Investment Advice from Warren Buffet’s Mentor: Words of Wisdom from Benjamin Graham

If you're new to "Think Your Way To Wealth", get free updates on debt reduction, saving money, and building wealth by subscribing to the RSS feed or via Email . Thanks for visiting!

Whenever I get worried about my retirement investments or stock market volatility, I try to remind myself how successful investors view the market and investing. Since I like to read, I frequently read books written by or about the “giants” of investing. Warren Buffet and Peter Lynch are two that come to mind, both extremely well known in the financial as well as the non-financial world. Several years ago, I became aware of Benjamin Graham, the author of “The Intelligent Investor” and “Security Analysis” (co-authored with David Dodd, a former student and colleague), the latter book known as the “bible” of investing on Wall Street. Graham is known as the “Father of Value Investing”, having laid the framework for modern day
stock analysis; Warren Buffet was a student of his, and reportedly the only student ever to receive an A+ in his class.

The following is an excerpt from an interview with Benjamin Graham, conducted in 1976 (shortly before his death). The full text of the interview can be found here:
A Conversation With Benjamin Graham.

(My comments are interspersed with block quotes)

What is your view of the financial community as a
whole?

Most of the stockbrokers, financial analysts, investment advisers, etc., are above average in intelligence, business honesty and sincerity. But they lack adequate experience with all types of security markets and an overall understanding of common stocks–of what I call “the nature of the beast.” They tend to take the market and themselves too seriously. They spend a large part of their time trying, valiantly and ineffectively, to do things they can’t do well.

What sort of things, for example?

“To forecast short- and long-term changes in the economy, and in the price level of common stocks, to select the most promising industry groups and individual issues–generally for the near-term future.”

Can the average manager of institutional funds obtain better
results than the Dow Jones Industrial Average or the Standard & Poor’s Index over the years?

No. In effect, that would mean that the stock market experts as a whole could beat themselves–a logical contradiction.

Do you think, therefore, that the average institutional
client should be content with the DJIA results or the equivalent?

Yes. Not only that, but I think they should require approximately such results over, say, a moving five-year average period as a condition for paying standard management fees to advisors and the like.

What about the objection made against so-called index
funds that different investors have different requirements?

At bottom that is only a convenient cliche or alibi to justify the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results.

I don’t think investors should stand for sub-par performance,
although we are sometimes limited in the choices we have, such as in a 401k.

Turning now to individual investors, do you think that
they are at a disadvantage compared with the institutions, because of the latter’s huge resources, superior facilities for obtaining information, etc.?

On the contrary, the typical investor has a great advantage over the large institutions.

Why?

Chiefly because these institutions have a relatively small field of common stocks to choose from–say 300 to 400 huge corporations–and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list–say, 30 issues or more–that offer attractive buying opportunities.

This is a very strong argument against actively managed funds, in my opinion.

What general rules would you offer the individual
investor for his investment policy over the years?

Let me suggest three such rules: (1) The individual investor should act consistently as an investor and not as a speculator. This means, in sum, that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase–in other words, that he has a margin of safety, in value terms, to protect his commitment. (2) The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. Typically, he should set a reasonable profit objective on each purchase–say 50 to 100 per cent–and a maximum holding period for this objective to be realized–say, two to three years. Purchases not realizing the gain objective at the end of the holding period should be sold out at the market. (3) Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines. I would suggest, in general, an average seven- or eight-year maturity for his bond holdings.

This is also an argument against a technique people frequently
use, (and I have myself) “buying what you know”. Just because you like a company’s product or service, if you do not perform due diligence of the company’s cash flow, income, and assets, you may not be doing much more than “guessing”. You should justify an individual stock purchase as a “good buy”, as opposed to saying to yourself, “Well, Company X seems like they really have their act together, I think I will buy a few shares”. The last sentence, however, is pure gold. After significant rises in the stock market, switch some of the stocks to bonds and vice-versa when the market declines. Why is it so hard to do this? And I don’t think he is implying market timing here, either.

In selecting the common stock portfolio, do you advise careful
study of and selectivity among different issues?

In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

The first time I read the last paragraph was the first time I had heard that Graham had changes his views somewhat on investing from those prescribed in “Security Analysis”, which was rather interesting to me.

In light of the recent market performance, it appears that Benjamin Graham’s advice still has merit. Here are a few tips I gleaned from reading it:

Don’t settle for below market performance from your actively managed funds, if possible.
Forecasting the overall trends of the market or the economy are extremely difficult,if not impossible. It is also extremely difficult to predict short term performance of individual stocks.
If picking individual stocks, look for value and perform due diligence.

After a significant rise in the overall market, one should certainly examine a rebalancing of one’s total portfolio, as well as after a significant decline.

Look for value, including based on earnings or dividend yield.