Book Review of The Intelligent Investor by Benjamin Graham

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Book Review of The Intelligent Investor by Benjamin Graham
This Book Review of The Intelligent Investor by Benjamin Graham is brought to you by Allison Davis from the Titans of Investing.

Genre: Non-fiction, Business
Author: Benjamin Graham
Book: The Intelligent Investor (Buy the Book)

Summary:

Written in  1949, Benjamin Graham’s book offers valuable, practical advice on how to become an Intelligent  Investor. Rather than focusing on an investor’s IQ, the commonly used measure of intelligence, Graham focuses on establishing a solid intellectual framework and developing emotional discipline.

For those wishing to obtain long-term gains, minimize losses, and control their self-defeating behavior,  The  Intelligent Investor provides an accurate framework for doing so.  From a book also referred to as “The Bible of Investing”, one will learn why these proverbial truths are written over sixty years ago still apply today.

Graham first establishes the importance of differentiating between investing and speculating. Although he believes speculation cannot be ignored completely, the Intelligent Investor will avoid speculation and maintain emotional discipline by thoroughly analyzing a company and the soundness of its underlying business before buying the stock.

Graham states that trying to beat the market by speculating may work in the short term, but the Intelligent Investor develops a fundamental framework that ignores temporary affirmations in exchange for long-term reliability.

In addition, a brief market history from 1900-1974 is given. Various bear and bull markets are documented in order to reveal market psychology for the investor. Although Graham does not recommend forecasting because investors are often wrong, it is important to acknowledge the past and pay attention to current factors. Most importantly, the Intelligent Investor should be confident that —

“full decade figures smooth out the year-to-year fluctuations and leave a general picture of persistent growth.”

One of the main points of Graham’s classic literature regards the investor’s choice to become either a defensive or enterprising investor. A defensive (passive) investor’s goal is to avoid serious mistakes or losses. Defensive investors are conservative; they do not devote the time to make frequent decisions. Defensive strategies create a permanent portfolio to run on autopilot and require minimum effort.

In contrast, enterprising (active or aggressive) investors are willing to devote time and the effort to care for the selection of securities. Active investors continually research, select, and monitor their mixture of stocks, bonds, and mutual funds. The rate of return is dependent upon the intelligent effort the investor is willing and able to invest.

The passive, defensive investor will receive the minimum return while the maximum return would be realized by the enterprising investor. Ultimately, both are intelligent, but the investor must decide which type applies to them and stick with it.

Graham also advises on how to react when the market fluctuates. He emphasizes how having the financial discipline and psychological maturity to endure the markets manipulative mind tricks will prove to be a worthy investment with great return. All in all, Graham’s message is clear: be confident in the market, your portfolio, and yourself. Resist the urge to follow the crowd’s initial, impulsive response.

The use of the analogy “Mr. Market” is illustrated to further this idea.   Mr. Market is depicted as a partner who comes to the investor every day telling him what he believes the investor’s interest is worth.  His daily communications with the Intelligent Investor are to be expected but should not influence the investor’s own evaluation of his interest.

In the same way, the investor should expect stocks in his portfolio to fluctuate and should not be concerned by these declines or get excited by advances. Instead, he should always remember these market quotations (Mr. Market) are there for his own convenience. He can either take advantage of these quotes or ignore them.

In regards to evaluating management, Graham proposes how his dividend policy can be utilized to accurately reflect shareholders’ needs. However, he also emphasizes how it is the Intelligent Investor’s responsibility to stay informed, read the proxy and provide their input to management.

Lastly, Graham reveals how implementing the Margin of Safety concept is the secret to successful investing. By utilizing the margin of safety, the Intelligent Investor can protect himself from uncontrollable events in the future. Graham believes maintaining a margin of safety is the best form of insurance for the Intelligent Investor.

In conclusion, Graham reinforces valuable principles which must be acted upon in order to become an Intelligent Investor:

  1. A stock is not just a ticker symbol; it is an ownership interest of an actual business.
  2. Shareholders have the responsibility to act accordingly; they are the only ones to blame when management is not representing their interest.
  3. The underlying value of a company does not depend on its share price; an investor must value the share and make their own decisions after careful research and analysis.
  4. The market is constantly fluctuating between unjustified optimism, where stocks are overpriced and unjustified pessimism, where stocks are undervalued.
  5. The future value of every investment is related to the present price. The more investors pay now, the lower their return will be.

