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John Emerson
John Emerson
Articles (106) 

Principles of Graham: Market Volatility, Dollar-Cost Averaging and 401K Investors

January 15, 2012 | About:

"Weight counts eventually. But votes count in the short term. And it's a very undemocratic way of voting. Unfortunately, they have no literacy tests in terms of voting qualifications, as you've all learned." — Warren Buffett, from his 1999 Sun Valley speech

In chapter eight of "The Intelligent Investor," Graham provides readers with a clear dichotomy between the practice of market timing vs. pricing securities. It is in essence an extension of Graham's concept of speculation versus investment which was discussed in detail in a previous article. http://www.gurufocus.com/news/154737/principles-of-graham-investment-vs-speculation

I believe Graham's aforementioned distinction has been widely misinterpreted, particularly in the form of the mainstream practice of dollar-cost averaging. Later in the article, I will make the case that dollar-cost averaging is not a valid value strategy and should never be uniformly employed without regard to the current price of equities or the general market.

For those of you who do not know, dollar-cost averaging is the process of purchasing small positions in an equity or a mutual fund over an extended period of time without regard to price. For instance, an investor might purchase a series of $500 positions in an S&P index fund on a monthly basis. The foundation of the idea is that the fluctuations of the market are unpredictable, hence the investor is safeguarding himself from overpaying for his positions in an investment when the price is high. Additionally, the process allows an investor to participate in a bargain when the price is low by systematically spreading out his purchases.

The obvious problem of dollar-cost averaging is that it does not place any value on pricing stocks or various stock indices. The obvious benefit of the process is that it protects the prototypical momentum-chaser from himself.

I believe the common fallacy which suggests that the practice of overweighing or underweighting one's equity holdings will invariably result in under performance to be predicated upon Graham's observation that "market timers" are generally interested in predicting market movement rather than pricing equities. That said, it has been my personal experience that most casual market observers tend to buy "overpriced" markets and sell "under priced" ones, although the process does not have to prove fatal for for intelligent investors so long as they lean upon the concept of pricing when adjusting their equity weighting.

Unfortunately, a high percentage of market-timers are indeed novice speculators and whether unwittingly or not, they rarely consider the underlying value of the equity or the market in general when adjusting their equity positions; instead they endeavor to predict the direction and the extent of the market fluctuations. Frequently such speculators act upon their emotions which are triggered by their current perception of market sentiment. For such investors, I do not recommend any attempt at market-timing.

With that qualification in mind, I will continue onward.

Buffett's Recent Market Calls

Top value investors are notorious for making market calls based upon existing market valuations. Twice in a little more than a decade Warren Buffett has made overall market calls which have proved to be prophetic. The two market calls have been particularly beneficial for savvy 401K investors. 401K investors generally have limited investing avenues and are typically forced to decide between various stock and bond funds, index funds or low-yielding money markets accounts.

In July of 1999 Buffett made his famous bear call which 401K investors should have heeded, based upon the bloated valuations of the market. The following is an excerpt provided by Alice Schroeder from Buffett's 1999 Sun Valley speech:

Buffett clicked a button, which illuminated a PowerPoint slide on a huge screen to his right. [17] Bill Gates, sitting in the audience, caught his breath for a second, until the notoriously fumble-fingered Buffett managed to get the first slide up. [18] DOW JONES


December 31, 1964 — 874.12 December 31, 1981 — 875.00

He walked over to the screen and started explaining.

"During these seventeen years, the size of the economy grew fivefold. The sales of the Fortune five hundred companies grew more than fivefold. [33] Yet, during these seventeen years, the stock market went exactly nowhere."

He backed up a step or two. "What you're doing when you invest is deferring consumption and laying money out now to get more money back at a later time. And there are really only two questions. One is how much you're going to get back, and the other is when.

"Now, Aesop was not much of a finance major, because he said something like, 'A bird in the hand is worth two in the bush.' But he doesn't say when." Interest rates — the cost of borrowing — Buffett explained, are the price of "when." They are to finance as gravity is to physics. As interest rates vary, the value of all financial assets — houses, stocks, bonds — changes, as if the price of birds had fluctuated. "And that's why sometimes a bird in the hand is better than two birds in the bush and sometimes two in the bush are better than one in the hand."

