Monday, September 1, 2008

The Intelligent Investor: Chapter 2

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 Chapter One, Graham made the case for a portfolio split between stocks and bonds. Graham suggests an even 50-50 split, but it can fluctuate to be 25-75 or vice versa, depending on whether the market is optimistic and overvaluing stocks or pessimistic and undervaluing stocks.

Why must all portfolios have both stocks and bonds?

Bonds are debts of a company. The interest and principal payments are enforceable at law, and must be paid by the corporation, just like any debt. Stocks, on the other hand, provide no enforcement mechanism for shareholders to force the corporation to pay dividends or to repurchase the shares (This is only partly true - shareholders can force repurchase of shares in some limited situations, though this is not relevant in general). Thus, bonds provide greater certainty of income in a market downturn than stocks.

Chapter two discusses inflation in more depth. Graham shows how inflation has occurred in the past and concludes that the intelligent investor must allow for the probability of continuing inflation in the future. Given that we must allow for inflation in the future, this will have an effect on the investments we make.

Bonds provide a fixed interest payment and principal repayment regardless of inflation. Thus, to invest solely in bonds would be to willingly allow yourself to become susceptible to loss of earning power due to inflation.

Graham shows that stocks are not adequate insurance against inflation, but that they provide some protection whereas bonds (in general - ignoring inflation adjusting bonds) provide no protection. In his commentary, Zweig shows that 78% of the time, stocks outpaced inflation, so they provide significantly better protection than bonds.

So, Bonds guard against downside losses associated with falling stock prices, and Stocks guard against loss of earning power associated with high inflation. Because investors cannot risk putting all of their eggs in one basket (be it bonds or stocks), the intelligent investor has a portfolio consisting of both bonds and stocks.

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