Warren Buffett is widely considered one of the greatest investors of
all time, but if you were to ask him whom he thinks is the greatest
investor, he would probably mention one man: his teacher,
Benjamin Graham. Graham was an investor and investing mentor who is generally considered the
father of security analysis and
value investing.
His
ideas and methods on investing are well documented in his books,
"Security Analysis" (1934), and "The Intelligent Investor" (1949), which
are two of the most famous investing texts. These texts are often
considered requisite reading material for any investor, but they aren't
easy reads. In this article, we'll condense Graham's main investing
principles and give you a head start on understanding his winning
philosophy.
Principle #1: Always Invest with a Margin of SafetyMargin of safety is the principle of buying a security at a significant discount to its
intrinsic value,
which is thought to not only provide high-return opportunities, but
also to minimize the downside risk of an investment. In simple terms,
Graham's goal was to buy assets worth $1 for 50 cents. He did this very,
very well.
To Graham, these business assets may have been valuable because of
their stable earning power or simply because of their liquid cash value.
It wasn't uncommon, for example, for Graham to invest in stocks where
the
liquid assets on the balance sheet (net of all debt) were worth more than the total
market cap
of the company (also known as "net nets" to Graham followers). This
means that Graham was effectively buying businesses for nothing. While
he had a number of other strategies, this was the typical investment
strategy for Graham.
This concept is very important for
investors to note, as value investing can provide substantial profits
once the market inevitably re-evaluates the stock and ups its price to
fair value.
It also provides protection on the downside if things don't work out as
planned and the business falters. The safety net of buying an
underlying business for much less than it is worth was the central theme
of Graham's success. When chosen carefully, Graham found that a further
decline in these undervalued stocks occurred infrequently.
While many of Graham's students succeeded using their own strategies, they all shared the
main idea of the "margin of safety."
Principle #2: Expect Volatility and Profit from ItInvesting in stocks means dealing with
volatility.
Instead of running for the exits during times of market stress, the
smart investor greets downturns as chances to find great investments.
Graham illustrated this with the analogy of "Mr. Market," the imaginary
business partner of each and every investor. Mr. Market offers investors
a daily price quote at which he would either buy an investor out or
sell his share of the business. Sometimes, he will be excited about the
prospects for the business and quote a high price. Other times, he is
depressed about the business's prospects and quotes a low price.
Because
the stock market has these same emotions, the lesson here is that you
shouldn't let Mr. Market's views dictate your own emotions, or worse,
lead you in your investment decisions. Instead, you should form your own
estimates of the business's value based on a sound and rational
examination of the facts. Furthermore, you should only buy when the
price offered makes sense and sell when the price becomes too high. Put
another way, the market
will fluctuate - sometimes wildly - but
rather than fearing volatility, use it to your advantage to get
bargains in the market or to sell out when your holdings become way
overvalued.
Here are two strategies that Graham suggested to help mitigate the negative effects of market volatility:
Dollar-Cost Averaging Dollar-cost averaging
is achieved by buying equal dollar amounts of investments at regular
intervals. It takes advantage of dips in the price and means that an
investor doesn't have to be concerned about buying his or her entire
position at the top of the market. Dollar-cost averaging is ideal for
passive investors and alleviates them of the responsibility of choosing
when and at what price to buy their positions.
SEE:
Take Advantage of Dollar-Cost Averaging and
Dollar-Cost Averaging Pays
Investing in Stocks and Bonds Graham recommended distributing one's portfolio evenly between
stocks and
bonds
as a way to preserve capital in market downturns while still achieving
growth of capital through bond income. Remember, Graham's philosophy
was, first and foremost, to preserve capital, and
then to try
to make it grow. He suggested having 25-75% of your investments in
bonds, and varying this based on market conditions. This strategy had
the added advantage of keeping investors from boredom, which leads to
the temptation to participate in unprofitable trading (i.e.
speculating).
Principle #3: Know What Kind of Investor You Are Graham
advised that investors know their investment selves. To illustrate
this, he made clear distinctions among various groups operating in the
stock market.
Active Vs. PassiveGraham referred to
active and
passive investors as "enterprising investors" and "defensive investors."
You
only have two real choices: The first choice is to make a serious
commitment in time and energy to become a good investor who equates the
quality and amount of hands-on research with the expected return. If
this isn't your cup of tea, then be content to get a passive ( possibly
lower) return but with much less time and work. Graham turned the
academic notion of "risk = return" on its head. For him, "Work =
Return." The more work you put into your investments, the higher your
return should be.
If you have neither the time nor the inclination to do quality research on your investments, then investing in an
index
is a good alternative. Graham said that the defensive investor could
get an average return by simply buying the 30 stocks of the
Dow Jones Industrial Average in equal amounts. Both Graham and Buffett said that getting even an average return - for example, equaling the return of the
S&P 500
- is more of an accomplishment than it might seem. The fallacy that
many people buy into, according to Graham, is that if it's so easy to
get an average return with little or no work (through indexing), then
just a little more work should yield a slightly higher return. The
reality is that most people who try this end up doing much worse than
average.
In modern terms, the defensive investor would be
an investor in index funds
of both stocks and bonds. In essence, they own the entire market,
benefiting from the areas that perform the best without trying to
predict those areas ahead of time. In doing so, an investor is virtually
guaranteed the market's return and avoids doing worse than average by
just letting the stock market's overall results dictate long-term
returns. According to Graham, beating the market is much easier said
than done, and many investors still find they don't beat the market.
Speculator Vs. InvestorNot
all people in the stock market are investors. Graham believed that it
was critical for people to determine whether they were investors or
speculators.
The difference is simple: an investor looks at a stock as part of a
business and the stockholder as the owner of the business, while the
speculator views himself as playing with expensive pieces of paper, with
no
intrinsic value.
For the speculator, value is only determined by what someone will pay
for the asset. To paraphrase Graham, there is intelligent speculating as
well as intelligent investing - just be sure you understand which you
are good at.
The Bottom LineGraham served as
the first great teacher of the investment discipline and his basic
ideas are timeless and essential for long-term success. He bought into
the notion of buying stocks based on the underlying value of a business
and turned it into a science at a time when almost all investors viewed
stocks as speculative. If you want to improve your investing skills, it
doesn't hurt to learn from the best. Graham continues to prove his worth
through his disciples, such as Warren Buffett, who have made a habit of
beating the market.
Read more:
http://www.investopedia.com/articles/basics/07/grahamprinciples.asp#ixzz28UVLHfnn
source: http://www.investopedia.com/articles/basics/07/grahamprinciples.asp#axzz27YfS3F7h
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