In discussing a general portfolio policy for defensive investors, Benjamin Graham starts chapter four by challenging the prevailing view of the 1970s that investors should seek a rate of return that is proportional to their risk tolerance.
Graham disagrees with that concept, positing instead that the rate of return should be proportional to the amount of “intelligent effort” an investor is willing and able to provide to the task. On this basis, passive investors who would provide only modest effort should aim for minimum returns. On the other hand, the enterprising investor, willing to commit to “maximum intelligence,” should aim for higher returns.
Allocation
From there, he goes back to the question of allocation, citing his standard advice of 25% to 75% in either stocks or bonds. That leads to the concept of the 50-50 portfolio, one made up of roughly equal parts of bonds and stocks.
Given his personal uncertainty (when this revised edition was published in 1973), he proceeds to a reallocation recommendation:
“We are thus led to put forward for most of our readers what may appear to be an oversimplified 50–50 formula. Under this plan the guiding rule is to maintain as nearly as practicable an equal division between bond and stock holdings. When changes in the market level have raised the common-stock component to, say, 55%, the balance would be restored by a sale of one-eleventh of the stock portfolio and the transfer of the proceeds to bonds.”
Of course, the same would be true if bonds had risen to become 55% (or whatever proportion) of the portfolio. Graham sees several advantages to this “oversimplified” approach for defensive investors:
- Extremely simple.
- Aims in the right direction.
- Gives investors the sense they are doing something in response to market moves.
- It will restrain investors from being drawn too far into common stocks as the market rises and “more dangerous heights.”
With this plan, he says conservative investors will be satisfied with gains in half of their portfolio in a rising market and solace in a severe decline when he or she loses less than his “venturesome friends.” Graham concedes the hard part of the plan will be adopting it and sticking to it when there are fears it is too conservative.
Bonds
The other half of the story, bonds, now comes under Graham’s eye. Specifically, he takes on a discussion about two key questions:
- Should the investor buy taxable or tax-free bonds?
- Should he or she buy shorter- or longer-term maturities?
His discussion of bonds is very much tied to the world of 1973, but he has at least two pieces of advice that are still helpful in 2018:
- The taxable/tax-free decision will be about arithmetic and the difference in yields as compared with tax brackets.
- The longer versus shorter decision involves this question: “Does the investor want to assure himself against a decline in the price of his bonds, but at the cost of (1) a lower annual yield and (2) loss of the possibility of an appreciable gain in principal value?”
Graham tells us he will return to the latter question in chapter eight.
Preferred stocks
Right from the start we suspect Graham does not think highly of straight, or nonconvertible, preferred stocks: “Really good preferred stocks can and do exist, but they are good in spite of their investment form, which is an inherently bad one.” He considers them to be weak because there is no share in profits beyond a fixed dividend rate, and little legal protection in the event of a company’s inability to pay its dividends. He says buy them at a bargain or not at all.
Other thoughts
At a website called The Intelligent Investor, named, of course, after Graham’s book, Max Asciutto compares Graham’s investment advice with the fable of the tortoise and the hare. That’s the story in which the slow but steady tortoise beats a fast but erratic hare to the finish line of their foot race. Asciutto comments, “The tortoise will seldom have exciting stocks to brag about at dinner parties, but he will slowly but surely grow his investments while focusing on his main source of income – his career.”
The blogger makes an important point we haven’t yet discussed: for most individual investors, their careers come first. Unless your investing brings in substantial dividends, capital gains and interest, let the law of comparative advantage be your friend.
Norm Rothery, at the Stingy Investor website, provides two other points of discussion: weeding-out and the exclusion of financial stocks from his defensive tests:
“Graham's approach is value oriented and it's best described as a weeding out process. If a company passes all of Graham's tests then it qualifies for possible investment by defensive investors. It should be noted that Graham's defensive test does not apply to Financial stocks.”
In this chapter, Graham has written about stocks, bonds and preferred stocks,elaborating on each of those categories. Writing at Research Affiliates, Charles Aram says he thinks Graham also would have embraced index funds if his career had lasted longer. In a 1974 speech (two years before his death and a year before Vanguard’s John Bogle launched the first index fund), Graham presciently said:
“More and more institutions are likely to realize that they cannot expect better than market-average results from their equity portfolios unless they have the advantage of better-than-average financial and security analysis. Logically this should move some of the institutions toward accepting the S&P 500 results as the norm for expectable performance. In turn this might lead to using the S&P 500…as [an] actual portfolio….”
Personally, this chapter reinforces the idea that a grand idea is building. Not in the sense of any particular idea, but in the sense of a philosophy or platform that prepares investors for all cycles and the long term.
Regarding specifics in this chapter, I’m impressed by what Graham called his oversimplified portfolio, which involved starting with something like a 50-50 split between stocks and bonds, and then maintaining that split over time. I will repeat its advantages here:
- Extremely simple.
- Aims in the right direction.
- Gives investors the sense they are doing something in response to market moves.
- It will restrain investors from being drawn too far into common stocks as the market rises and “more dangerous heights.”
On the day I write this, stock markets are pulling back over concern about a looming trade war between the U.S. and its trading partners (China, its NAFTA partners, Europe and Japan)—after a bull run that has lasted nine years. I can’t think of a better time to carefully consider Graham’s words of wisdom.
(This review is based on the 1973 revised edition of “The Intelligent Investor”; republished in 2003 with commentary by Jason Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series (beginning with 'The Intelligent Investor: A Guide for Beginners), as well as other articles about Graham, go here.)