In his flat, breathy twang, the words coming so fast that they sometimes ran over one another, Buffett related Aesop to the great bull market of the 1990s, which he described as baloney. Profits had grown much less than in that previous period, but birds in the bush were expensive because interest rates were low.

Fewer people wanted cash — the bird in the hand — at such low rates. So investors were paying unheard-of prices for those birds in the bush. Casually, Buffett referred to this as the "greed factor."

The audience, full of technology gurus who were changing the world while getting rich off the great bull market, sat silent. They were perched atop portfolios that were jam-packed with stocks trading at extravagant valuations. They felt terrific about that. It was a new paradigm, this dawning of the Internet age. Their attitude was that Buffett had no right to call them greedy. Warren — who'd hoarded his money for years and given very little away, who was so cheap his license plate said "Thrifty," who spent most of his time thinking about how to make money, who had blown the technology boom and missed the boat — was spitting in their champagne.

Buffett continued. There were only three ways the stock market could keep rising at ten percent or more a year. One was if interest rates fell and remained below historic levels. The second was if the share of the economy that went to investors, as opposed to employees and government and other things, rose above its already historically high level. [19] Or, he said, the economy could start growing faster than normal. [20] He called it "wishful thinking" to use optimistic assumptions like these.

Buffett was clearly stating to the "tech-heavy" audience at the July 1999 conference that the market was extremely overvalued and was due to for a correction. Although his earlier references to the lack of "literacy" of the market voters indicated that he was not setting a specific time-table for the inevitable market decline. The following chart of the S&P demonstrates his prophetic call.


As it turns out, Buffett's timing was just slightly early as the S&P peaked in early 2000. However, in retrospect, 401K investors who heeded his call and reduced their positions in S&P index funds owe Mr. Buffett a debt of gratitude.

More recently, on Oct. 16, 2008, Buffett published an editorial in the New York Times which indicated that he felt the valuation metrics were favorable for investors following rapid decline precipitated by the credit crisis. Once again his call was a little early as the S&P did not bottom until March of 2009. http://www.nytimes.com/2008/10/17/opinion/17buffett.html

That said, index investors who decided to overweight the S&P in the early fall of 2008 were rewarded significantly in the next several years. The real losers were panicked investors who exited the market following the crash and held their bearish sentiment throughout the market recovery.

Several lessons became clear for 401K investors. First of all, it makes sense to decrease one's allocation in stocks when the valuations become lofty. Secondly, it is imperative to hold on to equity positions following a market panic. Finally, is a good idea for the 401K investors to increase their equity allocations during periods of favorable market valuations.

Bond/Stock Allocation and Yields

At the beginning of Chapter 4 of "The Intelligent Investor," Graham discusses his recommendations for asset allocation for conservative investors. His recommendations are particularly poignant for 401K investors.

Graham recommends that defensive investors use a sliding scale of 25% to 75% stock/bond allocation. He suggests that investors ramp up stock positions during periods of protracted bear markets or during times when the market is significantly undervalued. Alternatively, Graham suggests that defensive investors should overweight bonds when the market valuations become lofty.

It should be noted that Graham recommends a 50/50 stock-to-bond allocation during normal periods. He further suggests that certain investors who tend to buy when the market is rising or tend to panic when the market is dropping, stick with this standard allocation at all times.

It is my contention that 401K investors should generally follow similar allocation rules; however, I believe occasionally conditions exist when investors should put up to 25% of their portfolio in cash. I would further suggest that during periods of extreme market undervaluation, investors should allocate 100% of their portfolio in stocks. A review of the following table which illustrates AAA bond yields compared to the composite earnings yield of the S&P 500 is in order.


It occurs to me that it makes little sense for defensive 401K investors to overweight stocks unless the difference between the Triple-A bond yields and stock earnings yields are favorable.

