Ben Graham’s Get-Rich Investing Secret, More Valuable Than Ever Guest Post: By Larry Light. Larry is the former senior editor for money and investing at Forbes and deputy personal finance editor at the Wall Street Journal, and author of a recent book, Taming the Beast: Wall Street’s Imperfect Answers to Making Money (Wiley 2011)

this shows how modern investing strategies evolved and how to profit from them now.

Modern investing began when the world was burning down. Benjamin Graham, a celebrated financier who was in the middle of the flames, invented a process of evaluating investments and popularized it during the Depression-ridden 1930s. It was a way for ordinary people to rebuild their decimated holdings and become wealthy.

In today’s rocky markets, old Ben (1894-1976) still has a lot to teach us about how to get rich investing. The big take-away: Be flexible enough not to get mired in any discipline. They all have strengths and flaws. Knowing what they are lets you navigate around the perils and land on the opportunities. Or at least gives you a better chance.

Before Graham came along, there had been no widely used investing systems. The capital markets were like wild frontiers. They too often operated on cronyism and outright fraud; they were swept by manias and laden with onerous debt. Cornelius Vanderbilt concocted a massive stock slide in 1869 by flooding the market with shares from his railroads, as a means of thwarting rival Jay Gould.

Ben Graham taught that investors must be analytical and diligent about choosing and managing their holdings. He provided an orderly method of evaluating stock and bonds.

Hand in hand with that insight was the strategy he invented, called value investing, which aims to find cheap, under-appreciated stocks. Inspired by his example, other investing systems later sprouted. Some extended Graham’s thinking; others were in opposition to it.

All sought to tame the unruly market beast, which was capable of bringing both destruction and riches. It’s significant that the symbols of Wall Street are both animals: the bull (optimistic) and the bear (pessimistic). Graham taught that people should be careful when dealing with such powerful, dangerous creatures.

Taken together the approaches created by Graham and his various successors form the foundation of investing in the 21st century: indexing, behaviorism, growth investing, hedging, on and on.

But here’s the rub. While the adherents of each often swear by their preferred system as the one true path, they all have deep flaws. Graham’s beloved value investing has a pretty good track record, except when it doesn’t.

Value investors were big under-performers in the late 1990s tech boom, and were devastated by the bear market that erupted in 2008 because what looked cheap and reliable – financial outfits like Lehman Brothers and Fannie Mae – were the first to fall when the credit crunch occurred.

Hidebound notions are obstacles to clear thinking, Graham argued. Stretch that concept, and you see that smart investors should be free to dip into any number of investing styles, provided they have done their homework.

It made no sense to stay out of growth stocks during the tech boom. From 2002 until 2007, real estate plays were very smart. Investing in a private hedge fund can be quite lucrative, provided that it is the right fund. Amaranth Advisors collapsed in 2006 when its managers bet the wrong way on energy futures. Its investors lost most of their money.

Graham disagreed with some of the more complex investing ideas that rose around investing after World War II. But he always wanted investors to be open-minded and decide for themselves.

Successful investors have an ambidextrous ability. They don’t put all their chips in one pot. While Graham is considered the avatar of value stocks, he also advocated owning a large slug of bonds, for safety’s sake.

Among the investing systems that, post-Graham, took form as entrenched beliefs are those aimed at diversifying holdings widely so they are better protected (now known as asset allocation), divining the influence of crowd psychology on the market (behaviorism), unmasking inept or fraudulent companies and betting against them (short selling), focusing on index funds that track the broad market instead of picking individual stocks, investing overseas where insular Americans tend not to look for terrific opportunities.

Certainly, a number of these ideas have been kicking around for a long time, yet merely in a minor sense. Nowadays, they are championed by hordes of professional adherents.

Example: Diversifying assets, so all of them don’t get slammed at once, is simple common sense that wise souls have long followed. Graham in his seminal book,Security Analysis, advised people to spread their holdings “to minimize the influence of luck and to allow maximum play to the law of probability.”

