For most of us the stock market is seen as a way for wealthy people to gamble their wealth on businesses rather than at the black jack table. The truth is that, whilst at the casino the house always wins, you can play the stock market to generate wealth. After the (rather grueling) experience of reading Benjamin Graham’s The Intelligent Investor I thought I’d share the five lessons that even a rookie like me got out of the book.
1. “Investors” are actually mostly just speculators
When we talk about “investing” in stocks, shares, and bonds most of us simply assume that it’s simply a gamble. However, Graham makes a clear distinction between what he calls “speculators” and “investors”:
“An investment operation is one which, upon thorough analysis, promises safety of principal and adequate return. Operations not meeting these requirements are speculative”
Speculators are those who are typically looking to make a lot of money quickly from dramatic swings in the market. They’ll look for stocks that are currently climbing quickly, or dropping fast, and pay little attention to the company itself. Whilst this has the potential to make money, the high risk involved means that speculators are unlikely to make any long-term gains.
On the other hand we have “investors”. Investors are those who research a company’s financial reports, look at the company’s stock price, and if the stock is being traded for less than the investor thinks its worth they will buy it. The difference is that investors looking for long-term, low-risk growth. So, if a company historically does well year-on-year but its stock price dips for whatever reason, the investor is likely to add that to their portfolio as that company is likely to continue to do well.
2. Defensive is usually the best way to start investing
Graham then divides investors into two categories “Enterprising” and “Defensive”. An enterprising investor is more willing (or able) to put in more time and care into finding investment opportunity and is likely to buy and sell at a higher frequency. This results in, as Graham states, “a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive [defensive] investor”.
A defensive investor is primarily concerned with avoiding mistakes or loses, and focuses on investments that provide them with the safety to be hands-off with their investments. Obviously it is more lucrative to be more enterprising but if you’re a rookie (like myself) being risk averse is far more likely to get better results as you learn the ropes.
Similarly, if you’re just starting on your path to financial freedom you’re probably time poor and can’t dedicate the amount of time required to do in-depth research on stocks.
3. Buy stocks for the same reasons you’d buy anything else
Despite my frugality in most areas, I’m not afraid to drop some cash on high quality goods. Window shopping is a time hole that I frequently find myself in. Browsing through pages looking for the product that offers all the features I need, reading the reviews for said product, and then bookmarking it so that I can pick it up when it’s cheaper.
For example, I love picking up high quality clothing because it will always look good, it’s built to last, and it’s dependable. But do ever buy it a full price? Of course not! I wait for a sale or look for it second-hand.
Investing in stocks is exactly the same idea. When investing in stocks you’re looking to buy companies that will always be an attractive investment, you’re looking for companies that are built to last, and you’re looking for companies that are dependable. Remember that you’re not looking to get rich quick, in the same way a classic leather jacket will look better with age, so should your portfolio.
What you’re paying for is stake in owning the business, so do your due diligence when investing. However, this time you’re not reading reviews on Amazon or Which? You’re looking through financial reports, asset portfolios, and debt all to find something that will look fantastic in your portfolio.
4. There is no such thing as a “system”, but you need to make investment policies
Anyone that tells you that they have a “system” that will consistently net you more than average growth is selling you snake oil. Investing isn’t so much about making money as it is about learning risk management i.e. controlling the amount of risk that you’ve placed on yourself. This means that you need to develop a policy for what you’ll buy, when you’ll sell, and when you’ll buy.
This means looking at your portfolio at regular intervals (every 6 months is recommended by Graham) and never have more than 25/75 per cent split on common stocks/bonds or vice versa. You’re looking to keep your portfolio at roughly a 50/50 per cent split. This is to counter the inevitable fluctuations in the market.
Here are a rundown of some of his other suggested policies:
- Only buy stock that has an annual turnover of at least $10 billion and that are in the top quarter or third of their industry by size
- Only buy shares of important companies that have at least 10 years of profitable operations and that are in a solid financial state
- A stocks risk rises with its price, so either wait for 50 per cent profit or after two years (although this differs from Warren Buffet’s policy of indefinitely holding stocks)
See how with these three core tenants of his investing policy Graham is looking to balance a level of risk that he can handle with getting the most out of his investments.
5. No one knows anything
It’s almost comical how frequently Graham tears down the notion that anyone on Wall Street (or any other financial market) has any idea of what’s likely to happen next. No one knows the future and if they did it’s likely we’d be praising them as a god (or they’d be in a government lab somewhere).
If the any of your news sites has a “hot” stock then that information is already in the hands of the thousands of people who are also looking at that site.
“It is absurd to think that the general public can ever make money out of market forecasts.”
The only way to make solid investments is to do the research yourself, develop an investment policy that minimises risk, and don’t believe anything you read.
Header Image Credit: TaxRebate.org.uk