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This book will not teach you how to beat the market. However, it will teach you how to reduce risk, protect your capital from loss and reliably generate sustainable returns over the long run. Warren Buffett calls the Intelligent Investor ""by far the best book on investing ever written.""
Benjamin's proven value investing approach replaces risky attempts to project future share prices with sound investments based on the underlying value of the company's tangible assets.
The Intelligent Investor by Benjamin Graham gives you everything you need to equip yourself with the investor's mindset necessary to avoid the panic of market fluctuations that plague the ordinary investor. Don't be ordinary. Be intelligent.
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Price and value are two different concepts, and stock prices frequently don't reflect a company's actual value. More risk does not necessarily correlate with more gain. On the contrary, a substantial margin of safety and the difference between stock price and fundamental asset value can protect against loss while improving potential upside. Value investing can help you create a core portfolio that frees you from the need to track market prices and guarantee maximum odds of a steady return.
What causes the stock market fluctuations and how influential are analysts to the share priceView answer
Stock market fluctuations are caused by a variety of factors. These include economic indicators, geopolitical events, corporate earnings reports, and changes in monetary policy. Investor sentiment and market speculation also play a significant role in driving the prices up or down.
Analysts can be influential to the share price to a certain extent. They provide research and forecasts about companies, including earnings estimates. If an analyst gives a positive recommendation or upgrades a stock, it can lead to increased investor interest and potentially a rise in the stock price. Conversely, a negative report or downgrade can cause the price to fall.
However, it's important to note that while analysts' opinions can influence investor behavior, they are just one of many factors that can affect a stock's price. The actual impact of an analyst's recommendation on a stock's price can vary widely depending on the overall market conditions and the specific circumstances of the company in question.
Graham's value investing approach is a reliable, risk-free path to protecting one's investments and generating decent stock market returns. It replaces risky speculation on future stock prices with a systematic way to derisk investments and build wealth.
It is essential to distinguish investment from speculation. An investment, according to Graham, is based on thorough analysis that promises both safeties of principal and an adequate return. Three components of this definition are essential:
Speculators, on the other hand, buy stocks based on projected future growth in price. Every nonprofessional who operates on margin or buys "hot" stocks is effectively speculating or gambling. Speculation lowers the odds of building wealth. Do not speculate under the illusion that you are making an investment decision. If you wish to speculate, put aside a small portion of the capital (below 10%) in a separate fund.
If people lose confidence in the Bank of England, do investors lose confidence in financial markets?View answer
The confidence in a country's central bank, such as the Bank of England, can indeed influence investor confidence in financial markets. If people lose confidence in the Bank of England, it could lead to uncertainty about the stability of the UK's financial system. This could make investors more cautious about investing in UK-based assets or in assets denominated in British pounds.
However, it's important to note that investor confidence is influenced by a multitude of factors, not just the perceived stability of a central bank. Other factors could include economic indicators, political stability, global market trends, and individual company performance.
So, while a loss of confidence in the Bank of England could impact investor confidence, it's just one of many factors that investors consider.
What causes a change in Market Sentiment?View answer
Market sentiment can be influenced by a variety of factors. Economic indicators such as GDP, employment rates, and inflation can cause shifts in market sentiment. For instance, positive economic news can boost investor confidence, leading to a bullish market sentiment. News and events, both domestic and international, can also impact market sentiment. Political instability, natural disasters, or major corporate announcements can cause investors to feel uncertain, leading to a bearish market sentiment. Market sentiment can also be influenced by psychological factors. Investor psychology can often be driven by fear and greed, which can cause overreactions to news events and lead to volatility in the market. Lastly, market sentiment can be influenced by technical factors such as market trends and patterns. Investors often look at these trends to gauge the overall direction of the market.
Do interest rates have a large influence over market dynamics?View answer
Yes, interest rates have a significant influence over market dynamics.
Higher interest rates can make borrowing costlier, which can reduce corporate profits and slow down economic growth, often leading to a decrease in stock prices. Conversely, lower interest rates can stimulate economic growth by making borrowing cheaper, potentially leading to an increase in stock prices.
Interest rates also affect bond prices. When interest rates rise, bond prices typically fall, and when interest rates fall, bond prices typically rise.
Moreover, interest rates can influence the foreign exchange market as investors may move their money to countries with higher interest rates.
However, it's important to note that while interest rates are a key factor, they are not the only factor influencing market dynamics. Other factors such as economic data, political events, and market sentiment also play a crucial role.
1. Betting on growth stocks
Many investors fall for the allure of growth stocks. Just because a growth stock performed better than average in the past and is projected to do so into the future doesn't mean it will — it's a risk.
2. Initial public offerings
Graham warns investors to avoid purchasing Initial Public Offerings (IPOs), particularly in bull markets — for two reasons. First, IPOs offer a higher built-in commission, leading to a harder sell. Second, new issues are nearly always sold near the peak of a bull market. The initial IPOs in a rising market lead to profits fuelling a frenzy for subsequent IPOs. A clear sign of the end of a bull market is when IPOs of small and nondescript companies have stock values higher than medium-sized enterprises with a long history. Since the prices of these new stocks usually crash to new lows, Graham warns investors to stay away from this kind of costly speculation.
