Introduction
The Intelligent Investor is a book written by Benjamin Graham and it mostly talks about the concept of Value Investing.
Many investors regard “The Intelligent Investor” as the Bible of Value Investing.
The Intelligent Investor book should be a starting point for individuals who wish to begin their stock market journey. The chapters of this book have laid the foundations of modern day investing techniques.
At the end, everything draws to the basics, where everything has been developed from. The Intelligent Investor is one such source for stock market investments .
The book is divided into 20 chapters, which are in itself a little advance for a beginner.
My aim is to prepare a series of summaries of each chapter of The Intelligent Investor, so that even a beginner can read and understand the message conveyed by the author.
Pro tip: You may also pick up the book and read my blog side by side for an ease of understanding.
The chapters of this book have laid the true foundation of stock market investments for generations. Therefore, take your sweet time to read, understand and self-learn from every line of the book.
It is needless to say that, The Intelligent Investor is my favourite book ever written on the topic of stock market.
Chapter 5: The Defensive Investor and Common Stocks
The author has described that there are particularly 3 types of investors: Defensive, Enterprise and Aggressive. The details of the latter are explained in the later course of the chapter.
The defensive investor is the kind of investor who dislikes taking any risk. As the name suggests, he is defensive in his strategies.
Some important definitions
Let’s break down some definitions that the author has used in the chapter.
Defensive Investor: A type of investor who does not take risks. He wants to play defensive and ensure that his investments are protected, even if that results in lowers returns.
Common Stocks: Stocks that have a large Market Capitalisation. They are large and stable companies that are a part of stock market indexes and provide standard returns. They have lower risks.
Growth Stocks: Stocks that have high growth potential. As per author, Growth Stocks are those that typically double its valuation within a span of 10 years.
Chapter 5 of The Intelligent Investor
The chapter 5 is divided into the following sub-sections:
- Rules for selecting Common Stocks
- Growth Stocks and Defensive Investor
- Making changes in your Portfolio
- Dollar Cost Averaging
- An investors personal situation
- Concept of Risk
Rules for selecting Common Stocks
The author has provided a four point thumb rule for selecting Common Stocks to make a part of ones Portfolio:
- Adequate but not excessive diversification
- Selected companies need to be large
- Long record of dividend payment
- Buying at the right price / fair valuations
The author suggests to prepare a portfolio with at least 10 stocks, but not more than 30 stocks. These needs to be well diversified in different sectors and companies.
The companies in the portfolio that you have selected need to be large. By large, the author means companies with large market capitalisation. Consider companies that are part of index groups.
The author favours companies that also provide annual dividends to its shareholders. Dividends are profits shared to the shareholders of the company.They are direct gains to the shareholders for appreciating and for staying invested for years.
Having a long history of dividend payout simply means that the company has made consistent profits and ensured that these profits are passed on to its shareholders.
You have selected your common stocks, but now when it comes to buying, what is the ideal price or a fair valuation to purchase them? The author provides us a thumb rule for that as well.
The investors need to put a limit on the price he is willing to pay in order to purchase the stocks. An ideal limit is the price should not be 25 times its earning potential. Which in technical jargon means the PE Ratio of the stock must not be more than 25.
Long story short, lower the PE, better is the gain to the investor.
Growth Stocks and the Defensive Investor
The authors thumb rule for a growth stock is basically choosing a company that doubles its returns within a period of 10 years. This means an average return of about 7.1% per annum.
Growth stocks should be purchased understanding the fact that one does not pay a high price to buy the stock.
It is needless to say that, growth stocks are already sold at high valuations. This is something the defensive investor needs to worry about.
Growth Stocks might look lucrative to buy, but something that goes up rapidly also has the tendency to fall down even faster.
When common stocks lose about 50% of their value during their market crash, Growth stocks tend to be even more vulnerable.
The author states that, there could be instances when one could make exorbitant profits by right stock selection and investing at the right time, but the defensive investor does more harm than good.
A defensive investor needs to focus on investing in Common Stocks rather than Growth Stocks. Large companies that are generally unpopular will provide reasonable returns and have lower risk.
Portfolio Changes
Now that you have made a portfolio of selecting common stocks, you need to periodically review it. With review and research, one needs to make the right changes to align with the market trend.
The author suggests that the Defensive Investor needs to review his portfolio at least once a year. This does not only mean to self review his portfolio, but also have an expert or a third-party to review it annually and incorporate the suggested changes.
Come what may, for every suggestions and alterations one makes in their portfolio, one should not forget the Rules of Selecting Common Stocks.
In modern times, investor can also use softwares and platforms provided by stock brokers to analyse the performance of the portfolio. But the author would however warn the investor to not rely completely on these softwares but have their own judgement.
Dollar Cost Averaging
Now that you have prepared your portfolio. How do you invest? Do you plan on investing your entire capital in one go? or do you devise a strategy to plan your investing periodically?
We are familiar with the concept of Systematic Investment Plan, where one invest a fixed sum of money in a fixed portfolio. The author calls this system of investing as “Formula Investment”
The monthly amount under the periodic investment may be small, but the returns after a period of 20 to 30 years are quite impressive and rewarding.
An investors personal situation
Consider the following 3 types of investors (as the example provided in the book):
- A widow: Left with $ 200,000 to support herself and her children
- A doctor: with savings of $ 100,000 and yearly saves $ 10,000
- A young man: earning $200 weekly and saving $ 1000 yearly
Think for a moment, the above 3 class of individuals need to have a different approach for investment. The widow cannot be an Aggressive Investor and invest the money in growth stocks or the young man need not be a Defensive Investor.
The author does not say that a defensive investor, like the widow in this example, could not be an aggressive investor.
But in her case, drawing $2000 every month with safe investments is more beneficial to risk the entire corpus in a growth stock.
The doctor, on the other hand, who earns periodically, could choose to be a defensive or a probable candidate to be an enterprising investor. This is because, he may not have the time to actively participate in his investment activities.
He could still walk the path of a defensive investor and choose to periodically invest his money in a portfolio of common stocks.
Finally, the young man could be an aggressive investor, yet need to park a portion of his investments in bonds and low risk alternatives. There is a great advantage for the young man to start his financial education and experiences in the initial stage of his life.
The young man, on his early days, could also make some losses being an aggressive investor. He could analyse the market, make his own judgments and place his bets to gain more experience.
Concept of Risk
It can be easily said that good Bonds are less risky as compared to Common Stocks and Common Stocks are less risky as compared to Growth Stocks.
But is this really a definition of risk?
A bond is clearly a high risk when it defaults in its interest payments, or a growth stock is less risky if it provides high dividends and continues to do so.
the author highlights that, people think the idea of risk is also considered when the prices of the stock falls, even though the decline may be cyclic or temporary in nature.
The author tries to explain from this section that, risk needs to be identified by the chances of losing money and not by these cyclic price fluctuations.
More about price fluctuation is explained in Chapter 8 of the Intelligent Investor.
Conclusion
The following is the summary of chapter 5 of the intelligent investor:
Firstly, one needs to understand the type of investor one is – Defensive, Enterprise or Aggressive. This understanding can be further refined by example of widow, doctor and young man provided above.
In case one decides to be a defensive investor, they are better off in selecting Common Stock with decent returns than a Growth Stock which high volatility and risk.
The rules of making a Portfolio of Common Stocks (as mentioned above) need to be followed even if one needs to make some yearly changes in their portfolio.
The “formula investment” is periodically investing small portions in a portfolio prepared a defensive investor as the returns after a prolonged could be rewarding.
