The Intelligent Investor breakdown series: CHAPTER 1

Previous: The Intelligent Investor breakdown series: INTRODUCTION

Investment versus Speculation: Results to Be Expected by the Intelligent Investor

Chapter 1 is what it’s heading suggest it to be. Part of chapter one was already explained in the introduction which laid down the basics. Chapter 1 goes into the details of what constitutes investment or speculation. It also goes into detail deconstructing the difference and therefore the accompanying results for a defensive and aggressive investor. So to keep it simple, chapter 1 is divided to three sections.

  1. Investment versus Speculation
  2. Results to Be Expected by the Defensive Investor
  3. Results to Be Expected by the Aggressive Investor

Technical words included:

  • Selling short: You borrow stock from someone else. You sell them for the price you received and buy them back at a lower price.

See introduction for rest.

Investment vs speculation

If you know Graham close and his disciple (Buffet), there is one thing they always warn you about and it is the dangers of speculation. Speculation, as opposed to investment, is a completely different activity and people, the media and the wall street itself always tend to mix them, disastrously so.

“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

The book details how the meaning of the word “investor” has changed over time. This is hardened with the fact that anyone who buys or sells security is called an “investor” by the wall street. Graham observes that the distinction between investor and speculator is a useful one and its disappearance is a cause of concern.

The author urges Wall Street to put forth this concern and make the distinction clear. Graham goes on to warn about huge speculative losses that people will have to deal with due to lack of awareness. Some stock markets themselves included speculative stocks on their capital and results weren’t good.

As per Graham, intelligent speculation exists just like intelligent investing does. However few things can make speculation go wrong.

  1. Speculating when you think you are investing.
  2. Speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it.
  3. Risking more money in speculation than you can afford to lose.

Graham here by laid the solid foundation to call any nonprofessional who is putting money in the stock market is speculating and not investing. These are people that go after hot common stocks expecting a quick fat return. The problem with the same people is that when you average their stock market earning over the long term, speculation will prove to be a zero-sum game.

Although I wanted to keep this series clean of Jason Zweig’s commentary, I am quoting one line that is way more powerful than the entire paragraphs of text you read in the book or this series.

“People who invest make money for themselves; people who speculate make money for their brokers.”

Jason Zweig on TII

Results to Be Expected by the Defensive Investor

The introduction section of the book has already described a defensive investor as one interested chiefly in safety plus freedom from bother. To derive an appropriate policy for the defensive investor, Graham would want to consider what he recommended 6 years ago (1965) and compare the changed market conditions to 1971- early 1972.

6 years ago (1965), Graham recommended “the proportion held in bonds be never less than 25% or more than 75%”. An easy pick would be to keep a 50-50 share between the two. The investor can alter his bond/stock holding according to the market keeping the 25-75% margin.

Graham then goes on to describe his learning from 1965 to early 1972 (book published in 1973) to which changes in the market, especially high-interest rates for bonds are indicating a different idea. At one point, the 25-75 split was put under suspicion because the high returns from bonds suggested a 100% capital allocation. In early 1972, both bonds and stocks were giving fair returns hence Graham’s idea of 25-75 splitting remains invincible.

Policy for a defensive investor

The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition.

  • Purchasing shares of well-established investment funds as opposed to creating his own common-stock portfolio.
  • Finding and investing in common trust funds. (if possible, use a recognized investment-counsel firm.)
  • Utilize the method of dollar-cost averaging.

Results to Be Expected by the Aggressive Investor

The aggressive investor is looking to make more money than the defensive one but first, he should make sure he is not loosing all of it. Graham considers few ways in which investors/speculators attempt to make money.

  1. Trading in the market: Purchasing stocks by how they are “behaving”.
  2. Short term selectivity: Purchasing stocks showing the prospects of short term profit.
  3. Long term selectivity: Buying stocks with excellent past records or investing in promising future technologies.

However, most promising stocks can have two problems -human error and the nature of competition. Human error at least from the investor side can be brought to a minimum with a great deal of knowledge and skill. The nature of competition is an obvious fact and it is well understood from the airlines’ example in the introduction section.

Hereon, Graham suggests that the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.

The chapter continues to details through more events and corresponding analysis as applied to aggressive investors. But the above line has concluded them all. If you want to take only one thing away from this chapter, this line is all of it.

Conclusion

Whether you are a defensive investor or an aggressive one, there are stocks that minimize risk and maximize guarantee. However, what Graham told must be kept close to your heart. You must look for adequate performance, not extra ordinary performance.

