The Intelligent Investor is probably the most impactful and everlasting book ever written about investment. The book was authored by Benjamin Graham firstly in 1949. Multiple editions were published later by Graham himself.
Graham was mostly known to be the teacher of Warren Buffett. Buffett recalls picking up a copy of The Intelligent Investor when he was about 18 years old and being totally mind-blown by Graham’s writing. Buffett later decided to attend Columbia Business School where Graham was a professor. There, the two met and later Buffett would go work for Graham in the beginning of his legendary career.
I will not summarize the book since most summaries of the book is easily found online. I will discuss my takes from the book and what I found the most interesting.
Investment vs. Speculation
My first impression was that “Graham means business!”, as he outlines clearly the differences between an investor and a speculator. An investor is someone who does research, understands the business that he/she is about to buy, and draw conclusions from what has happened. A speculator is someone who is speculating/guessing, does not have a solid understanding of what has happened, and is “hoping” things turn out well for his/her money. Graham has very rigid definitions of the two categories and does not seem happy with any blurred distinctions. He asks participants in the stock market to be clear with themselves of what they are. According to Graham, if someone accepts being an investor, he/she should also accept the amount of work and research. If someone accepts being a speculator, he/she should be mentally and financially prepared for losses. In the current market, it is exceedingly easy to spot both types of market participants. Someone buys a stock after it started to trend upwards; that is speculation. Someone might buy a stock that just crashed, hoping for a rebound. That is also speculation. To me, you are only investing if you have made an effort to understand all the information, and have a financial or economic reasoning that the company will do better.
Risk ≠ Return Mindset
One of the most interesting points that Graham makes in his book is that contrary to common belief, risk does not equal return. What does equal return is the amount of work you put in. In terms of market pricing, especially with bonds and options, returns are typically priced with probabilities. High probability events do not usually carry high returns. AAA Corporate bonds will never beat the market since the risk is minimum. However, in the stock market, risk often does not equal returns. If a company is in fact a financial fraud or really poorly run, it may have a low beta or it might currently have a cheap put option price, it will still go down eventually and the put options will be paid off significantly. An awesome example of this is Valeant. The company had a rather low beta, and had relatively cheap options prices prior to its crash to 30 dollars. The market did not seem to think it was probable that it would go down by that big of a margin. However, investors who have done their homework and shorted Valeant really were paid off. Therefore, it is crucially important to ingrain the mindset that risk does Not equal returns; you could buy something that is deemed to be low risk (such as the credit companies in 2008), and still lose from head-to-toe if you did not research properly.
Defensive Investor vs. Enterprising Investor
In terms of investors, Graham further differentiates between a defensive investor and an enterprising investor. The key difference is the amount of effort they put in. Graham argues that defensive investor is content with lower returns since he/she is not willing to put in the same amount of work that an enterprising investor does. Buffett often speaks on this point each time he is asked of “how does a regular investor make money?” Buffett advises someone who is not in finance to just buy S&P 500. He is a strong believer of the American economy and is sure that it will grow overtime. I will discuss that in a separate article on whether or not that is true. Dollar averaging the S&P indexes requires no effort and in the long run, it is a tremendously profitable strategy. Buffett is quite skeptical of investors’ ability to beat the market. Even in the recent shareholder meeting, he spoke on the true rarity of beating the market. The bottom line is, if you do not have much time to study the market, you could be a defensive investor betting on value companies that have a large market share, pay high dividends, and have financial information readily available, or you could simply purchase Indexes and ride with the American economy. The other option is that you could really get into the nitty-gritty and try to understand the reports, the industry, the executive team, the technology, the patents, etc, but it might not even pay off at the end according to Warren Buffett.
The most famous contribution of The Intelligent Investor is the concept of Mr. Market.
Suppose a rather goofy-looking fellow always comes to you and offers to buy your goods. First of all, you would find it weird since you did not ask for a valuation. Overtime, though, you get used to it and you also realize that this person is quite bipolar. On some days, he is happy and offers to pay you a lot of money and on other days, he is quite stingy, wanting all your stuff without paying you much at all. What anyone would do here is to take advantage of this situation, and sells your good when the person is happy and buys the same bag of goods back when he is unhappy.
The seemingly reasonable idea is often not followed in the actual market. When a stock starts to trend up, it starts to gain attention and coverage. As a result, people often hop on the bandwagon train and hope to get paid off. On the opposite side, when a stock slips under, people want to sell. You might ask, why is that the case? The fact of the matter is, people have a short memory span. They may remember what happened 20 years ago, but in their minds, that piece of memory is no longer relevant. In front of the possibility of more profit, they always find a way to tell themselves why this time is different, and why this time, the overvalued market will continue going up forever. Therefore, once a market starts trending up and becoming more loosely valued, participants in the market tend to only compare the current multiples to the recent highs. They start to view the current valuation, which might be grossly overdone, as a benchmark for fair valuation. This causes people to start buying when the market is high, and vice versa. This is the equivalent to selling your good to Mr. Market when he is unhappy, because you are worried that he will never be happy ever again. However, you know very well that he will once again be happy because he never stays in one mood forever. The bottom line is: sell because you are taking advantage of the valuation, and not because you are forced to sell or too scared to hold onto the stocks.
Finally, The Intelligent Investor is truly a cornerstone of security investment. I recommend it to anyone who is interested in the stock or bond market. Much of Graham’s insight was way ahead of his time and it is simply admirable to see how much it still applies to the current market.