Graham opens this chapter by discounting the popular view that an investor should aim for a return that is proportionate to the degree of risk he is ready to run. Instead, Graham says that the rate of return should depend on the amount of effort the investor is willing and able to put into the analysis.
“The minimum risk goes to the passive investor who wants both safety and freedom from concern. The maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill.”
Graham returns to his discussion in an earlier chapter of the proper portfolio consisting of a 50-50 distribution of stocks and bonds. This 50-50 distribution should be altered depending on the appearance of bargain prices as a result of a bear market (in which case, you should increase the % of stocks in your portfolio) or the appearance of dangerously high prices resulting from a bull market (in which case you should decrease the % of stocks in your portfolio).
Graham points out that maintaining anything other than 50-50 becomes difficult and requires a significant amount of dedication to reviewing your portfolio. A truly defensive (conservative) investor is generally satisfied to see only half of his portfolio increase in a bull market if this means that only half his portfolio decreases in a bear market, so Graham would urge you to keep a 50-50 split. The decision to alter this split depends on the temperament of the investor and his dedication to spending the time maintaining his portfolio.
With regard to the bond portion of a portfolio, Graham suggests most investors would be best served by staying away from high-yield junk bonds and instead sticking with high-quality bonds. Zweig points out that this suggestion is largely irrelevant to modern investors who have the option of investing in funds of bonds that diversify away much of the risk Graham cautions against.
Graham also discusses preferred stock, ultimately urging against this form of investment. Preferred shares lack the legal enforcement mechanism of bonds as well as the upside potential of common shares. He also says that the only time to buy preferred stocks is when “their price is unduly depressed by temporary adversity” which is the exact time when you would want the legal protection and creditor position of bonds. It will be a rare situation when preferred shares are the right investment for conservative investors. (Zweig calls them a “worst-of-both-worlds investment”)
This chapter ultimately discusses how aggressive a portfolio should be. Graham answers this question by looking not at the market but instead at the investor. If you are the kind of investor who is willing to continually research and monitor your portfolio (the active investor), then you can afford to deviate from the 50-50 bond-stock distribution that Graham suggests is safest. If, on the other hand, you have less time to invest in your portfolio (the defensive investor), then it would be best that you create a permanent portfolio that requires very little effort, but also has lower returns. If you are the latter, you must ensure that you do not fall prey to the market’s whims by buying what’s “hot” with little research, as this will almost surely lead to your ruin.
It is important to recognize that the intelligent investor can be either the active or defensive investor. Likewise, the unintelligent investor can be either as well! You must know your role and play it well.
Zweig points out that Graham makes no mention of age when discussion appropriate portfolio allocation. The common belief is that investors should become more conservative as they age, so as to ensure they will not sustain a financial disaster leaving them destitute with little time to recover before death. Zweig discounts this theory as a rule of thumb that fails to take into account individual circumstances. The intelligent investor must consider his own circumstances and risk tolerance. However, no matter what your risk tolerance, you should never deviate beyond the 25-75 allocations.