This is the fifth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the fourth chapter, which is on pages 88 to 100, and the Jason Zweig commentary, on pages 101 to 111.

A lot of people like to argue that the rate of return you can expect from an investment is directly related to the amount of risk you take on. The more risk you have, the greater the potential return – but also the greater risk if you suddenly need to pull out your money.

I’ve always felt that this is a very limited view of things and that it ignores the effort and intelligence of the investor. An investor who can invest a lot of time studying the market and specific investments and can apply cool reasoning and behavior to his or her investments can get a better return than an investor who just wants to stick his or her money somewhere.

Take index funds, for example. Stock index funds are made up of all of the stocks that meet a certain criteria. If you buy into an index fund, it’ll essentially do as well as the average of all of those stocks. That actually also lowers your risk a fair amount because you’re not tied to the ups and downs of a specific company.

For an investor with limited time to research and understand specific investments – such as me – that’s a great way to invest. However, I know that if I had adequate time to actually study the market and played it cool, I could often (not always, but often) pick specific stocks that would beat this return.

Why don’t I do that? With the amount of money I have to invest (relatively small) and the time it would take to actually do the research and pick the investments (relatively large), it’s not a cost-effective use of my time. Give me index funds or give me death!

This is much the same logic that this chapter provides. Graham also buys into the idea that an intelligent and patient investor has a big advantage over the “gambler”-investor.

Chapter 4 – General Portfolio Policy: The Defensive Investor
Graham opens the chapter defining two different kinds of investors: the “active” investor, which is the kind of investor that actively seeks new investments and invests serious time into studying investments, and the “passive” or “defensive” investor, the kind of investor that wants to invest once (or on a highly regular basis) and just let his or her portfolio run on autopilot.

Regardless of the activity that you apply to your investments, Graham sticks hard with his recommendation from the earlier chapter: 50% stocks, 50% bonds (or a close approximation thereof, with an absolute maximum of 75% in either side). It’s important to remember with a recommendation like that that Graham is very conservative in his investing, dreading the idea of an actual loss in capital. Only in the most dire of down markets (like 2008, for example) would such a portfolio actually deliver a loss to the investor.

Much of this chapter is spent talking about the various types of bonds that a person can buy: savings bonds, treasury notes/bills, municipal bonds, and corporate bonds dominate most of the chapter, with most of their ins and outs described. Graham doesn’t really come to a conclusion about any of them, merely pointing out that there is a huge diversity of options when it comes to the bond portion of your portfolio – some short term, some long term, some free from taxes, some not.

Commentary on Chapter 4
So, how can you tell whether you should be 75% stock and 25% bonds or 50/50 or 25/75? Or somewhere in between? Zweig argues that it mostly comes down to your goals, the stability in your life, your other savings, and your tolerance for risk. The more stable things are and the longer term your goals are, the higher your proportion of stocks can (and probably should) be.

Zweig also covers several additional options for the bond portion that didn’t exist in Graham’s day, such as bond funds, mortgage securities (no, no, no, no, NO!), and annuities. More importantly, Zweig actually looked at holding cash as an investment option in such things as high-interest online savings accounts and CDs. All of these can be a big part of the conservative half of one’s portfolio, sharing space with (or replacing) bonds.

Most interestingly, though, Zweig suggested that buying stocks solely for the dividends might be considered something that could be a part of the conservative side of a portfolio. Zweig points out that many common stocks pay out 3% or more of their value in dividends each year, so if you select a high-dividend stock from a very stable company, it could potentially serve as part of the conservative side of a defensive investor’s portfolio. I don’t know if I agree with this, given the inherent riskiness of owning individual stocks, that companies reset their dividends annually, and that even the most stable of companies can fall apart quicker than you might expect.

Next Friday, we’ll look at Chapter 5: The Defensive Investor and Common Stocks.

This is the third in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the third chapter, which is on pages 65 to 79, and the Jason Zweig commentary, on pages 80 to 87.

“Past performance is not a guarantee of future results.”

That phrase (or variations on it) is something you read over and over and over again if you read much about specific investments in the modern era. In fact, it’s printed so often that many people simply breeze on past it, not giving the phrase a second thought.

