The Intelligent Investor: The Defensive Investor and Common Stocks

intelligentThis is the sixth 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 fifth chapter, which is on pages 112 to 123, and the Jason Zweig commentary, on pages 124 to 132.

There’s one big underlying theme to this book that I didn’t expect. Yet, it keeps coming to the forefront again and again. It’s the one point that I believe Graham wants people to take home from this book.

Strong, thorough research is the most important part about owning stocks.

If you can’t – or aren’t willing to – put in a lot of time studying individual stocks, identifying ones that genuinely have potential to return good value to you over time, and keep careful tabs on those individual stocks, then you shouldn’t be investing in stocks.

Over and over again, Graham makes this point, in both obvious and subtle ways. He’s a strong, strong believer in knowing the company. If you don’t have clear, concrete reasons for buying a stock, then you shouldn’t be buying that stock, period.

What if you don’t have that time? This book was written before the advent of index funds, but I tend to think that broad-based index funds can be a reasonable replacement for the stock portion of your portfolio.

Chapter 5 – The Defensive Investor and Common Stocks
Graham’s advice, then, tends to focus on people who are willing to put in that extra time – and if you’re willing to do that, he has a lot of wisdom to share.

First of all, diversify. You should own at least ten different stocks, but more than thirty might be a mistake, as it becomes difficult to follow all of them carefully and also seek out new potential stock investments.

Second, invest in only large, prominent, and conservatively financed companies. Look for ones with little debt on the books and ones with a large market capitalization.

Third, invest only in companies with a long history of paying dividends. If a company rarely pays dividends, your only way to earn money from that company is if the market deems the stock to be valuable, and you shouldn’t trust that the market will do so.

Graham seems to point strongly towards the thirty stocks that make up the Dow Jones Industrial Average as a good place to start looking, as they usually match all of these criteria. I’d personally stretch that to include stocks that make up the S&P 500, but the Dow is a great place to find very large blue chip companies that are very stable and have paid dividends for a long time.

Other than that, Graham pooh-poohs many other common strategies. Buying growth stocks? Nope. Dollar-cost averaging? Good in theory, not great in practice. Portfolio adjustments? Be very, very careful – and only do annual evaluations. In short, be very, very wary and play it very, very cool.

Remember, this is Graham’s advice for the defensive, very conservative investor.

Commentary on Chapter 5
So, what does Jason Zweig have to say about all of this?

His big point is that simply “buying what you know” isn’t enough. You shouldn’t buy Starbucks’ stock simply because you drink their coffee. You need to spend the time to analyze the company’s situation, both internally and in the marketplace, and determine whether or not it’s a reasonable value. You can’t get there just by knowing the products they produce.

Zweig seems to generally feel that most people on the ground that are defensive investors are better off just buying mutual funds (preferably index funds) or seeking help from investment advisors, because the work needed to adequately study enough companies to build a good defensive portfolio is beyond what’s available to most people in their busy lives.

For me? I might tinker with individual stock buying, but I think I’d prefer to keep most of my money in index funds, simply because I, too, don’t feel like I have adequate time to really study enough stocks to build a good defensive stock portfolio.

Next Friday, we’ll look at Chapter 6: Portfolio Policy for the Enterprising Investor: Negative Approach.

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  1. Ryan McLean says:

    I don’t have a massive interest in stocks, especially seeing as the stock market isn’t going so well at the moment. But I love your book reviews and even though I will not read this book you always inspire me to write reviews on my blog. Thanks for your insight Im sure hard core investors will love this book. For me I love books about making money online. They are my favourite which is why I run a blog talking about that very topic

  2. Kevin says:

    Ryan – so you’d rather buy stocks at the top of the market than we’re they are on sale? I wish I had more money available to invest right now since there are so many good, dividend paying stocks trading for much less than they were even one year ago.

  3. Kevin says:

    Whoops, that should say “when” not “we’re”.

  4. JonFrance says:

    As this and any other good book on investing in stocks points out, before doing anything else you need to ask yourself whether you have the time and temperament needed for owning individual stocks. Ryan is saying he knows he isn’t going to put the time it takes into learning how to research stocks and doing the research, so buying individual stocks isn’t for him.

    Kevin’s pointing out that it is *also* necessary to have a temperament that knows how to shield itself from the emotion of seeing the market go up and down. Which I agree with, but I don’t think that Ryan was talking about that.

