Summary and Discussion – Chapter 10 – The Investor and His Advisers
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created January 6th, 2014
Last updated January 9th, 2014
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

• Investors should be skeptical if the promises made by their advisors seem too good to be true.
• Investors should be especially cautious when dealing with advisers whose loyalties are to large institutions rather than individual clients.
• It is always necessary to rely first and foremost on one’s own critical faculties.

It’s only natural that people should feel tempted to seek out advice from “experts” regarding their personal investment decisions. After all, we routinely defer to the expertise of others in matters such as medicine or law. “Yet,” as Graham notes, “there are peculiarities inherent in the very concept of investment advice.”

For one thing, the ultimate object of investment is to make money. Therefore, when dealing with “experts” (particularly those who wish to charge a fee for those insights), it is always worth asking oneself why such people would require fees for their income if they were indeed masterful investors. The relationship is akin to an alchemist wishing to sell you his secret. Why would he need to sell his knowledge if he could indeed turn lead to gold? [1]

The role of investment advisers becomes more reasonable if we assume that the objective of the investor is not so much to make money, full stop as it is to profit in a “normal,” “standard,” or otherwise reliable fashion. It is reasonable for an experienced adviser to offer “his superior training and experience to protect his clients against mistakes and to make sure that they obtain the results to which their money is entitled.” [2] Ideally, advisers would serve as voices of wisdom, protecting their clients from common missteps and steering well clear from any pretenses toward financial alchemy. Absent this modesty, “the question arises whether more is being asked or promised than is likely to be delivered.” [3]

Investment Counsel and Trust Services of Banks

What about the financial services industry? What kind of guidance can they offer the individual investor? The stream of information and opinions flowing forth from the world’s financial capitals—New York, Hong Kong, London, etc.—is vast, constant, and often self-contradicting. While information is invaluable to all investors, opinions provided by so-called experts are, to be frank, almost universally a waste of your time. The “stream” of financial information should be used only as a tool by the investor, something which she employs “to ascertain whether a given stock appears over- or undervalued at the current price in light of its indicated long-term future earning power.” The media torrent of the financial industry should never dictate one’s strategy. At the same time, it is an invaluable resource in the conduct of one’s research.

Advice from Brokerage Houses

Graham notes that much of the information accessible to investors is ultimately derived from brokerage houses which profit from the execution of financial transactions. The buying and selling of securities on behalf of clients can prove especially profitable, due to the commissions and other fees which they incur. Thus, brokers have a vested financial interest in increasing the quantity of transactions made by “clients”. [4] “In the past,” Graham writes, “Wall Street has thrived mainly on speculation, and stock-market speculators as a class were almost certain to lose money. Hence it has been logically impossible for brokerage houses to operate on a thoroughly professional basis. To do that would have required them to direct their efforts toward reducing rather than increasing their business.” What would a “thoroughly professional” brokerage service consist of? The operations of such a service would be “confined… to executing orders given to them, to supplying financial information and analyses, and to rendering opinions on the investment merits of securities.” [5]

The CFA Certificate for Financial Analysts

The professionalization of the field of financial analysis was well underway during the time of Graham’s writing, with the CFA (Chartered Financial Analyst) designation created in 1963. As Jason Zweig notes in his footnote to page 265, “Benjamin Graham was the prime force behind the establishment of the CFA program, which he advocated for nearly two decades before it became a reality.”

Dealings with Brokerage Houses

Graham notes that the late ‘60s and early ‘70s saw a number of embarrassing and high-profile bankruptcies among large New York Stock Exchange brokerage firms. In the course of these bankruptcies, it became clear that many of these firms had been engaging in reckless and short-sighted behaviour. “In effect,” he writes, “the [brokers] were speculating with the capital that was supposed to protect the customers against the ordinary financial hazards of the brokerage business, in order to make a double profit thereon. This was inexcusable; we refrain from saying more.” One wonders what Graham would think of modern financial derivatives which are used to “rehypothecate” (that is, to re-sell) the same assets repeatedly to an ever larger and more convoluted pool of “customers”. This, too, is inexcusable; I refrain from saying more.

Graham concludes this section by stressing caution when selecting brokers. Specifically, he recommends that investors should request for “the delivery and receipt of their securities [to be] handled by their bank.” As Zweig notes in his footnote to page 268, this advice is relevant due to the fact that “Nearly all brokerage transactions are now conducted electronically, and… are no longer physically “delivered”. Moreover, government initiatives such as the US’ Securities Investor Protection Corporation (SIPC) and the Canadian Investor Protection Fund (CIPF) significantly decrease the risk posed to individual investors by the potential default of brokerage houses. [6]

Investment Bankers

Graham’s commentary on this topic can be summarized through the following excerpt from pages 268-269:

“The relationship between the investment banker and the investor is basically that of the salesman to the prospective buyer. For many years past the great bulk of the new offerings [made by investment bankers] in dollar terms has consisted of bond issues that were purchased in the main by financial institutions such as banks and insurance companies. In this business the security salesmen have been dealing with shrewd and experienced buyers. Hence any recommendations made by the investment bankers to these customers have had to pass careful and skeptical scrutiny. Thus these transaction are almost always effected on a businesslike footing.

But a different situation obtains in the  relationship between the individual security buyer and the investment banking firms… Here the purchaser is frequently inexperienced and seldom shrewd. He is easily influenced by what the salesman tells him, especially in the case of common-stock issues, since often his unconfessed desire in buying is chiefly to make a quick profit. The effect of all this is that the public investor’s protection lies less in his own critical faculty than in the scruples and ethics of the offering houses.” [7]

On this last point, a certain famous line from Clint Eastwood comes to mind: Do you feel lucky?

Other Advisers

Commercial bankers, accountants, financial planners, lawyers, relatives, friends, and other contacts are all potential advisers when it comes to receiving guidance or feedback on one’s investment decisions. It is worth remembering, though, that “it is almost as difficult to select satisfactory lay advisers as it is to select the proper securities unaided. Much bad advice is given free.” Even when dealing with “expert” advisers, a critical perspective is essential so as to be conscious of potential biases, questionable motives, and/or simple incompetence on the part of the expert adviser(s) in question.

Summary

1. Investors “should be wary of all persons… who promise spectacular income or profits. This applies both to the selection of securities and to guidance in the elusive (and perhaps illusive) art of trading in the market.”
2. “Defensive investors… will not ordinarily be equipped to pass independent judgment on the security recommendations made by their advisers. But they can be explicit—and even repetitiously so—in stating the kind of securities they want to buy. If they follow our prescription they will confine themselves to high-grade bonds and the common stocks of leading corporations, preferably those that can be purchased at individual price levels that are not high in the light of experience and analysis.”
3. “The aggressive investor will ordinarily work in active cooperation with his advisers. He will want their recommendations explained in detail, and he will insist on passing his own judgment upon them. This means that the investor will gear his expectations and the character of his security operations to the development of his own knowledge and experience in the field.”
4. When dealing with advisers, one must always be conscious of the fact that the advice received may be logically and/or ethically unsound. [8]

Footnotes
[1] 257.
[2] 257.
[3] 257.
[4] As Graham notes on page 262, “A great deal is at stake in the innocent-appearing question whether “customers” or “clients” is the more appropriate name. A business has customers; a professional person or organization has clients.”
[5] 262.
[6] 267-268.
[7] 268-269.
[8] 270-271.