This is the ninth 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 eighth chapter, which is on pages 188 to 212, and the Jason Zweig commentary, on pages 213 to 225.
If there’s ever been a year where strong market fluctuations have been the rule rather than exception, 2008 is that year. It’s been a roller coaster ride, with triple digit gains and losses in the Dow Jones Industrial Average becoming the norm instead of the exception.
Because of this, I really looked forward to reading this chapter, even though I already had some idea of what Graham would say about market fluctuations. Given his earlier commentary, I completely expected Graham to advocate for sitting back, letting the fluctuations simply happen, and watch for bargains in quality companies when their stock prices are being tugged downward due to momentary fluctuations outside of the company’s control.
And that’s largely what I got, with some nuances. Graham’s philosophy throughout this book is consistent and logical, even if it might be a bit too conservative for more gung-ho investors.
Chapter 8 – The Investor and Market Fluctuations
Right off the bat, Graham argues that attempting to play market timing games is a fool’s game. One can never predict true market bottoms or peaks in advance – they can only be seen through hindsight. Graham also points out that some of the “markers” of a bottoming-out market won’t necessarily hold true for the next bottom, and that same effect holds true for peaks as well. In a nutshell, don’t bother trying to time things based on what you think the overall stock market is going to do.
However, for individual stocks, Graham thinks that timing can actually work well. In this case, though, Graham is referring to detailed study of a company: knowing that the company is sound, knowing how it compares to the competition, and knowing what a reasonable value of the stock should be. Once you’ve identified a good, quality company, then you should keep your eye out for the right price on that stock – when it goes below a certain number without any change in the nature of the company itself, then you buy.
This, in essence, is the key of the “buy low, sell high” idea. You don’t try to time the market at all. Instead, you merely seek out bargains in the things that you know, and you wait for them patiently.
What about selling? For the most part, Graham encourages people not to sell into fluctuations, either, and instead hold onto those steady, dividend-paying stocks. The only time Graham seems to encourage selling based on market conditions is if the prices you would get today are significantly out of whack with the long term history of the stock. For example, if the stock has pretty consistently held near a 12 P/E ratio, but is suddenly selling for 20, it’s probably a good time to sell it.
What’s the end result of all of this? A person who diligently follows Graham’s advice is going to almost always be doing the opposite of what everyone else is doing. When the bull market is roaring and everyone is buying, you’re likely to be holding or selling stocks. When the bear market is afoot and everyone is selling, you’re likely to buy up those value stocks.
What about bonds? Graham generally advocates buying bonds when there are no values to be had in the stock market. In other words, if you have money to invest and the stock market is roaring like a freight train, Graham suggests increasing the portion of bonds in your portfolio. Similarly, when the market is down, one may want to decrease the portion of their portfolio that is in bonds if there are appropriate value stocks out there for purchase. Again, it’s the opposite of what seems to be the convention on Wall Street.
Commentary on Chapter 8
Zweig spends most of the commentary ruminating on Graham’s “Mr. Market.” For those unfamiliar, Graham often liked to imagine the stock market as a person he called Mr. Market. This individual was essentially a manic depressive – when the stock market was rocketing, he’d offer to buy or sell you stocks at a price way beyond what the company was worth, but when the stock market was down, he’d only buy or sell at prices far below what the company should fetch. Graham argued that the way to deal with Mr. Market was patience – wait until he quoted you prices you liked.
Zweig uses several modern examples of irrational exuberance to show this “Mr. Market” phenomenon at work – and the dot-com boom certainly gave us a lot of examples. Zweig discusses Inktomi, which went from a peak well over $200 in 2000 to being worth a quarter a share in 2002, even though the fundamentals of the business actually improved over that time frame. In 2002, it was a bargain, and eventually Yahoo bought the company lock, stock, and barrel for roughly seven times that much.
So how can you avoid situations like Inktomi? Know what you’re buying, be patient, and only buy when the getting is good. Not only does this ensure that you get actual bargains, it also reduces the brokerage fees that a more frenetic buyer and seller would accumulate.
Zweig picks out a great quote from Graham that I think bears repeating here.
The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.
That, right there, is most of the lesson of this chapter in one sentence.
Next Friday, we’ll take a look at Chapter 9: Investing in Investment Funds.