  5. Oliver says:

    does anyone else think chapter 5 is a little contradictory? The first point it makes is to diversify, but it then goes on to say only invest in large companies which pay dividends. You are not diversifying much at all since the correlations between those stocks will be quite high…

  6. Rich says:

    I have the hard cover “classic test”, with a forward from John Bogle. He mentions that Graham became a fan of index funds later in life as the work to find value in individual stocks became significantly more difficult.
    Warren Buffet has also suggested that those who cannot devote themselves full-time to stock picking should buy index funds, and I am inclined to agree.
    Although there is the temptation, especially amount men I think, to gloat about their stock picks and what they are invested in. Index funds are simply not sexy to most people.

  7. George says:

    Index funds suck. There, I’ve said it and I feel better. :-)

    “Why?” Because of fees. Even the cheapest index fund has fees that are more than if you just went and bought your own basket of stocks. That’s why _ALL_ index funds have underperformed the market over time.

    Investing in an index fund is akin to betting red/black on a roulette wheel… the “house” gets their cut all the time and you’re not compensated for their take by superior investing. Why do we, as a culture, pay other people to manage our own money?

  8. J. says:

    George that’s only true to the extent that

    (a) you’re in a very small basket of stocks
    (b) you’re investing large sums
    (c) you’re making as rarely as possible
    and (d) you’re paying low commissions for each transaction

    most individuals cannot buy 500 stocks (S&P 500) or even 30 (DJI) on a monthly or even annual basis, and most certainly not inside the limits of an IRA and come out ahead after trading commissions. plus you have to pay a commission now and a commission later–how often will you sell stocks to turn them into cash when you need the money?

  9. George says:

    @J. –

    a) Correct. Why should I invest in the stocks that don’t perform? With an index fund, you’re committed to the bad with the good. Why should I invest in both FDX and UPS when, really, either one will be fine? An index fund doesn’t give you that choice. It’s very easy to read a financial statement and with 6-12 stocks, doesn’t take that much time… that small skill helped me bail out of WM 1.5 years before it completely imploded (hey, if they’re not earning enough to pay the dividend, then they’ve got trouble coming!).

    b) Maybe, maybe not… see answer to d)

    c) I didn’t understand your statement on this

    d) Commissions are very low at discount brokerages. Plus there are DRIPs, even for IRAs.

    In general, most individuals trade too often. Hold your money and buy only once a year to reduce trading fees. If you want to follow dollar-cost averaging, use a company’s DRIP. Holding for dividend growth/income is the answer to avoiding fees.

    If I do have a need to sell 100 shares of PEP, for instance, because I suddenly need $5,000 in cash, then the trade is about $9.99.

  10. George,
    In your PEP example you’re paying a “commission” of .2% to make that trade. With a good index fund you can pay as low as .12%, so saying fees are going to batter your returns doesn’t really fly.

    A couple of trades a year, unless you’re talking huge sums of money like J. said, will put you right where index funds are in terms of expenses.

    But I do agree that, if you have the time and temperament to follow individual stocks, and you’re a little lucky, you’ll do better than an index fund.

    Especially right now! Investing in Wal-Mart this year would have you up over 10% instead of down 30%.

  11. Index investing does not take away market risk. It would be equally easy to make the argument that you should not invest in index funds if you are not willing to put time into understanding the market. If you don’t then you are just “saving” in stocks as if it was some special currency.

  12. Shawn says:

    I agree that if you don’t have the time or desire to research individual stocks then mutual funds are the answer. However, you need not default to indexing. You can find a quality actively managed fund with little work on your end. I have been invested in Manning & Napier’s Pro-Blend Maximum Term Fund (EXHAX) and it has consistently beat the market during both bull and bear environemnts(especially 2000-2002). I prefer seeking a fund that will provide down market protection, which indexing does not. Just because quite a few actively managed funds do not beat their index doesn’t mean you can’t find some that do.

  13. Konrad says:

    Hi,
    a small comment on your analysis of this chapter as I’m also reading this book. I’m pretty sure Graham fully supports dollar-cost averaging. If I may quote it the precise paragraph,
    “It may be objected that dollar-cost averaging, while sound in principle, is rather unrealistic in practice… It seems to me that this apparent objection has lost much of its force in recent years… The monthly amount small, but the results after 20 or more years can be impressive and important to the saver.”
    You can reread that whole paragraph. I’m 100% certain that is an unequivocal and explicit support of dollar-cost averaging. Jason Zweig makes a similar endorsement in his commentary.

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