My rating: 85/100
See Book Notes for other books I have read. If you like my notes, go buy it!
Tagline: The definitive book on value investing.
Key Principles I’ve take from this book, noting that I’m considering myself a defensive investor:
- Diversify! Graham recommends, generally, an equal balance of 50/50 bonds/stocks. This ratio can be varied between 25/75 and 75/25 depending on the investors judgement of the market. More stocks when prices are cheap (bear market), and less stocks when the market is expensive (bull).
- The stock portion should be a total stock market index fund.
- Balance your portfolio every 6 months – no sooner.
- Defensive investors must confine themselves to a long record of profitable operations and strong financial conditions.
- Defensive investors should buy shares in well-established investment funds rather than create their own portfolios.
- Use “dollar cost averaging”, investing the same amount regularly regardless of market conditions. This amount and frequency does not need to be perfect, but merely aiming at regularity will help.
- Consider putting 1-2% of your portfolio in precious metals.
- You must protect cash against inflation. Consider buying REITs or TIPS.
- Do not try to time the market.
- A portion of your portfolio should be outside the economy of your home country.
Preface to Fourth Edition by Warren Buffet
To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.
Introduction: What This Book Expects to Accomplish
Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
The experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.
Chapter 1: Investment Versus Speculation: Results to Be Expected by the Intelligent Investor
An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.
Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.
true “cash equivalents” proved to be better investments in 1964 than common stocks – in spite of the inflation experience that in theory should have favored stocks over cash.
This is just another of an endless series of experiences over time that have demonstrated that the future of securities is never predictable.
Treasury Inflation-Protected Securities (TIPS), unlike other bonds, rise in value if the Consumer Price Index goes up, effectively immunizing the investor against losing money after inflation.
At all times have a significant part of your funds in bond-type holdings and a significant part also in equities. It is still true that they may choose between maintaining a simple 50/50 division between the two components or a ratio, dependent on their judgement, varying between a minimum of 25% and a maximum of 75% of either.
The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition.
As I’m reading these passages, I’m realizing how narrow-minded some of our thought processes can be in regard to our money. Some people fascinated by, and experienced in real-estate, for example, and have a tendency to invest heavily in what they know at the expense of a diversified portfolio. Their interest in the real-estate market is an easy one – they find it invigorating to search for properties and parcels to make money in that market, a fruitful endeavor indeed. However, they are short-sighted if they are not diversified in other accounts. An enlightened investor will thus analyze all their holdings and diversify accordingly. In my example, I own a house and should consider my ownership as an investment similar to buying a common stock. It just so happens to also be the place I live (which means it’s slightly different) – but my percentage of ownership in the house is a real one, and the equity needs to be balanced with other investments. This task is naturally a difficult one since it requires research and work into an arena that is not inherently interesting to the investor, compounded by the painful task of not investing in their area of interest. For our example, money must be taken from real estate investment and placed in something like boring and dull, like bonds.
Three supplementary concepts or practices for the defensive investor:
The first is the purchase of shares of well-established investment funds as an alternative to creating his own common-stock portfolio.
The third is “dollar-cost averaging“. Invest in common stocks the same number of dollars each month or each quarter.
Commentary on Chapter 1:
- You must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock;
- You must deliberately protect yourself against serious losses;
- You must aspire to “adequate,” not extraordinary, performance.
Just as sensible gamblers take, say $100 down to the casino floor and leave the rest of their money locked in the safe in their hotel room, the intelligent investor designates a tiny portion of her total portfolio as a “mad money” account. For most of us, 10% of our overall wealth is the maximum permissible amount to put at speculative risk. Never mingle the money in your speculative account with what’s in your investment accounts; never allow your speculative thinking to spill over into your investing activities; and never put more than 10% of your assets into your mad money account, no matter what happens.
