Showing posts with label The Intelligent Investor: General Portfolio Policy for the Defensive Investor. Show all posts
Showing posts with label The Intelligent Investor: General Portfolio Policy for the Defensive Investor. Show all posts

Tuesday 26 March 2013

Benjamin Graham's Intelligent Investor: The investments the Defensive Investor's should buy and should avoid.


The Defensive Investor’s Portfolio Policy
Those who can not afford to take risks should be content with a relatively low return.  
The rate of return is dependent upon the amount of effort put forth by an investor. 
As previously stated, the defensive investor’s portfolio should consist of no less than 25% high grade bonds and no less than 25% large stocks.
Yet these maxims are difficult to follow, because like the herd of Wall Street, when the market has been advancing, the temptation is strong to bet heavily on stocks.
This is the same facet of human nature that produces bear markets.  
The time to invest in the stock market is after it has suffered a large loss.
A 50% ratio of stocks and bonds was a prudent choice except during periods of excessive increases or decreases in stock value. 
This simple formula guards against the mistakes caused by human nature even if it does not provide for the best returns. 
Again, Safety of Principal is Graham’s chief concern.
Bonds  
The decision between purchasing taxable and tax-free bonds depends mainly on the difference in income to the investor after taxes. 
Those in a higher bracket have a greater incentive to closely examine this issue. 
For example, in 1972, an investor may have lost 30% of his income from investing in municipal issues (“munis”) as opposed to taxable issues. 
          
Bonds come in many types, a description of which follows.
 US Savings Bonds are a great choice.  In 1972, they came in two series:  E and H.  The Series H Bond paid semi-annual interest.  Series E Bonds did not pay interest, but rather sold at a discount to their coupon rate.  In 1972, Series E bonds provided the right to defer income tax payments until the bond was redeemed, which in some cases increased the value by as much as one-third.  Both E and H Series Bonds are redeemable at any time providing bondholders protection from shrinkage of principal during periods of rising interest rates (or rather, the ability to benefit from rising rates).  Both series paid in or around 5% in 1972.  Federal, but not state, income tax was payable on both series.  Graham recommends US Bonds due to their assurance of transferability, coupon rate, and security. 
Other US Bonds come in many varieties. 
Federal taxes, but not state taxes, are charged on other US Bonds.  Some of these issues are discounted heavily. 
Others bonds are guaranteed, but not issued, by the US government.  As of 1972, the US government had fully honored its commitments under all guarantee obligations.  Federal guarantees, in essence, permit additional spending by various federal agencies outside of their formal budgets.
State and Municipal Bonds are exempt from federal and state tax in the State of their issue. 
However, not all of these bonds possess sufficient protection to be considered worthy of investment.  
To be worthy of investment, a bond should possess a minimum rating of “A”.   
Corporate Bonds are taxable and offer higher yields than all types of government issues bonds. 
Junk Bonds are those that are less than investment grade.  Their title is aptly given.  The investor should steer clear of these issues.  The additional yield that junk bonds provide is rarely worth their risk.
Savings and Money Market Accounts are a viable substitute for US Bonds.  They usually pay interest rates close to rates paid on short-term USbonds
Preferred Stocks should be avoided. 
Not only does the preferred holder lack the legal claim of a bondholder (as a creditor), but also he lacks the profit possibilities of the common stock holder (as a partner).  
The only time to purchase preferred stock, if ever, is when its price is unduly depressed during times of temporary adversity.
Early redemption of bonds by issuers was commonplace before 1970, and resulted in an unfair advantage for the issuer by not allowing the investor to participate in significant upside values if interest rates fell. 
However, this practice largely stopped.  
The investor should sacrifice a small amount of yield to ensure that his bonds are not callable.

Thursday 2 July 2009

The Intelligent Investor: General Portfolio Policy for the Defensive Investor

Chapter 4 - General Portfolio Policy: The Defensive Investor
Graham opens the chapter defining two different kinds of investors: the “active” investor, which is the kind of investor that actively seeks new investments and invests serious time into studying investments, and the “passive” or “defensive” investor, the kind of investor that wants to invest once (or on a highly regular basis) and just let his or her portfolio run on autopilot.

Regardless of the activity that you apply to your investments, Graham sticks hard with his recommendation from the earlier chapter: 50% stocks, 50% bonds (or a close approximation thereof, with an absolute maximum of 75% in either side). It’s important to remember with a recommendation like that that Graham is very conservative in his investing, dreading the idea of an actual loss in capital. Only in the most dire of down markets (like 2008, for example) would such a portfolio actually deliver a loss to the investor.

Much of this chapter is spent talking about the various types of bonds that a person can buy:

  • savings bonds,
  • treasury notes/bills,
  • municipal bonds, and
  • corporate bonds
dominate most of the chapter, with most of their ins and outs described. Graham doesn’t really come to a conclusion about any of them, merely pointing out that there is a huge diversity of options when it comes to the bond portion of your portfolio -

  • some short term,
  • some long term,
  • some free from taxes,
  • some not.

Commentary on Chapter 4
So, how can you tell whether you should be 75% stock and 25% bonds or 50/50 or 25/75? Or somewhere in between? Zweig argues that it mostly comes down to

  • your goals,
  • the stability in your life,
  • your other savings, and
  • your tolerance for risk.
The more stable things are and the longer term your goals are, the higher your proportion of stocks can (and probably should) be.

Zweig also covers several additional options for the bond portion that didn’t exist in Graham’s day, such as bond funds, mortgage securities (no, no, no, no, NO!), and annuities. More importantly, Zweig actually looked at holding cash as an investment option in such things as high-interest online savings accounts and CDs. All of these can be a big part of the conservative half of one’s portfolio, sharing space with (or replacing) bonds.

Most interestingly, though, Zweig suggested that buying stocks solely for the dividends might be considered something that could be a part of the conservative side of a portfolio. Zweig points out that many common stocks pay out 3% or more of their value in dividends each year, so if you select a high-dividend stock from a very stable company, it could potentially serve as part of the conservative side of a defensive investor’s portfolio. I don’t know if I agree with this, given the inherent riskiness of owning individual stocks, that companies reset their dividends annually, and that even the most stable of companies can fall apart quicker than you might expect.


(Comment: In the absence of easy access to bonds for individual investors in Malaysia, the FDs and selected high-dividend stock from a very stable company are the 'equivalent' alternatives to the bond portion of the portfolio.)

Ref: The Intelligent Investor: General Portfolio Policy for the Defensive Investor