Thursday, August 28, 2008

The Intelligent Investor: Chapter 1

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

In the first chapter, Graham makes an important distinction between investors and speculators. Simply put, investors are those that put their money in investments. Investments are that which “upon thorough analysis promises safety of principal and an adequate return.” Everything else is speculative.

Graham repeatedly points to the sloppy language many people use in referring to themselves and others as investors, when in fact they are speculators.

This is more than mere semantics. Investors need not fear devastating and irreversible losses. This is because investors, by Graham’s definition, have put their money in investments which promise safety of principal. This is not to say that investors will never lose money, but it is true that investors will not suffer the same devastating losses as others, because they have protected their downside potential. For example, investors were not devastated by the losses associated with the dot com meltdown. Speculators were. Investors did not allow these companies to become the bulk of their portfolios because it was clear that the underlying value of the tech companies did not justify the excessive stock prices the market was assigning them.

This is not to say that speculation should be avoided at all cost. Instead, it must be kept to small portion of your portfolio (Graham suggests no more than 10%). Speculation does have virtues in that is necessary to promote entrepreneurship, as it allows untested new companies to raise capital for expansion.

Graham uses this chapter to expand on the core principles discussed in the introduction. Investors must do three things:

  • thoroughly analyze a company and the soundness of its underlying business;
  • deliberately protect against serious losses; and
  • aspire to adequate, not extraordinary, performance.
Extraordinary performance should not be the goal of the intelligent investor, as such performance often leads to unwarranted risks that compromise the investor’s return.

Note that none of these suggestions relate to the market price or what is “hot” in the market. Instead, Graham says the intelligent investor looks only at the underlying business. Of course, the valuation that the intelligent investor puts on the business must ultimately be compared to the market price, but this is not to suggest that the market price or pricing direction should be the sole characteristic of purchase.

Ignore the market’s often irrational behaviour and what appears to be “hot” even if others’ portfolios are outperforming yours as a result, because in the long run you are more likely to be better off. (This is how Warren Buffett was able to avoid the dot com meltdown)

For an investor to have a reasonable chance for continued adequate returns, he must follow policies that are (1) sound and promising, and (2) often not popular on Wall Street. This takes courage, determination and patience, but the intelligent investor can rest easy knowing that, in the long run, he is more likely to be better off.

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