However, no matter how intelligent an investor becomes, he cannot avoid the risk of being wrong. In order to compensate for this risk, he must use the Margin of Safety principle illustrated by Graham. The ultimate goal is to replace guesswork with emotional discipline and courage in order to become an Intelligent Investor.

Introduction

Warren  Buffet,  one  of  the  most  famous  and  successful  investors  of  all  time,  claims  The Intelligent Investor by Benjamin Graham is, “by far the best book on investing ever written.” Such a bold statement indicates both confidences in the book’s basic premise on how to approach value investing and concrete evidence that his suggestions are indeed powerful.

The archaic, incorrect idea that successful investing over a person’s lifetime depends on the investor’s IQ is replaced with the importance of building a  solid intellectual framework and developing emotional discipline. Written in 1949, Graham offers practical wisdom and communicates his ideas at such a level of eloquent simplicity that his assertions have withstood the test of time.

Commonly referred to as “The Bible of Investing”, the reader can also become the Intelligent Investor by adhering to three main timeless lessons covered in the book: how to minimize the chance of suffering permanent losses, how to maximize chances of achieving sustainable gains, and how to control self-defeating behavior.

Overall, the virtues of a simple portfolio policy are emphasized and his wisdom is displayed throughout the book. Upon reading this timeless piece of financial literature and putting Graham’s practices into action, a person can incorporate these strategies to become an Intelligent Investor.

Who is Benjamin Graham and Why is He Relevant?

If you were an avid baseball fan, it would be logical to conclude you have heard of Babe Ruth. In the same sense, every serious investor should know who Benjamin Graham was and what he believed in. As the father of value investing, he was not only one of the best investors to ever live, but also the most practical investment strategist. As any wise confidant would tell you, they learned their lessons the hard way. 

Graham discovered this idea of value investing and emotional intelligence after experiencing the disaster of financial loss and by studying for decades the history and psychology of the markets. Born in London in 1884 to an affluent family, he enjoyed a simple, easy life. However, after moving to America, his father passed and his family was on the brink of poverty. He witnessed firsthand what happened when his mother, who was borrowing on margin, lost all her money in the 1907 stock market crash.

He was fortunate to receive a degree from Columbia and decided to work on Wall Street. While there, he became an expert at researching companies and their stocks in an acute, analytical fashion. Graham even survived the Great Crash in 1929, and had one of the best long-term track records in Wall Street history by the time he retired in 1956. Graham’s secret to success is one of intelligence, common sense, and experience.

He developed his core principles over sixty years ago that Warren Buffet still lives by today. Graham’s wisdom lines every page and his simplistic delivery of valuable advice is similar to that of a trusted grandfather; Graham is someone who is honest and his guidance is practical for all investors—from the recent college graduate to the eighty-year-old retiree.  Simply reading  Graham’s ideology and putting it into action is an honorable tribute to one of the most relevant, greatest investors who ever lived.

Investment vs. Speculation: Which Path Should the Intelligent Investor Follow?

Over the years, confusion has arisen when distinguishing who is an investor and who is a speculator.  Quite simply, Graham settles the debate by defining the two:  

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

Speculation decreases your chances of building wealth and is ill-advised. However, just because one participates in the stock market does not deem him the title of Intelligent Investor. Graham gives three steps in order to avoid speculation and to maintain emotional discipline:

  1. Thoroughly analyze a company, and the soundness of its underlying business, before buying its stock
  2. Deliberately protect against serious losses
  3. Aspire to achieve adequate, not extraordinary, performance

On the other hand, speculation cannot be ignored completely. There are speculative factors which are sometimes unavoidable when high likelihoods of either profits or loss exist. “Intelligent Speculation” exists, but more often than not, speculation becomes unintelligent when a person

  1. Speculates when they think they are investing
  2. Speculates seriously when lacking proper knowledge or skill
  3. Risks more money than they can afford to lose

Much like oil and water, the two should not be mixed together because they will not blend for sustainable, long-term gains. Trying to beat the market by speculating may work in the short term, but the Intelligent Investor develops a fundamental framework that ignores temporary affirmations in exchange of long-term reliability.

In conclusion, the basic premise is that speculation may only produce temporary, short-term gains, as a speculative value does not equal true intrinsic value.