Chapter 2 The Investor and Inflation
The investment philosopher Peter L. Bernstein feels that Graham was “dead wrong” about precious metals, particularly gold, which (at least in the years after Graham wrote this chapter) has shown a robust ability to out pace inflation. Financial advisor William Bernstein agrees, pointing out that a tiny allocation to a precious-metals fund (say, 2% of your total assets) is too small to hurt your overall returns when gold does poorly. But, when gold does well, it’s returns are often so spectacular – sometimes exceeding 100% in a year – that it can, all by itself, set an otherwise lackluster portfolio glittering. However, the intelligent investor avoids investing in gold directly, with its high storage and insurance costs; instead, seek out a well-diversified mutual fund specializing in the stocks of previous-metal companies and charging below 1% in annual expenses. Limit your stake to 2% of your total financial assets (or perhaps 5% if you are over the age of 65).
Commentary on Chapter 2
As recently as 1973-1982, the United States went through one of the most painful bursts of inflation in our history. As measured by the Consumer Price Index, prices more than doubled over that period, rising at an annualized rate of nearly 9%. In 1979 alone, inflation raged at 13.3%, paralyzing the economy in what became known as “stagflation” – and leading many commentators to question whether America could compete in the global marketplace. Goods and services priced at $100 in the beginning of 1973 cost $230 by the end of 1982, shriveling the value of a dollar to less than 45 cents. No one who lived through it would scoff at such destruction of wealth; no one who is prudent can fail to protect against the risk that it might recur.
Since Graham last wrote, two inflation-fighters have become widely available to investors.
REITs. Real Estate Investment Trusts, or “reets”, are companies that own and collect rent from commercial and residential properties.
TIPS. Treasury Inflation-Protected Securities are government issued bonds that automatically go up when inflation rises.
You can buy TIPS directly from the U.S. government at www.publicdebt.treas.gov/of/ofinflin.htm, or in a low cost mutual fund like Vanuard Inflation-Protected Securities of Fidelity Inflation-Protected Bond Fund. Either directly or through a fund, TIPS are the ideal substitute for the proportion of your retirement funds you would otherwise keep in cash. Do not trade them: TIPS can be volatile in the short run, so they work best as a permanent, lifelong holding. For most investors, allocating at least 10% of your retirement assets to TIPS is an intelligent way to keep a portion of your money absolutely safe-and entirely beyond the reach of the long, invisible claws of inflation.
Chapter 3 A Century of Stock Market History: The Level of Stock Prices in Early 1972
Commentary on Chapter 3
The intelligent investor must never forecast the future exclusively by extrapolating the past.
Anyone who claims that the long-term record “proves” that stocks are guaranteed to outperform bonds or cash is an ignoramus.
The value of any investments is, and always must be, a function of the price you pay for it.
Shiller compares the current price of the S&P 500 index against average corporate profits over the past 10 years (after inflation). When his ratio goes well above 20, the market usually delivers poor returns afterward; when it drops well below 10, stocks typically produce handsome gains down the road.
In the financial markets, the worse the future looks, the better it usually turns out to be.
Chapter 4: General Portfolio Policy: The Defensive Investor
As a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds.
According to tradition the sound reason for increasing the percentage in common stocks would be the appearance of the “bargain price” levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgement of the investor the market level has become dangerously high.
Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity. (For aggressive investors)
Commentary on Chapter 4
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. My note: This is not always good advice.
You might suddenly need to yank your money out of stocks not 40 years from now, but 40 minutes from now.
- Are you single or married? What does your spouse or partner do for a living?
- Do you or will you have children? When will the tuition bills hit home?
- Will you inherit money, or will you end up financially responsible for aging, ailing parents?
- What factors might hurt your career? (If you work for a bank or a home builder, a jump in interest rates could put you out of a job. If you work for a chemical manufacturer, soaring oil prices could be bad news.)
- If you are self-employed, how long do businesses similar to your tend to survive?
- Do you need your investments to supplement your cash income? (In general, bonds will; stocks won’t).
- Given your salary and your spending needs, how much money can you afford to lose on your investments?