Yet virtually everything we can know about the stock market comes from past performance. Believing that the stock market will jump when the Federal Reserve cuts rates? It’s based on past performance. Believing that the stock market will fall on poor economic numbers? It’s based on past performance. Believing that a certain stock is undervalued compared to the rest of the market? It’s based on past performance.

That’s why it’s so valuable to look in detail at the history of the stock market. How has the market typically reacted to certain events? How have individual stocks reacted to certain events? How have things gone when the economy is thriving … and when the economy is slow?

This study is never a guarantee of what will happen, but it’s a pretty good guide. And that’s why Graham spends twenty pages or so delving into the past here.

Chapter 3 – A Century of Stock Market History
Graham spends this chapter drawing on a century’s worth of stock market history to come up with some general investment principles as to how to invest in the stock market in early 1972.

Now, at first glance, that might seem incredibly boring. “Why do I need to know how to invest in the 1972 stock market? Tell me what I need to know now.” If that’s your perspective and you’re merely seeking a specific investing recipe to follow, I suggest that you put this book down immediately and pick up a good book of investing recipes, like The Lazy Person’s Guide to Investing.

What’s actually worth studying here is the process. How does Graham come to the conclusions that he does about the stock market in 1972? He walks step by step through the logic, showing how the market in 1972 is very similar to earlier bull markets and patterns. He concluded that the bull run was likely somewhat near the top – he didn’t worry too much about actually guessing the specific top – and thus one should invest with that situation in mind.

Another thing worth noting is that Graham’s advice for the 1972 market really applies well to any stock market that’s riding a year-plus long bull market. His advice is basically don’t go into debt to invest right now and also don’t have more than half of your investment money in stocks – the rest should be in bonds, cash, real estate, etc.

Graham’s advice is conservative, but he doesn’t hide the fact that he doesn’t want investors to lose principal – that’s a constant theme throughout the book. Graham vastly prefers very conservative moves and patience, waiting carefully for a great investment opportunity instead of throwing the farm at any old piece of fool’s gold.

Commentary on Chapter 3
Zweig deftly takes Graham’s arguments about the 1971-1972 stock market and applies them to the stock market of 1999 and 2000. In both cases, that peak was followed by a drop and, if one had followed Graham’s general advice of how to invest conservatively at the peak of a stock market, you would have rolled right through it without much loss.

Zweig also makes the argument that, based on Graham’s calculations and the numbers in the stock market from 1993 to 2003, one could reasonably expect the 2003 to 2013 stock market to return roughly 6% – or 4% after inflation. Looking at the first half of that range, from January 2003 to October 2008, the stock market (by most metrics) is roughly back to where it started, with most of the gains coming in the form of dividends.

I couldn’t help but speculate, while reading this chapter and Zweig’s commentary, that this same exact “peak investing” philosophy applies very well to 2006 and 2007. I know that if I had gone very conservative in late 2007 with my investments – even if I just left what I had in stocks and merely started buying bonds instead – I’d be in a much better place financially right now. My retirement accounts wouldn’t be hurting nearly as much.

Next Friday, we’ll look at Chapter 4: General Portfolio Policy: The Defensive Investor.

This is the third in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the second chapter, which is on pages 47 to 57, and the Jason Zweig commentary, on pages 58 to 64.

Inflation.

It’s a word I’ve never liked. It represents an erosion in everything we work hard for. It naturally devalues our investments, working against growth. It causes items on the grocery store shelves to inch up in price, completely out of our control.

When my father was a boy, he would go to the gas station and fill up tanks of gas for his boat motor. The cost? Sixteen cents a gallon. Right now, I can buy a gallon for about $2.70 – that’s a sixteenfold increase. Over those sixty years, the price of a gallon of gas doubled, doubled again, doubled again, and doubled yet again.

In other words, the value of a 1940s dollar is roughly sixteen times the value of a dollar today.

It’s inflation that makes putting dollar bills under your mattress a completely worthless investment. Even if you did nothing more with your money than put it in a savings account bearing 2% interest, you’d still be protected at least a little bit against inflation. A dollar put away in that 2% interest savings account for sixty years would be worth $3.28 – better, but still not that sixteenfold increase we’d need to keep up.

The other solution would be to just invest everything in the stock market, but if 2008 has shown us anything, the stock market is a huge roller coaster. You might be way ahead of inflation a few years, then lose most of those gains the next.