Lately, though, an intellectual discipline has appeared to guide that diversification. An entire industry of financial planners has arisen, using sophisticated tools such as the computerized Monte Carlo simulations, which crunch hundred if not thousands of scenarios for your portfolio to see what the odds are it will last through retirement.

By the same token, people have been shorting stocks for centuries, although only now does a real discipline exist, with experts solely dedicated to ferreting out weaknesses and exploiting them. The accounting forensic work of big-shot short-sellers like James Chanos, who exposed the rotten insides of Enron, is new under the sun. Graham himself at times sold short, betting on the decline of stocks his own probes had shown to be over-hyped losers.

Some of these ideas, such as the hedge funds’ quant approach, went in directions that even the math-obsessed Graham likely would have disdained. The quant wizards believe they can divine market directions or exploit trading anomalies via extremely intricate calculations, possible only on computers.

The quants slice up funky bonds, packaging them into supposedly safer creatures with names like collateralized debt obligations. Also, the quants cobble together bafflingly complicated derivatives, which are phantom securities that are based on the behavior of actual securities.

While wide use of computers for investing didn’t exist until Graham was elderly and retired, he likely would have considered the quants too abstruse. He believed that the math needed to get a good picture of a stock’s true value was accessible to anyone with brains and dedication. Warren Buffett, his disciple, is leery of derivatives, which he labeled in 2002 as “financial weapons of mass destruction.”

Two latter-day ideas we know Graham disliked are: 1) growth investing, the notion that rising stocks should be snapped up because they surely will continue to rise, and 2) the efficient market hypothesis (EMH), which holds that trying to beat the market overall is silly – it’s the intellectual foundation for index funds.

Growth investing was very popular in the 1920s, although no one had a name for it. Growth investors usually don’t much care about whether a stock is any good; they only care if its price is rocketing. A market commentator named Gerald M. Loeb, whose book The Battle for Investment Survival, appeared around the time Security Analysis first did, counseled that investors should buy when a stock is hot, regardless of the price, then sell on any weakness.

But without examining stocks’ fundamentals, Graham said, that kind of investing is sheer folly. Such a strategy calls on someone to be ahead of the crowd, often an impossible task. A growth strategy, he wrote, “is largely a matter of A trying to decide what B, C and D are likely to think — with B, C, and D likely to do the same.”

At the end of his life, Graham took time to lambaste the fashionable idea of EMH, a then-new academic theory contending that a stock’s price is the summation of all publicly available knowledge. Thus, the theory says, with hordes of investors scrutinizing the market every day, it is doubtful that a stock can be mis-priced for long.

As a result, according to EMH, investors can’t beat the market overall, and their best bet is to buy an index fund that passively mirrors it, such as the Vanguard 500. The stocks in such a fund are pre-selected by dint of their index membership, without need of much human intervention.

And that seems like a pretty good idea. Indeed, from 2004 through 2008, Standard & Poor’s found that its S&P 500 index (covering large-capitalization stocks) did better than 72 percent of large-cap actively managed mutual funds, meaning those that pick stocks. The S&P MidCap 400 beat 76 percent of actively managed mid-cap funds, and the S&P SmallCap 600 did better than 85 percent of small-cap funds.

Graham’s argument against EMH was that ignorance and emotions are powerful factors in stock pricing, which prevent markets from operating anywhere near efficiency. Thus stock values, he said, are typically skewed higher or lower than they should be. Individual investigations of a stock’s true worth may show it is temporarily undervalued, hence a bargain waiting to be exploited.

Under the Graham approach, smart managers who have the tools to delve into the innards of corporate finances can be among the 28 percent of actively managed large-cap funds that beat the index, and the same goes for the 24 percent of mid-cap funds and the 15 percent of small-cap ones that best the market.

In the end, Ben Graham had one revelation that investors of all stripes can agree with: a lot of investing is done badly, which benefits those who do it well. “It is fortunate for Wall Street as an institution,” he said, “that a small minority of people can trade successfully, and that many others think they can.”