A Century of Stock-Market History: What the Intelligent Investor Can Glean

“History does not repeat itself but it does rhyme.”

-Mark Twain

Although knowledge of the recent history of stocks does not indicate what will happen tomorrow, it is important to understand the long-term relationships the market presents over a century. An Intelligent Investor understands the manner in which stocks made their advances through the cycles and economic times of the century.

For example, the “New Era” bull market culminated in 1929 with the collapse of the stock market followed by unpredictable fluctuations until 1949. In addition, World War II’s impact represented the largest decline for the Standard & Poor’s indices of 44% from 1939-1942 (due to Pearl Harbor).

The annual rate of return during this time was only 1.5% and thus the public was not eager to invest in the stock market. However, Graham points out this “rule of opposites” wherein the more excited investors become about the stock market, the more certain they are to be disappointed in the short run. Assuming the opposite, Graham saw the potential for the greatest bull market in history.

From 1949-1968, an average of 14% return led to a false idea that the rise would continue, yet there was a sharp decline from 1968-1970. However, after 1970, a speedy recovery reestablished a new all-time high for Standard & Poor’s industrials; the annual return from 1949-1970 turned out to be roughly 9%.

This brief market history reveals to the investor how to implement a consistent portfolio strategy. Although the 1900-1974 time period experienced both bull and bear markets, the Intelligent Investor should be confident —

“full decade figures smooth out the year-to-year fluctuations and leave a general picture of persistent growth.”

What does all this mean for the Intelligent Investor? The Intelligent Investor must never make predictions of the future based solely on the past. The stock market will disappoint everyone who believes a bullish market is here to stay and that high returns are predictable. While optimism is often encouraged in life, focusing on recent, high returns will lead to emotional investing, and eventually, illogical conclusions.

For instance, the average investor knows it is important to buy low and sell high. However, when they try to implement this basic knowledge, many investors simply act opposite and end up overpaying for stocks. So does that mean market history is useless?  Not necessarily, understanding the market’s long-term returns leaves a picture of general persistent growth and is enough to calm the Intelligent Investor’s nerves.

Graham advises that an investor must acknowledge the past, understand market psychology, but also realize that stock market performance depends on other factors as well. The three factors which determine the stock market’s performance include the following:

  1. The real growth – the rise of companies’ earnings and dividends
  2. Inflationary growth – general rise of prices throughout the economy
  3. Speculative growth (or decline) – any increase or decrease in the investing public’s appetite for stocks

The second lesson in Graham’s approach is that the only thing a person can be confident of while forecasting, is that they are probably wrong. The future will always surprise investors, markets will brutally surprise people who are most confident they are right.

Therefore, Graham advises investors to stay humble, which will keep them from taking too much risk. Lower your expectation, but do not lose hope; this idea of understanding market history,  coupled with emotional stability, is the underlying path to success Graham proposes.

Defensive vs. Enterprising Investor: Know Yourself and Stay on Course

“But the investor’s choice as between the defensive or the aggressive status is of major consequence to him, and he should not allow himself to be confused or compromised.”

-Benjamin Graham

In order to understand what role emotional stability plays in our overall success in the stock market, it is necessary to realize whether you are a defensive or enterprising investor. While an Intelligent Investor can be either defensive or enterprising, meaning either affiliation is a good choice, it is important to understand that the two types follow different general portfolio theories.

First, we must distinguish between the two. A defensive investor’s goal is to avoid serious mistakes or losses. Defensive investors are conservative; they do not put forth the time to make frequent decisions. Defensive strategies create a permanent portfolio to run on autopilot and require minimum effort.

In contrast, enterprising (active or aggressive) investors are willing to devote time and the effort to care for the selection of securities. Active investors continually research, select, and monitor their mixture of stocks, bonds, and mutual funds. The rate of return is dependent upon the intelligent effort the investor is willing and able to bear.

The passive, defensive investor will receive the minimum return while the maximum return will be realized by the enterprising investor. Both mentioned are equally intelligent, but the investor must decide which type applies to them and stick with it.

Alpha is an investor’s stock-picking ability and is calculated by how well the investor outperforms (or underperforms) the market’s return. Over time, Graham communicates how Intelligent Investors will witness far greater returns and obtain positive alpha. On the other hand, the Unintelligent Investors, those who do not follow Graham’s guidelines, will experience disappointing returns and even negative alpha.