How can an investor simultaneously protect themselves against risk and at the same time keep up with (or ahead of) inflation? That’s Graham’s topic here.

Chapter 2 – The Investor and Inflation
The biggest point that Graham makes in the chapter is that there really is no true hedge against inflation. He mostly looks at stocks, pointing out that ups and downs in the stock market are largely uncorrelated with the onward march of inflation. He also looks at the history of other assets and finds much the same – gold isn’t a great long-term hedge against inflation, either.

Another point I found really interesting: Graham suggests that, for your own calculations, you assume 3% annual inflation. He made this prediction in 1972 based on historical data, so I was curious to see how it stacked up. Lo and behold, he’s not that far off. Except for a rough patch at the end of the 1970s, annual inflation rates indeed average out to right around 3% over the long haul. There are some patches that are lower, with percentages in the 2s and even the 1s, and some higher, but the average isn’t all that far off since 1972.

I think it’s fairly reasonable to use that 3% number – or 3.5%, if you want to be conservative and guess a strong inflationary rate. It’s what Graham called almost four decades ago and it’s been pretty accurate over the long haul since then.

What about investment choices? Graham’s conclusion is that diversification is key. You shouldn’t put all your money into stocks (because of the volatility risk), nor should you put everything into bonds or cash (because they usually don’t earn enough to beat inflation). Balancing these two is the right way to go. In Graham’s words:

Just because of the uncertainties of the future the investor cannot afford to put all of his funds into one basket – neither the bond basket [...] nor in the stock basket, despite the prospect of continuing inflation.

Commentary on Chapter 2
Zweig does a great job of pointing out why inflation is sneaky.

There’s another reason investors overlook the importance of inflation: what psychologists call the “money illusion.” If you receive a 2% raise in a year when inflation runs at 4%, you will almost certainly feel better that you will if you take a 2% pay cut during a year when inflation is zero. Yet both changes in your salary leave you in a virtually identical position – 2% worse off after inflation.

A great return is nice, but it’s not all that great if it happens during a period of high inflation. Zweig immediately points to the late 1970s and early 1980s, where you could get a CD at 11% and it still wouldn’t even keep up with inflation.

As I write this, inflation is at roughly 5 to 6%, depending on the figure you use. The CPI (a common measure of inflation) actually fell from August to September 2008, so that rate of inflation may actually be going down. In comparison, as Zweig points out, we were barely at 2% inflation from 1997 to 2002.

The point? Inflation is not constant. And it’s not something you can predict, either. Instead, it’s a constant reminder that your dollar today will be worth less than a dollar tomorrow, slowly but surely. That’s a big reason why investing is worthwhile – investing helps your dollars keep pace with that growth, usually ahead of it, sometimes behind it, but always moving against that force.

One avenue that Zweig explores as a hedge against inflation are TIPS – treasury inflation-protected securities. These increase in value directly with inflation – if inflation is high, these return well. However, Zweig encourages you only to buy them in retirement accounts where you won’t be whacked with a tax penalty, because the taxation on TIPS can keep you on your toes otherwise.

Next Friday, we’ll look at Chapter 3: A Century of Stock-Market History: The Level of Stock Prices in Early 1972.

This is the second in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the first chapter, which is on pages 18 to 34, and the Jason Zweig commentary, on pages 35 to 46.

I have a friend who keeps cajoling me that I should become a day trader. “Come on!” he says. “You could write the stuff for The Simple Dollar while daytrading! It’s easy as pie!”

So one day I asked him to explain to me what he was doing. He offered up a bunch of explanations that basically amounted to technical analysis using a bunch of online tools.

Then I asked the $64,000 question: “Do you actually know anything about the companies whose stocks you’re buying and selling?” He responds, “Not too much, but I don’t need to.”

My friend is a speculator. That’s fine – it works for him. But it only works because he devotes his life to figuring out small inefficiencies in the market. He’s really passionate about finding them.

For most of us, though, we don’t have the time, patience, or interest to engage in that minutiae. We are investors.

