Updated on 11.19.08

The Intelligent Investor: A Negative Approach to Portfolio Policy for the Enterprising Investor

Trent Hamm

intelligentThis is the seventh 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 sixth chapter, which is on pages 133 to 144, and the Jason Zweig commentary, on pages 145 to 154.

As we’ve learned over the past two weeks, Graham’s view of a conservative investor is very conservative. Focus primarily on big, blue chip stocks that pay a dividend and counterbalance that with roughly an equal amount of bonds. Very conservative, indeed.

But what about those of us who are less conservative and want to seek out other investments? After all, isn’t The Intelligent Investor supposed to be a guide to value investing, not just “buy blue chips and wait”?

Graham starts to head down this path here as he turns his sights from the very conservative investor to the … less conservative investor, the type of person who would actually follow value investing principles and seek out investments that show every sign of being undervalued – and then invest in them.

But first, a chapter of cautionary advice. Graham is nothing if not cautious, after all. The focus here is on things that even enterprising investors should avoid.

Chapter 6 – Portfolio Policy for the Enterprising Investor: Negative Approach
So, what should you avoid?

First, avoid junk bonds. If they have anything less than a stellar bond rating, don’t bother, even if they appear to return very well. Junk bonds put your principal at risk, and the point of buying bonds is to have a safe portion of your portfolio.

Second, avoid foreign bonds. Here, there are stability issues, and it’s often hard to adequately judge the risk of buying bonds from government and private entities operating under rules unfamiliar to you. Today, arguably, Graham would be okay with buying bonds within the European Union, but I would guess Graham would avoid anything outside of that.

Third, avoid preferred stocks. Preferred stocks are ones that have a higher priority in the event of a liquidation of the business, but often come at a premium price. Almost always, Graham doesn’t feel these are worth any sort of premium. Of course, in the United States, preferred stock is generally not sold directly to individual investors, only to large institutions, so it’s largely a moot point.

Finally, avoid IPOs. To put it simply, new issues do not have any track record upon which to adequately judge the company. The “hype” of an IPO is all you really have to judge the issue on. Instead, let others jump into that feeding frenzy and wait until time has shown which companies swim and which ones sink.

Those are some good rules for anyone to follow, particularly if you’re concerned about not losing the money you invest. Most of these investments have a pretty significant amount of risk and in Graham’s world, one shouldn’t put the principal at undue risk.

Commentary on Chapter 6
Zweig looks at modern examples of all four of these cases and largely comes to the same conclusions as Graham: they’re quite risky and probably not worth it for the average investor. The only caveat that Zweig makes is that there could be room for a mutual fund of junk bonds in a large and diverse portfolio, but it should be considered risky and not be considered anywhere close to a “safe” portion of the portfolio.

Zweig also covers day trading here, describing it as something for most people to avoid. Why? In a world where trading is completely free and trades could be always executed without delay, many people could make a solid income from day trading.

But that’s not the real world. Brokerage fees can eat up a lot of one’s gains, as can trading delays. This forces day traders to walk a tightrope – it becomes a high risk game, and that’s not a game for an investor with any conservative streak. Zweig almost writes it off as gambling, in fact.

So, in short, avoid junk bonds, foreign bonds, IPOs, and day trading and you’re off to a good start in Graham’s world.

Next Friday, we’ll take a look at Chapter 7: Portfolio Policy for the Enterprising Investor: The Positive Side.

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  1. Joel says:

    Bah! Canadian bonds didn’t even get a mention. The only country in the G7 that has a balanced budget, has avoided a recession and the last safe haven with a securely regulated financial sector.

    The surprise is there’s no discussion of currency fluctuations – a bigger unknown than any of the risks mentioned.

  2. Canada seems to fly under the radar all the time, Joel. It’s weird…Canada is hardly ever mentioned in the news media either.

  3. Todd says:

    I have read the intelligent investor twice and it is an excellent book. I am currently reading the new edition of Security Analysis. I believe these books still have a great deal of value, despite being hyped exhaustively. However, I think for a more modern view, Value Investing by Bruce Greenwald and You can be a stock market genius (I know – terrible title) by Joel Greenblatt are two of the best books on value investing.

    Greenblatt focuses on market instances where individuals have an advantage over institutional investors, primarily a special situation investing book. He covers mergers, spinoffs, bankruptcies, etc.

    GreenWALD’s book is really just a good overview of the current landscape of value investing.

    If value investing really interests you, check these books out after the graham books. Of course there are dozens more – Seth Klarman’s incredibly expensive and out of print Margin of Safety, Mohnish Pabrai’s books, one billion books about Warren Buffet and his investing strategy, books by and about Marty Whitman – you get the point. I would start with Greenwald (chair of value investing program at Columbia) and work backward from there.

  4. Des says:

    Its weird that Zweig says day trading would be viable if trades were free. Zecco offers free trades, but I’m not sure that makes day trading altogether that much safer.

  5. You can almost hear Warren Buffett in this chapter. I love how often Graham tells the reader that most people should NOT be investing in individual stocks. How often does a book about stock investing tell you that? That’s when you know they have your best interests at heart…

    This book is the best.

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