It is easy to see these different types of investors as their actions are evident from their portfolio’s performance. In addition, because Graham believes that an investor’s IQ does not determine to invest intelligence, a person must become intelligent by selecting either the defensive or enterprising investor position. Intelligence is ultimately displayed by maintaining an investing philosophy for the long term and reaping the benefits.

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Are You Brave or Will You Cave?

The general portfolio theory for the defensive investor is a straight path requiring little deviation throughout the investor’s lifetime. The defensive investor should divide funds between high- grade bonds and high-grade common stocks.

The rule of thumb is to never have less than 25% or more than 75% in common stock, and a consequent inverse range of between 75% and 25% in bonds. Because investors struggle to cling to their stocks in a declining market, this percentage set aside for bonds will give you the courage to stay in the market.

Analysts and other financial theorist suggest maintaining a 50-50  diversification and increase or decrease based on the market. Graham would agree with the 50-50 split, however, he disagrees with increasing or decreasing their corresponding percentages based on the market. Even more so, he refutes the idea that the reason for increasing common stocks would be the appearance of bargain prices in a bear market.

Instead, he believes a person should reduce common stock when the market is dangerously high. These simple principles are difficult to follow because they go against human nature. It seems outrageous that a stockholder would lighten their holdings when the stock market advances and add to them with a decline.  However, Graham enlists in the rule of opposites and encourages investors to be pro-active, not reactive, to the markets pendulum-like swings.

In addition, Graham ignores age as a factor when considering the defensive investor’s portfolio allocations. In contrast to many financial publications, he believes your age does not determine how much risk you should take.

Circumstances in life, rather than age, should be the only factors that  cause  changes  in  your  allocations.  Graham repeatedly emphasizes that once these percentages are set, do not change them unless new, overwhelmingly powerful factors suggest a change.

The general portfolio theory for the aggressive or enterprising investor follows the same baseline model as the defensive investor, yet it also includes opportunities to take on more “adventurous” investments. For instance, the enterprising investor is more willing to branch out with a well- reasoned justification for departure.

Selection for the enterprising investor depends not only on his competence and knowledge but also weighs heavily on his individual interests and preferences. While the possibilities seem endless, Graham does offer a shortlist of boundaries:

  1. Leave high-grade preferred stocks to corporate buyers
  2. Avoid inferior types of bonds and preferred stocks unless they are a bargain and at least 30% under par
  3. Stay away from foreign government bond issues even when the yield may seem attractive

Graham offers simple explanations for his “off-limits” list. Foreign bonds have had a bad investment history since 1914. Although there might be no concrete reason about the future of these bonds, when trouble does come to these foreign countries, the owner has no legal means of enforcing their claim.

Well-documented examples include those who invested in the Republic of Cuba, Belgian Cigo, Greek, and Poland foreign government bonds. All of these bonds promptly decreased in value after they were issued and left investors with nothing. Also, be wary of new issues that may seem tempting and avoid common stocks with only great earnings in the past. Graham advises all investors to be wary of new issuances like IPOs.

As an Intelligent Investor, you should carefully examine and research these new issues prior to investing in them. Graham explains that new issues are typically sold under “favorable market condition”, meaning they are favorable for the seller and less favorable for the buyer. The enterprising investor should stay away from these IPOs and invest elsewhere.

In addition, new common stock issues tend to fall proportionally below the true value at which they were sold. The ability to resist the appeal of a salesman offering new common stock issues during a bull market is a trait all Intelligent Investors should acquire.

Success for the Enterprising Investor

As stated earlier, the enterprising investor will devote time, research, and emotional intelligence into obtaining an above average return. But how do you achieve better than average investment results? Graham offers two initial criteria for consideration:

  1. It must meet the investor’s test of being a sound company mentioned earlier
  2. It must be different from the policy followed by most speculators or investors

If the enterprising investor passes the first criteria, he is only passing the first phase of investing-research and analysis. Assuming the investor can maintain emotional discipline by not overreacting to the market, Graham then focuses on security selection. He has three recommendations in order to achieve a policy different from most speculators and investors.