Chapter 1 – Investment Versus Speculation: Results to Be Expected by the Intelligent Investor
Graham gets down to business. In only the second paragraph of the chapter, he specifies the difference between investors and speculators:

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

In Graham’s view, an investment is something that you’ve analyzed carefully. You know exactly what you’re buying. You know it’s stable for the long haul. You also know that it will give you an adequate return, either through an increase in share value or through healthy dividends for the price you pay.

The ones that scream “BUY! BUY! BUY! WE’RE ALL GETTING RICH!” when the stock market is high and then scream “SELL! SELL! WE’RE ALL GOING BANKRUPT!” when the market is low are speculators. The people that look for undervalued companies no matter what the market is doing, buy them, then only sell them if they actually need the money or if they’re not undervalued any more, those people are investors.

Graham argues that one of the biggest dangers for investors is that they’re speculating when they believe they’re investing. They buy a stock, for instance, based on a hot tip that, if true, might make it a good investment. Or they purchase a mutual fund based on a television ad or magazine ad, without really doing the due diligence to see whether it’s a quality investment based on sound principles that ensures quite a bit of safety in the investment and some sort of decent return.

Furthermore, Graham states that the only way you can be an investor (and not a speculator) that beats the market is by having an investment philosophy that’s based on sound logic that’s not popular on Wall Street at the moment.

I immediately thought of Jim Cramer’s comment on Graham during the peak of the 2000 stock market bubble, which Zweig mentioned in his commentary in the introduction:

In February 2000, hedge-fund manager James J. Cramer proclaimed that Internet-related companies “are the only ones worth owning right now.” These “winners of the new world,” as he called them, “are the only ones that are going higher consistently in good days and bad.” Cramer even took a potshot at Graham: “You have to throw out all of the matrices and formulas and texts that existed before the Web … If we used any of what Graham and Dodd teach us, we wouldn’t have a dime under management.”

[...]

By year-end 2002, [...] a $10,000 investment spread equally across Cramer’s picks would have lost 94%, leaving you with a grand total of $597.44.

Interestingly, most of the internet stocks during the dot com bubble wouldn’t have passed the Graham test. Not even close. Score one for the unpopular method.

So, what can we learn here? Don’t invest without knowing what you’re buying. Study it very carefully before you buy. If you want to speculate, that’s fine, but don’t speculate with any money you’ll actually need for the future.

Commentary on Chapter 1
Zweig does a good job of boiling down Graham’s view on what investment is, summarizing it in three points:

* you must thoroughly analyze a company, and the soundness of the underlying businesses, before you buy its stock;
* you must deliberately protect yourself against serious losses;
* you must aspire to “adequate,” not extraordinary, performance.

If you want an absurd return that’s going to blow away the market over the short term, value investing probably isn’t for you. Having said that, though, Graham’s principles are intended to avoid huge losses as well. That’s because the entire idea is to seek out undervalued companies – ones that, for some reason, the market has overlooked. Maybe they’re boring. Maybe they have an undeserved bad reputation.

Zweig makes that point again a bit later:

If they beat the market over any period, no matter how dangerous or dumb their tactics, people boasted that they were “right.” But the intelligent investor has no interest in being temporarily right.

In short, investing fads are a joke. Just a few weeks ago, I scathed the book Millionaire by Thirty because it was just that – an investing fad with short term success that the author tried to parlay into this great investing strategy that was timeless. It wasn’t. Zweig points out at least a dozen more similar investing fads or shortcut formulas, all of which worked over the short term, and none of which work over the long term.

What does work, then? Knowing in detail what you’re investing in. Is it a good, stable, safe company? Is it undervalued? Does it pay solid dividends? Those are where the real values are at. They’re not glamorous, but if you can find them, you’ll always do well, no matter how the market changes.

Next Friday, we’ll look at Chapter 2: The Investor and Inflation.

This is the first in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the introduction, which is on pages 1 to 11, and the Jason Zweig commentary, on pages 12 to 17.

Let’s start right off with the three big questions you’ll probably have if you see The Intelligent Investor on the shelves at your local bookstore or library – or if you see offhand mention of it in some magazine or online article somewhere.

What is The Intelligent Investor? First published in 1949 (and revised several times afterward), The Intelligent Investor is a very widely acclaimed book on value investing. Value investing refers to the practice of seeking out underpriced stocks as identified by some form of analysis, usually in comparison to various attributes of the company and its competitors. In its simplest form, everyone who bargain hunts is doing some form of value investing – you’re seeking out situations where particular items are undervalued compared to what they actually should be, and usually, you determine this value based on knowing what similar items are worth and how popular an item is.

