The Intelligent Investor: Investment Versus Speculation

intelligentThis 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.

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  1. This specu lation mentality is exactly what is driving the fear in the marketplace right now.
    Why do you think Warren Buffett is buying and investing now…because some companies are seriously undervalued due to fear and specualtion.
    There are some companies that are selling for less than thier book value!
    (This means that if all of the company assets were liquidated, they would end up with more money than if they sold all of the outstanding shares in the marketplace.)
    Do your due diligence, buy great companies, wait 5-10 years and become wealthy.
    Buffett is investing now, are you?

  2. Ryan McLean says:

    Sounds like a really cool book.
    Did Warren ever write any books himself? If he has then Im sure they might even be better than this book now.
    When are you writing your book?
    I released my first ebook yesterday called “Make Money Commenting”…it has had small success but I can improve a lot as a writer and marketer

  3. Ryan,
    To my knowledge Warren has not written any books himself. But many have been written about him; including “The Warren Buffett Way”.
    His Berkshire Hathaway shareholder reports are liekly the best reading you will find with regard to Warren’s views on investing.

  4. Russ says:

    I believe in a variation of Graham’s philosophy . . .

    I believe that regardless of how well you know and understand a company, there is still an abnormal amount of risk associated with individual companies and their stocks. Even if you own 20 or 30 or 40, it’s still difficult to diversify away company or industry specific risks.

    My alternative for my self and the families I work with is to invest in a low cost, tax efficient, highly diversified portfolio of institutional index-type funds with exposures to all the markets around the world. The result is a portfolio of over 10,000 underlying securities.

    Obviously, there’s no way to “know” what you’re investing in with this approach, but it’s very important to understand the relationship between risk and return and know how and why you’re invested in the manner you choose.

    As Buffett as has said many times before, “Risk is not knowing what you’re doing”

    Great post, thanks

  5. JonFrance says:

    @Ryan:
    In addition to what Tyler mentions which answers your question more directly, it’s important to note that Warren Buffet learned investing directly from Graham at Columbia. Graham was Buffet’s mentor, and had such an effect on him that he named one of his sons after him. Knowing this helps put his quote about The Intelligent Investor in context.

  6. Derek says:

    Hey Trent, I just want to thank you for doing this. I Have read The Intelligent Investor before, but this is helping me reread it and it is helpful. Thank you.

  7. David says:

    From what I think I have learned about Buffett and Graham, I don’t think Buffett is doing anything markedly different than what Graham advocated fifty years ago: wait for Mr. Market to offer you a piece of a good company at a bargain price, and buy it. Buffett does use the “moat” analogy quite a bit (high barriers to entry) that help refine the search.

    I would caution about placing too much stock (sorry, had to take the pun) in book value, and finding values in companies selling for less than book. General Motors may have billions in book value, but the true measure is what the next best use of those assets is worth. Exampele: Is a John Deere combine in Boone, IA “worth” its book value? You bet–the farmer in Oskaloosa can use it tomorrow for its identical, intended use. Is that same John Deere combine worth its book value if it is parked on St. Croix, Virgin Islands? I think it should be discounted. Now think about General Motors’ book value. How much of that is represented by industry-specific tooling bolted to the floor of a factory in Flint? Who is going to pay “full price” for that? Not me, and I don’t think you should either. Having said that, I just bought ADM which was selling at a discount to its book value. GM may have trouble selling cars, but I don’t see ADM having trouble selling agricultural products based on corn and soybeans. Those assets (even the ethanol refineries) should be productive for years to come. (And as you may suspect, I, like Trent, live in Iowa…)

  8. David T. says:

    I think this review is great but it is important to keep in mind that Warren Buffet also disagreed with many of Graham’s philosophies. Graham wanted to judge everything by numbers only. As Buffet grew in experience he realized that things like “the moat”, reputation and management experience also had some value and needed to be factored into the equation.

    David

  9. Kevin says:

    A Buffet biography just came out recently that I’m going to check out soon. This book might have to come after that one on my “to-read” list.

  10. Katie says:

    In defense of Cramer, he doesn’t advocate buy and hold. He moved his fund out of a lot of these names before they crashed. He also foresaw this mortgage mess (youtube his rant, it’s quite entertaining, but more chilling, it’s right on). His advice is not for people who want to buy stocks and wait 10, 20 years for their profits to grow, so it’s harsh and a bit unfair to point out that his picks failed when he himself realized they were going to and got the heck out of them. That is NOT to say he’s always right, at all!

  11. Shane H says:

    Hi

    Remember too Warren Buffets words of wisdom about Index funds:” A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money,”

    Love the site BTW

    Shane

  12. Dan says:

    I find it hard to understand a book and review like this. When I read things telling me vaguely to do something, it’s almost better not to read it at all. For example, the book says to “study carefully before you buy” and “don’t invest without knowing …” and “have an investment philosophy”. Study what? Know what? Have what investment philosophy?
    This is like telling me,”Go downtown and you will see many things..”, then I go get lost on the way because I don’t know the way, then get lost, frustrated, give up and go back home where I’m comfortable.

    Just telling me to “do” something without any meaning is useless.

  13. Eric says:

    The main thing I got out of this chapter was the compare and contrast between Graham’s definition of a Defensive (i.e., passive) investor and an Aggressive investor.

    As a relatively uneducated investor (although perhaps only in my own mind’s eye), these concepts were somewhat unfamiliar to me but made perfect sense. Where I am now, I’d consider myself a Defensive investor. I’ve got my regular and automatic contributions going into my Federal TSP and my Roth IRA and I forget about them for the most part. “Fix and forget it.”

    With patience and more education and experience, I hope to be more of an Aggressive investor.

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