With the proverbial short memories of people in the stock market – Benjamin Graham, 1949
Often we recommend The Little Book of Common Sense Investing by John C. Bogle as the first book on investing to be read by college or university students who ask us for some guidance in investing. In this book Bogle spends a chapter on outlining Benjamin Graham’s views regarding the defensive investor. Bogle is correct when he states that in Graham’s view the defensive investor is to divide his portfolio in United States Savings Bonds and a passive diversified list of leading common stocks. However the astute reader of The Intelligent Investor knows that this recommendation comes with a BIG warning, a warning Graham repeats many times over. Based on a scanned reading of The Intelligent Investor we are able to find at least 12 instances of the same warning for the defensive investor … unmentioned by Bogle in The Little Book of Common Sense Investing. Let’s have a look (emphasis in bold added).
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"The buyer of common stocks must assure himself that he is not making his purchases at a time when the general market level is a definitely high one, as judged by established standards of common-stock values.
“If we accept our reasoning with respect to what today's intelligent individual investor will buy, we are led to several wide and important categories of securities which he will not buy: 2) Leading common stocks when the market is at high levels as judged by past experience.
"A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defensive investor, whose emphasis is on long-pull holding, but as such it represents an essential minimum of attention to market levels.
On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is higher than can be justified by well-established standards of value.
"If they [defensive investors] follow our prescription they will confine themselves to United States Saving Bonds and the common stocks of leading corporations purchased at levels that are not high in the light of experience and analysis.
"In other words, by bidding up the market quotations for common stocks to unprecedented heights the self-styled common-stock investor destroyed the very arithmetical advantage which was supposed to justify prudent commitments in stocks rather than in bonds.
"Common-stock investment as a whole presents a psychological hazard, because stock buyers are subject to human weakness and are prone to talk like investors and to act like speculators. But assuming that the common-stock investor can hold himself rigidly to a true investment pattern - which means that he will stick to high-grade stocks bought at reasonable prices - then the experience of the past fifty years supports the view that he will fare appreciable better than the bond investor. The conclusions of Edgar Lawrence Smith remain sound, as long as the investor does not depart from the fundamental relationships of price to earnings and to the assets upon which those conclusions were founded.
"This would protect the investor against the common error of buying good stocks at high levels of the general market.
“The defensive investor who follows our suggestions will purchase only United States government bonds plus a diversified list of leading commons stocks. He is to make sure that the price at which he bought the latter is not unduly high as judged by historical standards.
“That program would call for only a minimum of aid from the security analyst. He would be asked only to supply a list of large, long-established and prosperous companies and to certify that the individual stock price of each, or perhaps the group or average price, is not high in the light of experience.
“It may be quite enough if he [the defensive investor] buys a well-diversified cross section at any time except when the general market level has advanced into an area that cannot be justified by established standards of value.
“The danger to investors lies in concentrating their purchases in the upper levels of the market or in buying non-representative common stocks which carry more than average risk of diminished earning power.
The message is clear. The defensive investor can and should buy “a representative list of common stocks” to earn his fair share of stock market returns provided that valuation levels are “not unduly high as judged by historical standards”. As valuation levels of the general market reach into high to extremely high territory however, not uncommon in financial history, chances are increasingly likely that our easy-going investor will be confronted with long-term or permanent capital losses. In the conclusions of The Intelligent Investor, on p. 244, Graham states:
“Nor can the investor count with confidence on an eventual recovery – although this does come about in some proportion of the cases – for he has never had a real safety margin to tide him through adversity.
The uncertainty surrounding the possibility of large price declines translating into long-term or permanent capital losses assures that common stocks will become psychological dynamite for our lay investor. Consequently our defensive investor will sell out somewhere near the bottom of the market – with losses of between 50 to 75% – and … never return to the stock market again.
The Little Book on Common Sense Investing is definitely a good primer for student investors. For the best book on common sense investing and notably the key to consistent long-term capital gains we direct students to The Intelligent Investor (1949).
Steven De Klerck
Article by Pure Value Capital