The Intelligent Investor

The Intelligent Investor is an investment classic authored by Benjamin Graham, affectionately known as the Dean of Wall Street to many investors. To quote Adam Smith's Money Game,"The reason that Graham is the undisputed dean is that before him there was no profession and after him they began to call it that." Graham founded security analysis as a discipline and laid out several key investment principles which remain hugely relevant even till today.

Warren Buffett, the Oracle of Omaha, endorsed the invesment classic by declaring "I read the first edition of this book early in 1950, when I was nineteen. I thought then it was by far the best book about investing ever written. I still think it is."

Similarly, I read the latest edition of this book in 2008 when I was nineteen and also thought that it was by far the best book about investing ever written. Unfortunately, the similarities end here, for I do not possess the intellectual prowess of Warren Buffett to comprehend the theories completely and neither have I read even a fraction of the number of investment books which he voraciously devoured over the years.

My objectives of writing this post (and subsequent posts) are twofold:

First, to distill the key elements of investing from this classic and

Second, to reinforce my understanding of the topics covered

Chapter 1

Investment vs Speculation: Results to Be Expected by the Intelligent Investor

1) An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return.

2) The distinction between investment and speculation in common stocks has always been a useful one.

3) Risks are inseparable from the opportunities of profits they offer, and both of which must be allowed for in the investor's calculations.

4) Classification of two types of investors: Defensive and Aggressive

Comments

Why did Graham define investment as a form of operation? It is unsound to think of investing as purchasing shares of a single company, we must acknowledge the high degree of risk involved in holding just one stock. As the old adage goes, "Never put all your eggs in one basket." Adequate, rather than extreme diversification is essential to obtaining a favourable result. In addition, investing is not necessarily restricted to the purchase or sale of equities, there are many different forms of investment in the corporate universe, such as bonds, convertibles, real estate, forex, options and derivatives, etc.

Thorough analysis means the detailed evaluation of the quantitative and qualitative aspects of the prospective investment, with the aim to derive an estimation of the intrinsic value expressed in terms of a range of values, which is to be compared with the market price in formulating the appropriate course of action. It entails the careful scrutiny of annual reports released by the company and conducting elaborate analysis of industry outlook and managerial quality.

Safety of principal refers to the investor being reasonably confident that a substantial part of his principal is adequately protected under normal conditions and even when business climate takes a change for the worse. An example will be ensuring that the company can meet its interest requirements for extended periods of time to award its securities investment merit.

Adequate return depends on the type of investor you are instead of the degree of risk you are willing to run. Conventional wisdom states that risk and return are positively correlated, one must be willing to bear a higher level of risk in order to achieve a higher return on investment. On the contrary, Graham proposed that return is determined by the amount of intelligent effort that the investor is able and willing to devote in his investment endeavor.

First, Graham states that the investor should attain a sharp understanding of the differences between investment and speculation. There is nothing wrong with speculation, just that an overwhelming majority of speculators ended up with huge investment losses and terrible economic fates.

Investing does not guarantee that one can accumulate huge amounts of wealth, as reflected in what Graham wrote: There are no sure and easy paths to riches on Wall Street or anywhere else. What matters is the investor know what he is doing, and do the right thing. Risk and return coexist, while we must acknowledge the truth that it is impossible to eliminate ALL risks involved in an investment, it is within the investor's ability to minimise the risk level to maximise the potential return on investment.

Warren Buffett captures the essence by saying, "Risk comes from not knowing what you are doing." Incidentally we analysed the DBS High Notes 5 case study in my Business, Government and Society (BGS) course and came to the conclusion that not knowing the commitments and terms of DBS High Notes led to the purchase of unsound securities by retail investors at unattractive terms.

Does this imply that investors who lack the required knowledge are doomed to suffer neverending losses from their stockmarket participation? Fortunately for the vast majority, the answer is a firm NO. Investors who lack the qualities for successful investing should elect to play the role of a defensive investor. In this case, the defensive investor will opt for extreme diversification by periodically investing a fixed amount of money in an index fund with very low expenses.

This strategy is known as Dollar Cost Averaging, which enables the defensive investor to take advantage of market fluctuations by acquiring more shares when the price is low and vice versa, resulting in a satisfactory average price for his holdings. On the other hand, it is much more difficult to operate as an aggressive investor and I shall elaborate this concept in greater detail in my next post.