Benjamin Graham

Chapter 4 – General Portfolio Policy

Summary and Discussion – Chapter 4 – General Portfolio Policy: The Defensive Investor
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created November 20th 2013
Last updated November 20th 2013
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

  • More risk does not necessarily imply more reward. Rather, reward increases in line with the intelligent effort brought to bear by the investor.
  • Defensive investors should divide their funds between high-grade bonds and high-grade common stocks.
  • In selecting bonds, investors have a number of factors to consider.

Graham notes, then refutes, a common notion: Generally, people speak of a ratio between risk and return wherein increased risk is associated with a higher expectable rate of return (we will here ignore the fact that, in so speaking, one implicitly ignores the equal and opposite side of the equation). In this manner, people speak such notions such as that “the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run.” [1]

“Our view,” he parries, “is different.” [2]

“The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task.”

Accordingly, Graham sets out recommendations for two distinct classes of investors: The defensive, or “passive” investor, who values convenience and security above prospective superior results; and the enterprising investor, who has the time, competence, and inclination to delve deeper into the art of investing in pursuit of increased performance.

The recommendations of this chapter are for the defensive investor.

The Basic Problem of Bond-Stock Allocation

The basic principle which should guide the defensive investor is that “He should divide his funds between high-grade bonds and high-grade common stocks.” [3]

To this, Graham adds that “[he] should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds.” [4] As a general rule (i.e. barring significant perceived price imbalances) “the standard division should be an equal one, or 50-50, between the two major investment mediums.” [5]

“The Problem”

The approach which Graham outlines above makes perfect sense in theory, but is notoriously difficult to implement in practice (or, in his words, “These copybook maxims have always been easy to enunciate and always difficult to follow”) [6]. This is not because of any extraneous or technological factors, but rather because of the human factor: One’s own individual psychology. It is exceedingly difficult to refrain from buying securities when the price of those securities is advancing; conversely, it is equally difficult to refrain from selling securities when their price is in decline. However, it is precisely this restraint which is necessary for one to avoid falling into the perilous trap of buying high and selling low–that counterproductive instinct which is at the heart of mass-market behaviour. The trick, Graham argues, is to profit from that irrationality; not contribute to it.

The Bond Component

With regard to the bond component of her portfolio, should the investor buy taxable or tax-free bonds? Shorter-term or longer-term maturities? [7] These are the four principal questions which the investor must ask herself.

Taxable or tax-free?

“The tax decision should be mainly a matter of arithmetic, turning on the difference in yields as compared with the investor’s tax bracket.” [8]

When to Buy Taxable Bonds When to Buy Tax-Free Bonds
If the tax liability incurred on taxes paid on the taxable bonds will be less than the increased yield offered by the taxable bonds relative to tax-free alternatives.In other words, if the yield on taxable bonds more than compensates for their tax liability. If the tax liability incurred on taxes paid on the taxable bonds will be greater than the increased yield offered by the taxable bonds relative to tax-free alternatives.In other words, if the yield on taxable bonds does not compensate for their tax liability.

Shorter-term or longer-term maturities?

“The choice of longer versus shorter maturities involves quite a different question, viz.: Does the investor want to assure himself against a decline in the price of his bonds, but at the cost of (1) a lower annual yield and (2) loss of the possibility of an appreciable gain in principal value?” [9]

When to Buy Shorter-Term Maturities When to Buy Longer-Term Maturities
When one values (generally) decreased probability of default more than annual yield.
When one anticipates that interest rates will rise in the medium and long term.
When one value annual yield more than (generally) decreased probability of default.
When one anticipates that interest rates will fall.

Footnotes
[1] 88.
[2] 88.
[3] 89.
[4] 89.
[5] 89.
[6] 89.
[7] 91.
[8] 91-92.
[9] 92.

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