If, after considering these factors, you feel you can take the higher risks inherent in the greater ownership of stocks, you belong around Graham’s minimum 25% in bonds or cash. If not, then steer mostly clear of stocks, edging toward Graham’s maximum of 75% in bonds or cash.
Once you set these target percentages, change them only as your life circumstances change. Do not buy more stocks because the stock market has gone up; do not sell them because it has gone down. The very heart of Graham’s approach is to replace guesswork with discipline. Fortunately, through your 401(k), it’s easy to put your portfolio on permanent autopilot. Let’s say you are comfortable with a hairly high level of risk – say, 70% in stocks and only 25% in bonds. Visit your 401(k)s website and sell enough of your stock funds to “rebalance” back to your 70/30 target. The key is to rebalance on a predictable, patient schedule – not so often that you will drive yourself crazy, and not so seldom that your targets will get out of whack. I suggest that you rebalance every six months.
Why not 100% stocks.
Graham advises you never to have more than 75% of your assets in stocks. But is putting all your money into the stock market inadvisable for everyone? For a tiny minority of investors, a 100% stock portfolio may make sense. You are one if 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 most recent bear market
- did not sell stocks during the most recent bear market
- bought more stocks during the most recent bear market
- have read chapter 8 in this book and implemented a formal plan to control your own investing behavior.
Unless you can honestly pass all these tests, you have no business putting all your money in stocks. Anyone who panicked in the last bear market is going to panic in the next one – and will regret having no cushion of cash and bonds.
My note: If you have 1 year of cash available, does that not mean, by definition, some portion of your portfolio is cash?
Buy only tax-free (municipal) bonds outside your retirement accounts.
For most investors, bond funds beat individual bonds hands down. Major firms like Vanguard, Fidelity, Schwab, and T. Rowe Price offer a broad menu of funds at low cost.
Preferred Stock. Preferred shares are a worst-of-both-worlds investment.
Chapter 5 The Defensive Investor and Common Stocks
If you had invested $1 in US stocks in 1900 and spent all your dividends, your stock portfolio would have grown to $198 by 2000. But if you had reinvested all your dividends, your stock portfolio would have been worth $16,797! Far from being an afterthought, dividends are the greatest force in stock investing.
Rules for the Common Stock Component
The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter: Here we would suggest four rules to be followed:
- There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.
- Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense is clear. Observations on this point are added at the end of the chapter.
- Each company should have a long record of continuous dividend payments. To be specific on this point we would suggest the requirement of continuous dividend payments for 10 years.
- The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve month period.
My note: I’m struggling to understand #4. Is this EBITDA? For example, Ford in 2019 had EBITDA of $9.064B. The stock price is currently $5.24. Ah, here it is:
The price to earnings ratio is calculated by taking the latest closing price and dividing it by the most recent earnings per share (EPS) number. The PE ratio is a simple way to assess whether a stock is over or under valued and is the most widely used valuation measure. Ford Motor PE ratio as of May 07, 2020 is 8.85.
We regard growth stocks as a whole as too uncertain and risky a vehicle for the defensive investor.
The kind of securities to be purchased and the rate of return to be sought depend not on the investor’s financial resources but on his financial equipment in terms of knowledge, experience, and temperament.
An investment contains a risk if there is a fair possibility that the holder may have to sell at a time when the price is well below cost.
Commentary on Chapter 5
An old Turkish proverb says, “After you burn your mouth on hot milk, you blow on your yogurt.”
Lynch’s rule – “You can outperform the experts if you use your edge by investing in companies or industries you already understand.” But Lynch’s rule can work only if you follow its corollary as well: “Finding the promising company is only the first step. The next step is doing the research – studying its financial statements and estimating its business value.
Sadly, the employees of Enron, Global Crossing, and WorldCom – many of whom put nearly all their retirement assets in their own company’s stock, only to be wiped out – learned that insiders often possess only the illusion of knowledge, not the real thing.