The above chart reveals that only on rare occasions has the S&P composite earnings yield exceeded that of AAA corporate bond yields in the last 30 years. Indeed, the bull market in bonds which began in the early 1980s has seen corporate yields drop from 16% to its current level of just slightly above 4%. Certainly, 401K investors who have held the bulk of their money in bond funds or blended mutual funds have dramatically outperformed their equity-heavy counterparts during that period.

While equity-heavy investors may have been rejoicing and patting themselves on the back during the decade of the 1990s, despite the unfavorable spreads, many of that same group now refers to their retirement accounts as "201Ks". Common sense dictates that unfavorable spreads can only defy logic for a limited period of time and eventually intelligent investors will be vindicated, although bull or bear markets in corporate bonds can continue for decades as the chart clearly demonstrates.

It should be noted that the value of bond mutual funds fluctuate on the basis of interest rate movements as well as accrued yields. In other words, while the long bull market in bonds has seen interest yields drop precipitously; the steady drop in interest rates has increased the market value of the various bonds which are contained in the funds.

The Change That Occurred in 2008/2009

Beginning in late 2008, the spread between composite earnings yields for the S&P vs. AAA bond yields turned significantly favorable for the first time in decades. For the astute 401K investor, the signal to overweight equities vs. bonds in their retirement portfolios was flashing. Unfortunately for most 401K investors, at the same time the buying opportunity was presenting itself so too was their level of apprehension about the direction of stock market. Instead of increasing their positions in stocks vs. bonds and cash, many 401K investors were busy liquidating their equity positions entirely.

Retirement investors who followed Graham's concept of pricing as opposed to timing were using the opportunity to increase their equity positions. Defensive retirement investors who steadfastly maintained their 50/50 positions in the form of blended mutual funds were also well served by ignoring the market volatility. Unfortunately for nervous investors, the large declines reflected in their monthly statements pushed many of them into emotional rather than rational decisions. The irrational nature of Mr. Market had simply exerted too much pain and apprehension on such types. Many of the same 401 investors who were overly optimistic during decade of the 1990s, when stock to bond spreads were highly unfavorable, were now selling when the spreads were finally at an acceptable level to overweight equities.

The lesson is clear, 401K investors who are unwilling to overweight or underweight stock positions based upon their valuations rather than market sentiment are much better served to merely stay with Graham's 50/50 strategy.

Dollar-Cost Averaging and Blue Chip Stocks

Defensive investors who wish to invest a portion of their personal savings in blue-chip stocks can enhance their returns by abandoning traditional dollar-cost averaging principles. Instead of blindly purchasing a small amount of a blue-chip company on a monthly basis without regard to price, the defensive investor should employ a modicum of stock valuation research using the following steps:

1) Identify the key valuation metric for the stock, e.g., price to book, price to earnings ratios.

2) Calculate the trailing 10-year average for the key metric.

3) Only purchase the blue-chip stock when the key metric is trading below its 10-year average.

4) Gradually increase the purchase amount if the valuation metrics for the stock turn increasingly favorable.

Since Berkshire (NYSE:BRK.A)(NYSE:BRK.B) is now available for investment to the average investor through the B-shares, it provides a perfect example of how a minimal amount of valuation work can improve the results for the defensive investor.

The key investment metric for BRK.B is its price to book ratio. Anyone who disputes that claim should review Mr. Buffett's dictum last fall where he proclaimed that he would buy back shares of the company up to 1.1x of its stated book value. Common sense dictates that long-term investors who wish to hold a percentage of their holdings in BRK.B should step up their purchases when the stock trades at or below this key metric.

The following provides a summary table displaying the average price to book ratio of BRK.A for the trailing 10 years:

Industry: Property & Casualty Insurance

Avg P/E Price/ Sales Price/ Book Net Profit Margin (%)
12/10 14.90 1.45 1.26 9.5
12/09 18.10 1.37 1.18 7.2
12/08 38.10 1.39 1.37 4.6
12/07 13.60 1.85 1.82 11.2
12/06 13.20 1.72 1.57 11.2
12/05 15.50 1.67 1.49 10.4
12/04 18.60 1.82 1.58 9.8
12/03 13.80 2.03 1.67 12.8
12/02 25.90 2.64 1.74 10.1

A quick calculation reveals that the 10-year trailing average price to book ratio for Berkshire Hathaway is 1.368x. Therefore, long-term investors should not add to their positions in the stock until they are able to purchase the company at a figure below that amount. I would recommend that defensive long-term investors begin to invest significantly in BRK.B when they can purchase the equity at a 10% discount to its long-term price to book average. That current figure is 1.23x book value.