Graham knew well that taming the beast of investing is hard, brain-challenging work.

 

Investing Systems: Pros and Cons

TAMING THE BEAST breaks down the various approaches that have grown up over the past half-century:

Value Investing. Numerous studies indicate the strategy of finding under-valued gems does better over time than growth investing. Still, it flags badly in some periods, such as in the late 1990s tech boom. And the risk of a “value trap,” cheap stocks that should stay that way, always lurks. Warren Buffett got rich as a value investor. Not everyone has.

Stock-centric Investing. According to Wharton Professor Jeremy Siegel, stocks over the past two centuries have been the best investment by far, averaging 7% growth yearly, after inflation. Result: Stock funds dominate retirement accounts. But the Lost Decade (2000-2009), when stocks went nowhere, shows the limitations of this thesis.

Index Funds. Capturing the entire market, these funds routinely beat actively managed ones. Their flaws are that some index funds don’t track the indexes very well. And in bull markets, the indexes are over-exposed to the hottest stocks, which usually crash the worst when bad times arrive.

Bond Investing. The increasing complexity of this once boring asset class has made it a better opportunity – and also riskier. Pimco’s Bill Gross demonstrates how to ride them to great profit. Bonds are good ballast for a portfolio, in general. Inflation and poor credit quality are their downsides. Mortgage-backed bonds and junk bonds have tanked in the past, damaging investors.

Growth Investing. Thomas Rowe Price, founder of the T. Rowe Price securities firm, preached that the best time to invest in a stock with accelerating revenue and earnings was at the start of its life cycle. While many growth issues are faddish things that soon shrivel, smart growth investing can be very lucrative. Cliff Asness regularly beats the indexes by choosing the top stocks with the best price performance.

International Investing. Only a quarter of U.S. investments are in foreign holdings. Yet as the iconic investor John Templeton showed, overseas is where great prospects lie. He spotted Japan’s emergence early. After World War II, America claimed 90% of global equity capitalization; by 2010, that had dwindled to half, as others arose. China is the latest darling, although it has many weaknesses that may thwart investors in its securities.

Real Estate. Property logged enormous appreciation since World War II. The weakness is its dependence on debt. That in recent years un-did many a zealous homeowner, saddled with a too-large mortgage. Packaging dicey mortgages into securities almost crashed the global financial system in 2008. Despite the current housing slump, nice ways to play property still exist via good real estate investment trusts.

Alternatives. Currencies, commodities, gold and timber were once the province of the rich. New investment vehicles make it possible for ordinary people to get into them. Alas, these assets all have suffered extended periods of price weakness. Currencies and commodities in particular are highly volatile.

Asset Allocation. Ben Graham advocated spreading one’s holdings widely so weakness in one area could be offset by strength in another. An entire professional, financial planning, has been created to help people do that. Economist Harry Markowitz invented Modern Portfolio Theory to aid diversifying. Some financial models, however, depend on the bell curve and past returns, which proved tragically wrong in 2008.

Short Selling. Dedicated short sellers like James Chanos (he shorted Enron) and David Einhorn (Lehman Brothers) serve as good harbingers of trouble in various investments. While widely vilified, they cleanse the system. Yet this is a highly risky way to invest. Sometimes, a shorted stock will move badly against you.

Hedge Funds. These lightly regulated investing pools, long off-limits to those without $1 million in investable assets, can show extraordinary returns through their sophisticated moves. Lately, some have opened mutual fund arms to allow the less-wealthy in. Not all are winners, however. Long Term Capital Management’s wipeout in the late 1990s threatened to harm the entire financial system.

Behaviorism. This new academic discipline seeks to codify what veteran investors like Graham knew first-hand: Emotions and human fallibility animate much of investing. Behavioral studies highlight what to avoid instead of what to invest in. Graham’s whimsical character, Mr. Market, is a manic-depressive, just the opposite of what a good investor should be.

 

To purchase Larry’s recent book on Amazon.com, click on the following link- Taming the Beast: Wall Street’s Imperfect Answers to Making Money