A defensive investor runs – and wins – the race by sitting still.
Chapter 6 Portfolio Policy for the Enterprising Investor: Negative Approach
Chapter 6 Commentary
The lesson is clear: Don’t just do something, stand there. It’s time for everyone to acknowledge that the term “long-term investor” is redundant.
Chapter 7 Portfolio Policy for the Enterprising Investor: The Positive Side
The enterprising investor concentrate on the larger companies that are going through a period of unpopularity.
high multiplier means highly leveraged
Purchase of Bargain Issues
We define a bargain issue as one which, on the basis of facts established by analysis, appears to be worth considerable more than it is selling for. To be as concrete as possible, let us suggest that an issue is not a true “bargain” unless the indicated value is at least 50% more than the price.
There are two tests by which a bargain common stock is detected. The first is by the method of appraisal. This relies largely on estimating future earnings and then multiplying these by a factor appropriate to the particular issue. If the resultant value is sufficiently above the market price – and if the investor has confidence in the technique employed – he can tag the stock as a bargain.
Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus we have what appear to be two major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.
The investor would need more than a mere falling off in both earnings and price to give him a sound basis for purchase. He should require an indication of at least resonable stability of earnings over the past decade or more plus sufficient size and financial strength to meet possible setbacks in the future.
A third cause for an unduly low price for a common stock may be the market’s failure to recognize its true earnings picture.
The type of bargain issue that can be most readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations. (Net working capital meaning a company’s current assets (such as cash, marketable, securities, and inventories) minus its total liabilities (including preferred stock and long-term debt).
“Never buy into a lawsuit” remains a valid rule for all but the most intrepid investors to live by.
Commentary on Chapter 7
A study by two finance professors at Duke University found that if you had followed the recommendations of the best 10% of all market-timing newsletters, you would have earned a 12.6% annualized return from 1991 through 1995. But if you had ignored them and kept your money in a stock index fund, you would have earned 16.4%.
Growth stocks are worth buying when their prices are reasonable, but when their price/earnings ratios go much above 25 or 30 the odds get ugly.
If you live in the United States, work in the United States, and get paid in US dollars, you are already making a multilayered bet on the US economy. To be prudent, you should put some of your investment portfolio elsewhere – simply because no one, anywhere, can ever know what the future will bring at home or abroad.
Chapter 8 The Investor and Market Fluctuations
It is easy for us to tell you not to speculate; the hard thing will be for you to follow this advice. If you want to speculate do so with your eyes open, knowing that you will probably lose money in the end; be sure to limit the amount at risk and to separate it completely from your investment program.
We are convinced that the average investor cannot deal successfully with price movements by endeavoring to forecast them.
Nearly all the bull markets had a number of well-defined characteristics in common, such as:
- a historically high price level,
- high price/earnings ratios,
- low dividend yields as against bond yields,
- much speculation on margin,
- and many offerings of new common-stock issues of poor quality (IPOs).
It seems realistic to us for the investor to endeavor to base his present policy on the classic formula – i.e. to wait for demonstrable bear-market levels before buying any common stocks. Our recommended policy has, however, made provision for changes in the proportion of common stocks to bonds in the portfolio, if the investor chooses to do so, according as the level of stock prices appears less or more attractive by value standards.
The moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last.
Many of these “formula planners” would have sold all their stocks at the end of 1954, after the US stock market rose 52.6%, the second highest yearly return then on record. Over the next five years, these market-timers would likely have stood on the sidelines as stocks doubled.
It is for these reasons of human nature, even more than by calculation of financial gain or loss, that we favor some kinds of mechanical method for varying the proportion of bonds to stocks in the investor’s portfolio. The chief advantage, perhaps, is that such a formula will give him something to do. As the market advances he will from time to time make sales out of his stock-holdings, putting the proceeds into bonds; as it declines he will reverse the procedure. These activities will provide some outlet for his otherwise too-pent-up-energies. If he is the right kind of investor he will take added satisfaction from the thought that his operations are exactly opposite from the crowd.
Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is a perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other person’s mistakes of judgement.
Let us close this section with something in the nature of a parable. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgement and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. conceivably they may give him a warning signal which he will do well to heed – this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.
Moral: Nothing important on Wall Street can be counted on to occur exactly in the same way as it happened before.
Commentary on Chapter 8
Most of the time, the market is mostly accurate in pricing most stocks.
My note: Find out how to research the value of cash and other liquid assets compared to the current stock price. – A place to start here is the P/B ratio, or price to book ratio. Obviously it’s more complex than that, but a start.
One of Graham’s most powerful insights is this: “The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is a perversely transforming his basic advantage into a basic disadvantage.”
What does Graham mean by those words “basic advantage”? He means that the intelligent individual investor has the full freedom to choose whether or not to follow Mr. Market. You have the luxury of being able to think for yourself.
You can control:
- Your brokerage costs, by trading rarely, patiently, and cheaply
- Your ownership costs, by refusing to buy mutual funds with excessive annual expenses
- Your expectations, by using realism, not fantasy, to forecast your returns
- Your risk, by deciding how much of your total assets to put at hazard in the stock market, by diversifying, and by rebalancing
- Your tax bills, by holding stocks for at least one year and, whenever possible, for at least five years, to lower your capital gains liability
- and, most of all, your own behavior.
Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.
If your investment horizon is long – at least 25 or 30 years – there is only one sensible approach: Buy every month, automatically, and whenever else you can spare some money. The single best choice for this lifelong holding is a total stock-market index fund. Sell only when you need the cash.
News You Could Use
Stocks are crashing, so you turn on the television to catch the latest market news. But instead of CNBC or CNN, imagine that you can tune in to the Benjamin Graham Financial Network. On the BGFN, the audio doesn’t capture that famous sour clang of the market’s closing bell; the video doesn’t home in on brokers scurrying across the floor of the stock exchange like angry rodents. Nor does BGFN run any footage of investors gasping on frozen sidewalks as red arrows whiz overhead on electronic stock tickers.
Instead, the image that fills your TV screen is the facade of the NYSE, festooned with a huge banner reading: “SALE! 50% OFF!” As intro music, Bachman-Turner Overdrive can be heard blaring a few bars of their old barn-burner, “You Ain’t Seen Nothin’ Yet.” Then the anchorman announces brihtly, “Stocks became more attractive yet again today, as the Dow dropped another 2.5% on heavy volume – the fourth day in a row that stocks have gotten cheaper. Tech investors fared even better, as leading companies like Microsoft lost nearly 5% on the day, making them even more affordable. That comes on top of the good news of the past year, in which stocks have already lost 50%, putting them at bargain levels not seen in years. And some prominent analysts are optimistic that prices may drop still further in the weeks and months to come.
Investment Owner’s Contract
I, _______ _______, hereby state that I am an investor who is seeking to accumulate wealth for many years into the future.
I know that there will be many times when I will be tempted to invest in stocks or bonds because they have gone (or “are going”) up in price, and other times when I will be tempted to sell my investments because they have gone (or “are going”) down.
I hereby declare my refusal to let a herd of strangers make my financial decisions for me. I further make a solemn commitment never to invest because the stock market has gone up, and never to sell because it has gone down. Instead, I will invest $___.00 per month, every month, through an automatic investment plan or “dollar cost averaging program,” into the following mutual fund(s) or diversified portfolio(s):
I will also invest additional amounts whenever I can afford to spare the cash (and can afford to lose in the short run).
I hereby declare that I will hold each of these investments continually through at least the following date (which must be a minimum of 10 years after the date of this contract): _______ ___, 20__. The only exceptions allowed under the terms of this contract are a sudden, pressing need for cash, like health-care emergency or the loss of my job, or a planned expenditure like a housing down payment or a tuition bill.
