get divorced, become disabled, or suffer who knows what other kind of life's little surprises.

Finally, many people stop investing precisely because the stock market goes down. Psychologists have shown that most of us do a very poor job of predicting today how we will feel about an emotionally charged event in the future. When stocks are up 15% or 20% a year, as they did in the 1980s and 1990s, it's easy to imagine that you and your stocks are married for life. But when you watch every dollar you invested getting bashed down to a dime, it's hard to resist bailing out into the "safety" of bonds and cash. Instead of buying and holding their stocks, many people end up buying high, selling low, and holding nothing but their heads in their hands. Because so few investors have the guts to cling to stocks in a falling market, Graham insists that everyone should keep a minimum of 25% in bonds. That cushion, he argues, will give you the courage to keep the rest of your money in stocks even when stocks stink.

Zweig suggests you not place 100% of your money in stocks unless you ...

- have set aside enough cash to support your family for at least one year
- will be investing steadily for at least 20 years to come
- survived the bear market that began in 2000
- did not sell stocks during the bear market that began in 2000
- bought more stocks during the bear market that began in 2000
- have read chapter 8 of Graham's Intelligent Investor (human psychology emphasis)

Well... that tells you why Wallstraits keeps 100% our our security portfolio in stocks!

Sage@wallstraits.com


Credits: Much of this article is extracted or adapted from Chapter 4 of Ben Graham's 1973 The Intelligent Investor, and comments on this chapter by Martin Zweig, The Intelligent Investor reprint, 2003.

POSTED :07 Jun 2006