The first recommendation is to invest in the relatively large, but unpopular company. The market has a habit of overvaluing popular common stocks with excellent growth; therefore, it would be logical to assume the market also undervalues companies with subpar growth and unsatisfactory developments.  

The enterprising investor should concentrate on the large companies going through a period of unpopularity because small companies carry too much risk and are often neglected by the market. Also, larger companies have a double advantage over other companies because they have the resources, such as capital and brainpower, to carry them through adversity and bounce back.

The market is quick to respond to larger companies with any reasonable improvement. Graham’s second recommendation is to purchase bargain issues. A bargain issue is one which appears to be worth considerably more than it is selling for. More specifically, a bargain means the intrinsic value is at least 50% more than the current price. These bargains can be determined by valuing their appraisals and taking the present value of future cash flows.

The other way to value firms is by looking at their net current assets and working capital. Either method will reveal whether or not the security is a bargain. The third and final recommendation is to invest in special situations such as mergers and acquisitions, or firms undergoing legal procedures, as they tend to be undervalued by the market.

Underlying all of these recommendations remains the assumption that the enterprising investor possesses considerable knowledge of security values–enough to view his own securities equivalent to a  business.  Graham warns there is no middle ground,  and the path of an enterprising investor is not for everyone.

The Market Pendulum: The Correct Way to React to the Swings

Investors understand long-term bonds have wide price swings during their lifetimes and common stock portfolios tend to fluctuate over a period of several years. Certainly these are facts of life and events the Intelligent Investor has no control over. However, the Intelligent Investor can be prepared for these possibilities both financially and psychologically.

While it is easy to say a person should not speculate, putting those words into action is vitally important. Having the financial discipline and psychological maturity to endure the markets manipulative mind tricks will prove to be a worthy investment with great return.

As the market swings, much like a pendulum, the investor must hold tight to his principles and beliefs.  Between 1897 and 1949 there were 10 complete market cycles going from bear market low to bull market high and back to bear market low. Maintaining emotional discipline during these market cycles is difficult, but well-advised. A serious investor should not believe month-to- month fluctuations will make them rich or poor.

Even long term fluctuations in the market cause great unrest to the immature investor; psychological problems grow here as the pendulum swings and thus leads to strong temptations for imprudent actions. All in all, Graham’s message is clear: be confident in the market, your portfolio, and yourself. Resist the urge to follow the crowd’s initial, impulsive response.

To illustrate this point further, Graham gives the following example of how an investor may question himself upon receiving positive information:

“Your stocks advance, good! You are richer than you were, good! But has the price risen too high, and should you think of selling? Or should you kick yourself for not having bought more shares when the price was lower? Or, worst of all—should you now give way to the bull market atmosphere, become infected with enthusiasm, the overconfidence and the greed of the great public market (of which, after all, you are a part of), and make larger and [more] dangerous commitments?”

These are common questions an investor must confront on a daily basis. The simple answer to each posed question is “no.” As stated before, do not overreact and resist the tendency to follow the crowd.  Graham believes many people overact because they want to react somehow; they feel the need, the desire, the urge to make something happen.

Perhaps it is human nature that we factor some mechanical method for adjusting our portfolio as it gives the investor a way to respond. However, the right kind of investor will not let his emotional reaction overtake his discipline. So, how does a person know if he is on the right path? Quite simply, Graham states,

“as long as his operations are exactly opposite from the crowd, he is reacting in a positive manner.”

Graham offers more advice for achieving emotional discipline by stating the true investor is scarcely ever forced to sell his shares. In fact, most times he is free to ignore the current price quotation and rely on his own beliefs. While he needs to pay attention to the price, it should not control his decisions. Those who allow the price to stampede them tend to worry, and thus, lose all advantages the market has to offer. On the contrary, it is wise to establish a personal “True North”, and use one’s carefully researched beliefs about the company’s intrinsic value as their guiding compass.

The Mr. Market Analogy

By far one of the most important concepts of the book is the idea of “Mr. Market” and the fluctuations that ensue from his antics:

Pretend you own a small share of a private business that cost you $1,000. One of your partners, Mr. Market, tells you every day what he thinks your interest is worth and even offers to buy you out or sell additional interest based on his assumptions. Sometimes, his offers seem reasonable, justified, and logical. Often times though, he lets his enthusiasms or fears overreact leading to unreasonably valued propositions.