I am, by signing below, stating my intention not only to abide by the terms of this contract, but to re-read this document whenever I am tempted to sell any of my investments.
This contract is valid only when signed by at least one witness, and must be kept in a safe place that is easily accessible for future reference.
Chapter 9 Investing in Investment Funds
There are different ways of classifying the funds. Balanced Funds have broad division in their portfolio, generally one third bonds. Stock funds are nearly all common stocks. Load funds add a selling charge to the value before charge. No-load Funds make no such charge; the managements are content with the usual investment-counsel fees for handling the capital.
The investor who want to make an intelligent commitment in fund shares has thus a large and somewhat bewildering variety of choices before him.
Overall results of these ten funds (see table 9-1) for 1961-1970 were not appreciably different from those of the S&P 500.
A wide difference exists between the results of the individual funds.
Let us consider the question first in a simplified fashion. Why shouldn’t the investor find out what fund has made the best showing of the lot over a period of sufficient years in the past, assume from this that its management is the most capable and will therefore do better than average in the future, and put his money in that fund?
The evidence has been conflicting over the years. …. Such results in themselves may indicate only that the fund managers are taking undue speculative risks, and getting away with some for the time being.
All financial experience up to now indicates that large funds, soundly managed, can produce at best only slightly better than average results over the years. If they are unsoundly managed they can produce spectacular, but largely illusory, profits for a while, followed inevitably by calamitous losses.
We arrive at one of the few clearly evident rules for investors choices. If you want to put money in investment funds, but a group of closed-end shares at a discount of, say, 10% to 15% from asset value, instead of paying a premium of about 9% above asset value for shares of an open-end company.
Commentary on Chapter 9
But mutual funds aren’t perfect; they are almost perfect, and that word makes all the difference. Because of their imperfections, most funds underperform the market, overcharge their investors, create tax headaches, and suffer erratic swings in performance. The intelligent investor must choose funds with great care in order to avoid ending up owning a big fat mess.
Buying funds based purely on their past performance is one of the stupidest things an investor can do.
- The average fund does not pick stocks well enough to overcome its costs of researching and trading them;
- the higher a fund’s expenses, the lower its returns;
- the more frequently a fund trades its stocks, the less it tends to earn;
- highly volatile funds, which bounce up and down more than average, are likely to stay volatile;
- funds with high past returns are unlikely to remain winners for long.
A fund with $100M in assets might pay 1% a year in trading costs. But, if high returns send the fund mushrooming up to $10B, its trades could easily eat up at least 2% of those assets.
An index fund – which owns all the stocks in the market, all the time, without any pretense of being able to select the “best” and avoid the “worst” – will beat most funds over the long run.
Late in his life, Graham praised index funds as the best choice for individual investors, as does Warren Buffett.
Decades of research have proven that funds with higher fees earn lower returns over time.
I skipped chapters 10-19.
Chapter 20 “Margin of Safety” as the Central Concept of Investment
A railroad should have earned its total fixed charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income.
The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt.
You can crudely but conveniently approximate a company’s earning power per share by taking the inverse of its price/earnings ratio; a stock with a P/E ratio of 11 can be said to have earning power of 9%. Today “earning power” is often called “earnings yield”.
The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments.
Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety.
For most investors, diversification is the simplest and cheapest way to widen your margin of safety.
We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase.
There is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough.
Investment is most intelligent when it is most businesslike.
The first and most obvious of these principles is, “Know what you are doing – know your business.”
A second business principle: “Do not enter upon an operation – that is, manufacturing or trading in an item – unless a reliable calculation shows that it has a fair chance to yield a reasonable profit.“
A fourth business rule is more positive: “Have the courage of your knowledge and experience.“
You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.
Commentary on Chapter 20
When he was asked to sum up everything he had learned in his long career about how to get rich, the legendary financier J.K. Klingenstein of Wertheim & Co. answered simply: “Don’t lose.”