This is the tenth 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 ninth chapter, which is on pages 226 to 241, and the Jason Zweig commentary, on pages 242 to 256.
It’s worth noting that Graham wrote this chapter in 1972, predating the advent of the index fund. When Graham discusses the idea of investment funds, Graham is largely talking about traditional-style mutual funds – ones managed by a fund manager who makes the decisions about what investments should be held by the fund.
An index fund, on the other hand, isn’t actively managed by anyone. Instead, it’s managed by a handful of very straightforward rules on what should and should not be held by the fund. For example, an index fund of the S&P 500 (like the Vanguard 500) holds only stocks that are listed on the S&P 500 index, a statistic used widely to gauge the market health of large domestic companies. Here’s more information about index funds.
Unsurprisingly, Graham isn’t particularly a big cheerleader of traditional mutual funds. One of Graham’s big requirements for investing is that you know exactly what you’re invested in, and by buying into a fund, you cede that control to someone else. Yet it was just a few chapters earlier that Graham basically outlined the idea behind an index fund and spoke very positively of the idea.
One can’t help but wonder what Graham might have said today about the proliferation of index funds and the rise of Vanguard.
Chapter 9 – Investing in Investment Funds
Graham basically says that there are three questions you need to answer before investing in any fund.
1. Is there any way by which the investor can assure himself better than average results by choosing the right funds? [...]
2. If not, how can he avoid choosing funds that will give him worse than average results?
3. Can he make intelligent choices between different types of funds – e.g., balanced versus all-stock, open-end versus closed-end, load versus no-load?
Graham states that in general, individuals who invest in balanced funds tend to do better than individuals who invest in individual common stocks. The reason is simple: a person who is not an expert at picking individual stocks and balancing a portfolio is usually better off in the hands of a professional money manager even after the costs.
However (and this is big), Graham largely seems to suggest that the fees in a typical mutual fund are far too high and the time invested in finding a bargain fund (one with good results with limited costs) is well worth the time. He also believes that you should not expect to ever radically beat the market with a fund, and that funds who have astounding short term gains are usually not playing a healthy long-term gain – something that’s been shown over and over again over the history of investing.
Much of Graham’s specific commentary in this chapter deals with the specifics of mutual funds as they existed in the late 1960s, an era in which index funds did not yet exist and legal constraints on funds were substantially different than they are now. As a result, it’s much more sensible to look at the big picture here and not get bogged down in specifics.
Commentary on Chapter 9
Zweig has the advantage of knowledge of three more decades of investing history and he definitely uses it here. For the most part, Zweig applies Graham’s three big questions to modern mutual funds – and the results aren’t pretty.
Zweig seems to conclude that managed mutual funds are not a good investment for the typical investor. Over a long period, very few funds even manage to match the market, let alone beat the market. Why is this? Assuming there were no fees or costs, a truly average fund would match the market and (in theory) half of all funds would do that well or better. However, once you add in fees and costs, this sinks many of those market-beaters to a rate of return worse than the overall market.
Given that, though, Zweig is a big fan of index funds, as they overcome several of the problems with managed funds. They’re designed merely to match the market with an extremely low cost, which means that a typical index fund should beat a solid majority of mutual funds covering the same area.
Of course, Zweig advises that even if you’re using an index fund strategy, you still need to pay attention to diversification and should not have all of your eggs in one basket. Just because you’re invested with index funds doesn’t mean you shouldn’t balance your portfolio between stocks, bonds, and cash.
Next Friday, we’ll take a look at Chapter 10: The Investor and His Advisers.