So, if you are a prudent, Intelligent Investor, would you let Mr. Market’s daily communication with you determine your $1,000 interest in the business? If you agreed with him, then yes you would. Or if you wanted to trade with him, you might. You may be happy to buy him out when he gives a very low price, or you may be happy to sell him all your interest if he gives you an extremely high price. But for a majority of the time, you would be wise to form your own idea of the value of your interest based on the reports from the company’s operations and financial statements.

In the same way, the Intelligent Investor is in that position when owning a common stock. He can either choose to take advantage of the daily market price, or leave it alone and trust his own judgment and beliefs. While signals are misleading,  the  fluctuations can only have one significant meaning for the investor: to buy wisely when prices fall and to sell wisely when they increase. All in all, he would do better if he forgets about the stock market and instead focuses on dividend returns and operating results of his company.

Again, the most important distinction between investors and speculators is their attitude toward these stock market movements. A speculator’s primary motive is to anticipate and profit from these fluctuations. The investor, on the other hand, wants to acquire and hold suitable securities at reasonable prices. Market movements are important, but most times it would be wise to refrain from buying or selling.

The investor should expect stocks in his portfolio to fluctuate and should not be concerned by these declines or get excited by advances. Instead, he should always remember these market quotations are there for his own convenience. He can either take advantage of these quotes or ignore them. Instead of acting foolishly, he should always revert back to the following motto:

“Never  buy  a  stock  immediately  after  a  substantial  rise,  or  sell  one  immediately  after  a substantial drop.”

Shareholders and Management: The Proposed Solution

The question of how to evaluate management has been debated from multiple perspectives. The idea of corporate governance is a buzzword in the financial and accounting realms. However, Graham offers his insight on how to determine whether management is performing well or if they should be challenged.

Investors are easy to please, but they also demand explanations when things are going wrong. It is known that poor management leads to poor market prices, but when are investors allowed to challenge management with effective, reasonable questions?

Graham states we are justified in posing questions to managements when the following occur:

  1. Results are unsatisfactory in themselves (independent of other firms)
  2. Results are poorer than their competitors
  3. Results have led to unsatisfactory market prices for a long duration of time

Everyone knows these events occur repeatedly, so why don’t stockholders react? In theory, investors, in a class system, would be considered king. Although they have the ability to hire and fire management acting contradictory to their wills, they don’t. Shareholders, as Graham calls it, are

 “a complete washout…they show neither intelligence nor alertness.”

 Appalled by our inaction, he fervently hopes all investors realize that when you buy stock in a company, you become an owner of the company. Managers and CEOs work for you, not the other way around. Unfortunately, many investors focus so much into buying socks, but little into owning it.

Graham offers us two basic questions we must use to judge the efficiency of management:

  1. Is management reasonably efficient?
  2. Are the interests of the average outside shareholder properly recognized?

If the answer to the first question is “No”, then a change is needed and expected. With other stockholders who agree, read the proxy material and learn why the company has been unsuccessful; identify what needs to be changed and what can be reasonably demanded from management.

Proxy material is of the upmost importance as it entails the agenda for annual meetings, discloses compensation/stock ownership of management, and other important accounting matters. The proxy can be a warning sign of bad things to come, or an invitation to the party when good things are on the horizon.

Unfortunately, sometimes only half of investors read these statements. Understanding and voting on your proxy is as fundamental as choosing what stocks to purchase. In turn, if the company crumbles due to your lack of input, you only have yourself to blame.

If the answer to the second question is “No”, then a change is needed and expected. Managers believe they always know what is best for their investors. However, this is nothing other than company propaganda. Management may appear to run a company well, yet the best interests are not properly recognized because they are not efficient with their capital.

Because managers always want the most capital they can receive, they will often operate with more capital than necessary  and  refuse  to  pay  dividends.  Thus,  Graham  introduces  a  solution  to  the  above problems in the form of a dividend policy.

Dividend Policy Explained

Companies many times refuse to pay dividends because they believe they are better users of that money, and therefore, create value for the shareholders by retaining the funds for profitable expansion or an increase in stock price. On the other hand, many investors depend on dividend income and believe that the profits belong to the shareholders. While there are strong theories on both sides, Graham compromises by stating:

“It is our belief that shareholders should demand of their managements either a normal payout of earnings, or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per share earnings.”