Should BRK.B continue to decline in terms of price to book, it would serve the defensive investor well to step up the size of his/her purchases so long as they have cash available and do not employ leverage.

Defensive investors who are interested in dollar-cost averaging should identify a basket of such equities, define their key metrics and then invest their monthly allotment in the most favorable equities. If no favorable valuation are available or if the investor is becoming increasing over-weighted in one stock, they should hold their monthly allotment in cash and wait for a more favorable valuation.

The current price to book ratio for BRK.B is 1.22.

Let's take one more example. Johnson and Johnson (NYSE:JNJ) would provide defensive investors with another possible long-term candidate for buy-and-hold investing. The following table depicts the key investment metric for JNJ, its 10-year trailing price to earning ratio:

Industry: Drug Manufacturers - Major

Avg P/E Price/ Sales Price/ Book Net Profit Margin (%)
01/11 13.00 2.80 2.99 21.7
01/10 13.20 2.90 3.51 19.8
12/08 14.20 2.60 3.81 20.3
12/07 17.60 3.21 4.42 17.3
12/06 16.70 3.67 4.86 20.7
01/06 19.30 3.57 4.62 19.9
01/05 20.40 4.01 5.92 17.3
12/03 22.00 3.64 5.59 17.2
12/02 26.60 4.47 6.95 18.2

The 10-year average trailing price to earning ratio for JNJ is 16.27; therefore defensive investors should utilize their dollar cost averaging strategy for the stock only if it trades at a 14.6x earnings or less. Should the company continue to trade at a significant discount to that level, defensive investors would be well served to increase the level of their purchases if they have available cash.

The current trailing P/E ratio for JNJ is 15.92. If a defensive investor was deciding whether to invest his monthly allotment in JNJ or BRK.B, the buy would be BRK.B since JNJ is now trading at an unfavorable valuation in relation to its key metric.


Contrary to popular belief, intelligent defensive investors can engage in a bit of market timing and live to tell about their experience. Of course the key underlying principle that these investors must utilize is Graham's concept of pricing vs. speculating.

Clearly, if an investor is impatient and endeavors to predict the short-term movement of the equity markets or routinely engages in speculation about the short-term volatility of an equity, such an investor should never attempt to time the market. Such investors should stick strictly to conventional index investing and dollar-cost averaging strategies.

On the other hand, if a defensive investor is willing to put in a minimal amount of effort in ascertaining whether the current price for a stock is trading at a significant discount to its intrinsic value; the investor will likely increase the amount of his/her capital gains in the longer term.

Lastly, it behooves investors to pay attention when value-oriented market mavens such as Warren Buffett, make one of their rare market calls. When this rare event occurs, one can be certain that the value maven has sufficient justification in the way of favorable pricing to make such a call. Just bear in mind that value gurus are not oracles when predicting the exact bottom or the exact top of a market.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 4.2/5 (17 votes)


Bill.Smith - 5 years ago    Report SPAM
John: great article! I'm of the same belief. For my 401K I strive to simply buy the equity indices when it makes business-sense to do so, ie. when stock returns have the potential to be higher than AAA bond returns with a margin of safety. For anyone that's interested, take a look at my article Dollar Cost Averaging with a Brain to see how I've put this into practice. It served me well, keeping me mostly in cash (75%) the majority of 2011 while markets were overvalued. Valuations matter, even with an index, and like you mentioned in your article, I also don't think it makes sense to overpay just to implement a mechanical DCA program, since the price you pay determines your returns. As of my 31 Oct 2011 statement, the TTM return using this approach was 9.2%, while the S&P was 5.8%. For full year performance, the S&P was flat, while the approach yielded 7.12%. I think that's enough of a difference that I'll continue with it.

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