The Intelligent Investor breakdown series: INTRODUCTION

What is the TII Breakdown series?

The Intelligent Investor is a book written by the British-born American investor, economist, and professor Benjamin Graham. It is considered the bible for stock market investing and is recommended by a multitude of investors including most notably Warren Buffet himself. The book first published in 1949 has been updated multiple times and the last original edition was published in 1973 which preface and appendices by Warren Buffett.

Graham died in 1976, however, there are more recent versions of the book with updated commentary by Jason Zweig. The commentary exists mostly to emphasize the relevance of the book in the modern age. As an old book, people might feel that it is outdated. But it has been proved with the time that there is an underlying principle of investment that remains solid over the decades. The same is mentioned in the introduction of the book. This series will ignore the comments from Jason Zweig and focus on the original content itself.

Why this series exist?

The Intelligent Investor has 21 sections. An “Introduction” section along with 20 chapters. It is important to grasp all sections of the book. This series aims to breakdown all the 21 sections one by one. So this post serves both as the introduction of the series as well as break down the introduction section of the book.

The book is supposed to be the beginner-friendly version of his previous work “Security Analysis” however many people find the book hard to understand. Reading it myself, I can say it is an intermediate book but if you want to start learning to invest with TII, you can. It is not impossible to understand, it just takes time.

My ultimate aim with this series is to make it easy for any beginner to understand the book. So I will breakdown the book chapter by chapter and try explaining them to the best of my abilities.

Who is the author of this series?

Since this series will be a long time consuming read you might want to know the qualification of the author. The Intelligent Investor book itself claims to be beginner-friendly however it is easy to get lost in the pool of technical words and jargon in the book. If someone with an economics degree reads this book, it might be very easy to grasp. I am NOT that someone. I don’t have a degree in economics or finance or whatever. I am a bachelor in Mechanical Engineering and my only relation to economics is a mandatory one-semester course on business economics I had to do half-way through the engineering.

That course more or less didn’t make much of an impact as I was still struggling to understand the book as I got sunk in the pool of technical words and jargon. And that is what I want you to know. I am just someone who read each section multiple times, Googled things and learned them from scratch. This is why YOU can understand this book and apply it in your life.

I hope with the aid of this series, you will do it in no time with or without the backdrop of having anything in economics/finance. With that being said, let’s begin the series. I recommend reading the book on parallel with the series.

Introduction: What This Book Expects To Accomplish

So this is the first section of the book and as the title suggests, the author wants to lay down what he wants to accomplish with it. To fully understand the introduction section, you will have to complete the book and read the intro again. For now, let us dive where the introduction is taking us.

Technical words included:

  • Securities: A security, in general, is a tradable financial asset. In this book, it is a term used to describe either stock or bonds.
    More: https://en.wikipedia.org/wiki/Security_(finance)
  • Stocks: A share in a company.
    More: https://www.investopedia.com/terms/s/stock.asp
    PS: The term “common stock” in the book as per Graham’s narration simply refers to any stock that can be bought. It is easy to confuse with the technical terms Common stock vs Preferred stock
  • Bonds: An individual bond is a piece of a massive loan. When government or large corporates need big loans, they divide them into many pieces each piece making up a single bond. Bonds, as opposed to stocks, have a maturity date by which the principal amount is paid back. Otherwise, the loan defaults.
    More: https://www.investopedia.com/terms/b/bond.asp
    In the book “High-grade Bond” just means bonds that are investment-worthy that produce high yield and has a very low chance of defaulting.
  • Dividends: The share of the profit given to a shareholder/stock owner.
    More: https://www.investopedia.com/terms/d/dividend.asp
  • Investor: Someone who simply invests in the stock market. (For this book, no confusion with broader meanings of the term.)
  • Speculators/Traders: These are not the same people but in this book, they create the same problem. Speculators give out feeds just by looking at some market symbols and traders buy and sell following them.
  • Dow Jones Industrial Average: DJIA is a number that is used to indicate the health of the economy. It is calculated by picking the 30 biggest companies in the stock market. The logic is that if these 30 companies are doing well, the entire economy is doing well. The 30 companies are not fixed and change over time. Higher the DJIA, better the economy.
    Best explained in this video: https://www.youtube.com/watch?v=xCOFepwuz-Q
  • Dollar-cost averaging: Easily explained in this less than 2-minute video.
  • Dow theory:https://www.investopedia.com/terms/d/dowtheory.asp
  • Inflation: Increase in price of goods over time/devaluation of currency over time.
    More: https://www.investopedia.com/terms/i/inflation.asp
  • Tangible-asset value: “Tangible” – the one that you can physically see/touch. The Tangible-asset value of a company is simply the value of the company’s physical properties (real estate, machinery, etc.) and financial balance.
    Goodwill, patents, copyrights are not included in the Tangible-asset value.