Who is Benjamin Graham? Is he a legitimate expert with a worthwhile point of view? In a word, yes. Benjamin Graham was the inventor (along with David Dodd) of value investing. He began teaching the approach at Columbia Business School in 1928 and he published many books on value investing, including this one and Security Analysis (1934). Most notably, Graham was Warren Buffett’s mentor – Buffett actually attended Columbia Business School simply to learn from Graham. So, yeah, Graham knows what he’s talking about.

Is The Intelligent Investor a worthwhile read for me? The Intelligent Investor was Graham’s attempt to explain value investing to the layman. That doesn’t mean that it’s a simple book by any means – it’s very meaty, indeed. I think Warren Buffett’s comment on the book says it best: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” It’s meaty, tough, challenging reading – but it’s perhaps some of the most valuable reading you can invest your time in when it comes to the stock market.

So, let’s dig in right at the start.

Introduction: What This Book Expects to Accomplish

We must say at the outset that this is not a “how to make a million” book. There are no sure and easy paths to riches on Wall Street or anywhere else.

In short, if you want a quick and easy path to becoming rich in the stock market, you’re not going to find it here. Because it doesn’t exist.

The big point that Graham seeks to make in the introduction is that the stock market is at least somewhat unpredictable. He points out how World War I caused the New York Stock Exchange to shut down for a long time, whereas two months before no one saw America entering the war. I was reminded of 9/11, actually, and the impact that had on so many aspects of America, and how no one really saw it coming.

Graham offers up many, many examples of how the stock market had gone up and down between World War I and the early 1970s, sometimes for predictable reasons, sometimes for unforeseen reasons. Not only that, no one was able to predict how much the market would go up or go down during any of these changes.

Because of this unpredictability, Graham argues that the only way you can get ahead in investing is by sticking to a set of basic principles through thick and thin. He doesn’t guarantee that his set of principles will beat the market, but he does state that these principles have worked well over a long period of time (roughly 50 years) because the principles aren’t about timing the market, but about evaluating the businesses themselves.

Commentary on the Introduction
Each chapter in the book (at least, the HarperBusiness Essentials edition that’s commonly found in bookstores) features some additional commentary by Jason Zweig, written in 2003. Zweig is the author of several personal finance books and is a personal finance columnist for the Wall Street Journal after having previously written for Money Magazine, among other places. The point of the commentary is to attempt to put a more modern spin on the things Graham says and, for the most part, it’s a good supplement.

Zweig’s main focus is on the tech bubble bursting from 2000 and 2002, showing the irrational exuberance of people in late 1999 and early 2000 and showing what happened to them. My favorite:

After his Amerindo Technology Fund rose an incredible 248.9% in 1999, portfolio manager Alberto Vilar ridiculed anyone who dared to doubt that the Internet was a perpetual moneymaking machine: “If you’re out of this sector, you’re going to underperform. You’re in a horse and buggy, and I’m in a Porsche. You don’t like tenfold growth opportunities? Then go with someone else.”

Later,

If you had invested $10,000 in Vilar’s fund at the end of 1999, you would have finished 2002 with just $1,195 left – one of the worst destructions of wealth in the history of the mutual fund industry.

2008 is another great example of this, actually. The stock market is down 25%. People are panicking. Jim Cramer’s out there telling people to sell all their stocks unless they won’t need the money in the next five years. Of course, this follows on the tail of a five year bull market (2003 to 2007) where every single year saw double digit growth and the S&P 500 went up 80% in face value (not including all of the dividends paid out in that period).

The market goes up, the market goes down. How does The Intelligent Investor deal with it?

[T]his book will teach you three powerful lessons:
+ how you can minimize the odds of suffering irreversible losses;
+ how you can maximize the chances of achieving sustainable games;
+ how you can control the self-defeating behavior that keeps most investors from reaching their full potential.

And Graham’s ticket to that is value investing.

Next Friday, we’ll look at Chapter 1: Investment versus Speculation: Results to Be Expected by the Intelligent Investor.