Updated on 09.15.14

General Portfolio Policy for the Defensive Investor

Trent Hamm

intelligentThis is the fifth 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 fourth chapter, which is on pages 88 to 100, and the Jason Zweig commentary, on pages 101 to 111.

A lot of people like to argue that the rate of return you can expect from an investment is directly related to the amount of risk you take on. The more risk you have, the greater the potential return – but also the greater risk if you suddenly need to pull out your money.

I’ve always felt that this is a very limited view of things and that it ignores the effort and intelligence of the investor. An investor who can invest a lot of time studying the market and specific investments and can apply cool reasoning and behavior to his or her investments can get a better return than an investor who just wants to stick his or her money somewhere.

Take index funds, for example. Stock index funds are made up of all of the stocks that meet a certain criteria. If you buy into an index fund, it’ll essentially do as well as the average of all of those stocks. That actually also lowers your risk a fair amount because you’re not tied to the ups and downs of a specific company.

For an investor with limited time to research and understand specific investments – such as me – that’s a great way to invest. However, I know that if I had adequate time to actually study the market and played it cool, I could often (not always, but often) pick specific stocks that would beat this return.

Why don’t I do that? With the amount of money I have to invest (relatively small) and the time it would take to actually do the research and pick the investments (relatively large), it’s not a cost-effective use of my time. Give me index funds or give me death!

This is much the same logic that this chapter provides. Graham also buys into the idea that an intelligent and patient investor has a big advantage over the “gambler”-investor.

Chapter 4 – General Portfolio Policy: The Defensive Investor
Graham opens the chapter defining two different kinds of investors: the “active” investor, which is the kind of investor that actively seeks new investments and invests serious time into studying investments, and the “passive” or “defensive” investor, the kind of investor that wants to invest once (or on a highly regular basis) and just let his or her portfolio run on autopilot.

Regardless of the activity that you apply to your investments, Graham sticks hard with his recommendation from the earlier chapter: 50% stocks, 50% bonds (or a close approximation thereof, with an absolute maximum of 75% in either side). It’s important to remember with a recommendation like that that Graham is very conservative in his investing, dreading the idea of an actual loss in capital. Only in the most dire of down markets (like 2008, for example) would such a portfolio actually deliver a loss to the investor.

Much of this chapter is spent talking about the various types of bonds that a person can buy: savings bonds, treasury notes/bills, municipal bonds, and corporate bonds dominate most of the chapter, with most of their ins and outs described. Graham doesn’t really come to a conclusion about any of them, merely pointing out that there is a huge diversity of options when it comes to the bond portion of your portfolio – some short term, some long term, some free from taxes, some not.

Commentary on Chapter 4
So, how can you tell whether you should be 75% stock and 25% bonds or 50/50 or 25/75? Or somewhere in between? Zweig argues that it mostly comes down to your goals, the stability in your life, your other savings, and your tolerance for risk. The more stable things are and the longer term your goals are, the higher your proportion of stocks can (and probably should) be.

Zweig also covers several additional options for the bond portion that didn’t exist in Graham’s day, such as bond funds, mortgage securities (no, no, no, no, NO!), and annuities. More importantly, Zweig actually looked at holding cash as an investment option in such things as high-interest online savings accounts and CDs. All of these can be a big part of the conservative half of one’s portfolio, sharing space with (or replacing) bonds.

Most interestingly, though, Zweig suggested that buying stocks solely for the dividends might be considered something that could be a part of the conservative side of a portfolio. Zweig points out that many common stocks pay out 3% or more of their value in dividends each year, so if you select a high-dividend stock from a very stable company, it could potentially serve as part of the conservative side of a defensive investor’s portfolio. I don’t know if I agree with this, given the inherent riskiness of owning individual stocks, that companies reset their dividends annually, and that even the most stable of companies can fall apart quicker than you might expect.

Next Friday, we’ll look at Chapter 5: The Defensive Investor and Common Stocks.

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  1. Trent,
    In respect your your last paragraph on dividend investing; you are correct in your statement about a company re-setting the dividend or “falling apart”.
    However, with the additional aforementioned risk comes an upside potential not available with bonds or savings accounts and that is capital appreciation.
    Of course Zweig is not comparing apples to apples in this situation, which is unfair to the reader.
    He certainly should introduce the conept of Risk Adjusted Rate of Return which takes into account the risk relationship between the types of investments discussed.
    This analysis levels the playing field, so to speak, and would provide the reader with a much clearer picture of the investment options.

  2. Kevin says:

    Sounds like we are in the same boat, Trent. I know I could do well by investing in dividend paying stocks instead of just doing the index fund thing, but I don’t think I have enough invested to make the extra time spent worthwhile. My biggest balance is the 401(k) which only allows investing in American Funds – which I’m no big fan of anyway.

  3. Faculties says:

    It’s common to think that we could pick stocks that would beat the market — but look how often the pros are doing it — about half the time. My guess is that that’s how often, with careful study, we’d do it too — about half the time. An index fund gives the benefit of “about half the time” without all the sweat. Furthermore, it guarantees that our average will be no lower than the market average — something that picking your own stocks doesn’t guarantee. I’m just wary of that thing we all have that tells us all that we’re above average in savvy and knowhow — we can’t all be above average.

  4. George says:

    @Faculties –

    “It’s common to think that we could pick stocks that would beat the market — but look how often the pros are doing it — about half the time.”

    I chart my investments vs. the S&P 500 (I make an entry in a spreadsheet each month as the statements come in) and know for a fact that I’ve outperformed that index over the past 11 years. Outperformed by 30% so far.

    So it can be done and done more often than half the time.

  5. Rich says:

    I think it’s important to define risk before you begin to invest.

    In an ideal world you could increase your returns by accepting higher volatility. When “risk” is defined this way it is refering to systematic risk which is inherent to the market, vs nonsystematic risk which is the risk of an individual stock and all of the good and bad stuff that comes with it (management etc).

    So higher risk from the stock market should theoretically give higher returns. Taking on a high risk stock (such as penny stocks) will not reward you with a higher return. Buying index funds, as you mentioned, allows you to easily diversify away most non-systematic risk, so now you only have to deal with market fluctuations. And I think this is where the bond-stock split comes into play for most investors.

  6. Breaking down this book into these small, digestible pieces is gold, Trent. I would recommend that you package these up at the end and add the compilation to the Downloadables section. That book and that Downloadable would be something I’d recommend to any beginning investor or book club.

  7. Ranga says:

    I agree with ‘Writer’s Coin’. such a compilation would be a very valuable one.

  8. This is a great book for people looking to get into investing. It’s a little advanced, but with Jason Zweig’s comments it makes it a little more digestible. And with your breakdown it makes it even easier.

  9. I agree with you 100% that intelligence and patient is the key to results. Without the both of them forget it. I am still learning a lot of things about stocks and bonds. For the fact that this was Warrens mentor, I think that I will try reading it.

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