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Shortly before Benjamin Graham died, he gave an interview reflecting on everything learned during his 60+ year career. The interview is titled A Conversation with Benjamin Graham by the Financial Analyst Journal. Graham’s profound answers offer powerful lessons for investors still to this day.
During the course of Benjamin Graham’s career, he published a vast number of articles, speeches, and reports documenting his investment principles. By far, the most referenced of these publications are two time-tested books, Security Analysis and The Intelligent Investor.
But, none of Graham’s publications are more relevant to individual investors than his last interview. As Daniel Webster famously said, “Wisdom begins at the end.”[drizzle]
A Conversation With Benjamin Graham
This article is the third of a multi-part series called, Lessons From A Conversation with Benjamin Graham. In this series, we look at each of Graham’s answers and see how they are relevant to investors today.
Part 3 breaks down three questions from A Conversation with Benjamin Graham. The questions focus on Graham’s recommended approach for how an investor should build a common stock portfolio.
Question: What general rules would you offer the individual investor for his investment policy over the years?
Ben Graham: Let me suggest three such rules:
(1) The individual investor should act consistently as an investor and not as a speculator. This means, in sum, that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase–in other words, that he has a margin of safety, in value terms, to protect his commitment.
(2) The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase–say 50 to 100 per cent–and a maximum holding period for this objective to be realized–say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market.
(3) Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines. I would suggest, in general, an average seven- or eight-year maturity for his bond holdings.
Translation: Graham’s long answer to a short question comes down to three main points: establish buy rules, establish sell rules, and allocate to reduce volatility. When setting buy and sell rules, objectivity is the most important thing. Consistently following calculated buy and sell rules prevents emotions from getting in the way of sound reasoning. In the third part of his answer, Graham suggests that investors put a large portion of their investments in bonds. This is because historically bonds have been much less volatile than stocks. Anyone who invests in common stocks will see negative returns at some point. To paraphrase Charlie Munger, if you’re not comfortable seeing your stocks go down 50%, you have no business buying stocks at all. Graham’s advice to own bonds is to help investors emotionally during the rough times.
Question: In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?
Ben Graham: In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.
Translation: This is a shocking statement from the author of Security Analysis. At first glance, it appears that Graham is disregarding everything he has advocated for throughout his career. After taking a closer look at his answer, however, it’s clear that this isn’t the case. The two key phrases in Graham’s response are: “elaborate techniques” and “limited extent”. After six decades, Benjamin Graham realized that detailed analysis – or “elaborate techniques” – do not result in superior returns. Therefore, he agrees with the Efficient Market Hypothesis only to a “very limited extent”. As you’ll see in his next answer, he does believe investors can beat the market using simple strategies.
Question: What general approach to portfolio formation do you advocate?
Ben Graham: Essentially, a highly simplified one that applies a single criteria or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole–i.e., on the group results–rather than on the expectations for individual issues.
Translation: This is arguably the most important question of the entire interview for individual investors. What approach should investors use to build their common stock portfolios? Graham’s answer is profoundly simple. He recommends a strategy which buys a group of stocks based on one or two criteria. It’s interesting because most index funds invest using only one or two criteria. For example, an S&P 500 index fund buys the 500 largest stocks based on market capitalization. Many other index funds buy stocks according to the sector a company operates in. Graham, however, does not advocate making investment decisions based on market-cap or sectors. He specifically recommends investors select stocks based on valuation using quantitative data.
At the very end of Benjamin Graham’s career, he offered individual investors some profound advice. The best way to profit in the stock market is to follow a simple investment approach. He recommends one which sets buy and sell rules based on one or two criteria.
In the next edition of Lessons from A Conversation with Benjamin Graham, we’ll discuss the specific investment strategies Graham recommended.
Mitchell Mauer is the Founder of TheStockMarketBlueprint.com. The Stock Market Blueprint is a site that finds value stocks for investors building long-term wealth. The site’s investment philosophy is anchored in principles established by Benjamin Graham and his most reputable followers over the last 100 years.[/drizzle]