The purpose of this book is to supply, in a form suitable for laymen, guidance in the adoption and execution of an investment policy. Comparatively little will be said here about the technique of analyzing securities; attention will be paid chiefly to investment principles and investors’ attitudes.

– Benjamin Graham, The Intelligent Investor

The actual content of the book starts with this couple of lines. These two lines are beautiful as I think it neatly describes what the book is about and to whom it is written. It isn’t written for experts, it is written for anyone and everyone.

The book walks you through so many things intending to make you understand that your attitude as an investor is way above your knowledge and intellectual capacity. That is the number one thing you need to take away from this book. The author goes on to describe the attitude and other know-hows throughout the book as we will see in the coming chapters.

Benjamin is on to the point in explaining things with quotes that are easy to keep in mind.

“Those who do not remember the past are condemned to repeat it.” – The words of George Santayana repeated in the book as Benjamin explains how financial history is an important subject in investment. The book is based on decades of financial history that you need to learn as you will be deemed to encounter something similar in your future.

The introduction section then goes on to draw a line between speculators (traders) and investors. This is well done by picking an example from John J. Raskob who proposed a theory on how savings of just 15 USD per month invested – with dividends reinvested – in common stocks can earn 80,000 USD in 20 years. I was surprised and taken by that theory as well until the book deconstructs its actual feasibility by theoretically estimating it. They found the value is way lower and could be even negative after adjusting for inflation. The purpose of this deconstruction was to show how optimistic forecasts from speculators like this can go wrong and go wrong wildly.

The book hereby draws the line between speculators/traders and investors. The other category (non-investors) are just looking at a graph and seeing things as either up and down. They just buy and sell stocks without understanding them. It’s an action completely based on some numbers and mechanical means. It is mostly controlled by sudden bursts of emotion. This is something you want to avoid and choose to be The Intelligent Investor instead.

The book then goes on to explain its history. Since the original release in 1949, the economy has gone through numerous changes and the book was updated accordingly. The last version of the book released in 1973 had to accommodate for plentiful of changes as described in the book itself. It is mentioned to emphasize the point that the underlying principles of investment remain the same over the decades.

Now the book takes us to two different kinds of investors -defensive (passive) or enterprise (active/aggressive).

The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average.” – Benjamin Graham, The Intelligent Investor.

It is sounded obvious that an active investor will earn more over time compared to the passive one. The book is not vouching for one or the another and is written for both of them.

This is more important coming to where the book takes us next. Graham sights an example of investments in the airline industry. It is obvious that back in 1940, the airline industry made as much excitement as internet stocks made the previous three decades. The idea was simple, the number of air passengers will grow in the coming decades. The numbers will triple/quadruple and hence airline industry is one of the best to invest in. While the “speculation” that there will be an enormous increase in airline passengers was true to the last bit, the idea that one should invest in airline stocks because of it turned out to be miserable.

Those who invested in airline industries suffered a huge loss even when the industry grew in size and demand for air travel sky rocketed. This is again to emphasize why speculation shouldn’t be confused with investment even if they are obvious.

Those who jumped to buy the airline stocks because of its obvious prospects maybe the “aggressive” investors. The book shares two morals from this.

  1. Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
  2. The experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.

With this, the author debunks the idea that an ever-growing industry with ever-growing companies in them may no always be the ideal investment destination. To this day, it is agreed that the airline industry as a whole has collective negative returns. There is something more than what meets the eye.

The next paragraph(s) is written on how investors attitude is the key to success. Investments like the one mentioned in the airline industry come from excitement and temptations. You the intelligent investor shall not be deceived by such temptations and are expected to show patience and restraint.

“The habit of relating what is paid to what is being offered is an invaluable trait in investment.” The author writes as a means to emphasize the need to calculate the intrinsic value of a stock first.

The rest of the introduction section spends its time debunking the speculative approach and its pitfalls. The book in the coming chapters will take you more through the pitfalls associated as it recommends a “Margin of safety” approach towards investment.

Next: The Intelligent Investor breakdown series: CHAPTER 1 (Coming soon)