By enforcing this dividend policy, managers are held accountable and shareholders are in control.

The Secret of Sound Investing: Margin of Safety

The secret of sound investing can be summarized in three distinct words: Margin of Safety. This ingredient is required when choosing bonds and preferred stocks. Defined for the bondholder as “the past ability to earn in excess of interest requirements,” margin of safety is used by investors to protect themselves in the case of future declines.

For the bondholder, the margin of safety is the accurate estimate of the future. If the margin is large, then it is enough to assume that future earning will not fall below past earnings, thus leaving the investor protected from the uncontrollable events of the future.

The common stock holder can also experience a margin of safety. As Graham defines it,

“The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments.”

Graham believes maintaining a margin of safety is the best form of insurance for the Intelligent Investor. In addition, he goes into detail about how the margin of safety is related to other important financial factors.

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Relationship between Margin of Safety and Diversification

As expected, there is a strong correlation between margin of safety and diversification. Even when there is a substantial margin of safety, an individual security may lose value and fail the investor. Margin of safety only ensures the investor has a better chance for profit than for loss, not necessarily that loss is impossible.

Graham indicates the margin of safety alone will not protect the Intelligent  Investor.  Therefore,  he endorses diversification as a conservative investment principle which goes hand-in-hand with a margin of safety. Quite simply, by diversifying your portfolio, you automatically assume this margin of safety in the case of an individual security’s failure.

Relationship between Margin of Safety and Risk

Losing money is inevitable. Unfortunately, The Intelligent Investor doesn’t offer a fool-proof solution for avoiding risk all together. However, Graham does offer interesting insights in explaining that risk not only applies in our portfolios but also internally – inside the Intelligent Investor’s own mind. Ultimately, if you overestimate how well you understand the investment and overstate your ability of emotional discipline during market drops, it would not matter how the market behaves.

Risk is not defined merely by what investments are in your portfolio, but also what kind of behavior you assume as an investor. Because risk is due to probabilities and consequences, it is important to understand your true knowledge of the investment, and consequently how you may react to certain outcomes. The Intelligent Investor’s own psychoanalysis will thus lead to following these concepts of the margin of safety and risk, helping to protect him when he has incorrect predictions.

Mr. Market’s crazy antics may tempt a person to leave  these  lessons  behind  and  pursue  a  meaningless  chase  after  an  unconquerable  feat. However, with a sense of inner self and confidence in the lessons learned from Graham, the Intelligent Investor will thrive.

Conclusion

When Graham first entered Wall Street in 1914, no one would have guessed he would introduce such a revolutionarily, simple, and effective approach to investing. His approach to becoming an Intelligent Investor is easier than one would assume. However, this approach comes an extraordinary challenge to maintain emotional discipline.  His core principles still apply to today’s financial market.

It should be of no surprise that his wisdom derives from his simplistic approach and humble achievements. Graham reinforces valuable principles, which must be acted upon. First, a stock is not just a ticker symbol; it is an ownership interest of an actual business. Second, shareholders have the responsibility to act accordingly; they are the only ones to blame when management is not representing their interest.

Third, the underlying value of a company does not depend on its share price; a person must value the share and make decisions after careful research and analysis. Fourth, the market is constantly fluctuating between unjustified optimism, where stocks are overpriced and unjustified pessimism, where stocks are undervalued.

The Intelligent Investor recognizes these situations and buys from the pessimist and sells to the optimist. Finally, the future value of every investment is related to the present price. The more investors pay now, the lower their return will be. He concludes by reminding investors that no matter how intelligent they are, they will be wrong at some point and cannot eliminate this risk.

In order to compensate for this risk, an investor must use the Margin of Safety principle illustrated by Graham. Managing to never overpay can greatly minimize the inevitable occurrences  of being wrong during an investing career.  Lastly,  and most importantly,  by replacing guesswork with emotional discipline and courage, a person can hope to achieve long- term success as an Intelligent Investor.

HookedtoBooks.com would like to thank the Titans of Investing for allowing us to publish this content. Titans is a student organization founded by Britt Harris. Learn more about the organization and the man behind it by clicking either of these links.

Britt always taught us Titans that Wisdom is Cheap, and the principal can find treasure troves of the good stuff in books. We hope only will also express their thanks to the Titans if the book review brought wisdom into their lives.

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