In the 1980's bull market, 4000 stocks flooded the market, leading to the crash of 1987. IPOs dried up between 1988 -1990, contributing to the 90's bull market where nearly 5000 new stocks were listed. After the Dotcom bubble, only 88 companies issued IPOs in 2001. An investor who bought every IPO at its public closing price from 1980 to 2001 would have underperformed the market by more than 23% annually.
Defensive and enterprising investors
There are two types of investors, according to Graham: Defensive and Enterprising Investors.
Defensive investors primarily seek to avoid losses, generate a decent return and minimize time spent on the stock market by creating a portfolio that virtually runs on autopilot.
The Enterprising investor is willing to devote more time and effort to researching securities, hoping to make a better average return than the passive investor over the long term. Graham's enterprising investor is not someone willing to take more risks than the defensive investor. Playing with risk is the domain of a speculator. The enterprising investor must have sufficient knowledge of securities to consider his investments equivalent to a full-time business.
The enterprising approach is physically and intellectually taxing, while the passive approach is emotionally demanding, asking the investor to do nothing for years. There is no room for a middle ground between a defensive and enterprising investor. An ordinary investor can achieve a decent result with minimal effort, but even a marginal improvement on this result requires extraordinary knowledge and skill. Putting a little more time and effort to improve outcomes through stock selection is sure to result in below-average returns. Therefore, most investors must recognize that they are defensive investors and should use suitable strategies.
The predictive and protective approaches
Investors can take advantage of market swings in two ways. Prediction involves estimating the future growth of a company's earnings through mathematical methods. Speculators attempt to time the market by buying based on growth predictions and selling based on predicted declines. Projection is dangerous because the future is uncertain, and inflation, economic recessions, pandemics and geopolitical upheavals often arrive without warning. Graham argues that it is a fool's errand for an ordinary investor to attempt making money by timing the market.
Graham advocates for a protection-based approach that does not try to time the market. Value investors should identify and invest in large, conservatively financed companies whose present value (as estimated by tangible assets) is substantially below their current stock prices. A protection-based approach creates a margin to absorb unfavorable developments in the future. The focus is on ensuring tangible value in purchasing the stock at current prices
Think like a partner
A shareholder can see themselves as the buyer and seller of shares whose prices vary by the moment or as a minority partner in a private business whose value depends on the assets and profits of the enterprise. While many companies are worth far more than their net assets, the buyers of their stock become dependent on the stock market fluctuations.
Investors should limit themselves to securities currently selling for not that far above their tangible asset value for both practical and psychological reasons. When an investor pays well above net asset value for a share, they become a speculator dependent on the vagaries of the stock market to generate a profit. However, an investor who buys shares near the net-asset value of a company can consider themselves the part-owner of a sound and expanding business acquired at a reasonable price. Unlike the speculator who paid high multiples of earnings and tangible assets, they can take a detached view and ignore stock market fluctuations. This conservative policy is likely to work out better than risky investments based on anticipated growth.
Meet Mr. Market
Graham gives the allegory of Mr. Market to illustrate the investor's ideal attitude to the stock market. Imagine you paid $1000 to buy a small share in a private business. One of the partners, Mr. Market, tells you every day what your share is worth and offers to buy or sell additional interest in the business. Unlike a private buyer, Mr. Market often quotes exuberantly high values or absurdly low ones. Given this situation, there is no way a sensible investor will rely on Mr. Market to understand the underlying value of their shareholding. However, they would be more than happy to buy from Mr. Market when he quotes meager rates and sell to Mr. Market when he quotes relatively high rates.
Similarly, a defensive investor who has made a value-based investment based on sound business fundamentals will ignore the stock market valuation apart from taking advantage of its swings. Graham goes so far as to say that the single biggest reason investors fail is that they pay too much attention to what the stock market is currently doing. Intelligent investors should be comfortable holding their stocks even if they don't see the daily stock market prices for years. Experiments have shown that investors who received frequent news updates about their stocks earned half the returns of investors who received no information at all.
Graham suggests a mechanical 50-50 split between stocks and bonds for defensive investors to guard against over-purchasing shares in a bull market and rushing into bonds in a bear market. The only action they should take is to rebalance their portfolio every six months if market developments alter this 50-50 ratio by over 5%.
On the other hand, enterprising investors can increase their stocks up to 75% when markets are low and reduce it up to 25% when markets are at their peak. However, a minimum of 25% in bonds is necessary to give investors the peace of mind to hold onto stocks in the worst bear markets.
Unless investors are in the lowest tax bracket, they should purchase only tax-free municipal bonds. The only place to own taxable bonds is inside the 401(k) account. As interest rates rise, short-term bonds fall less than long-term bonds. But when interest rates fall, a long-term bond will outperform short-term ones. Therefore, to avoid guessing interest rates, it's best to buy bonds that mature in five to 10 years as they remain relatively stable. Bond funds are a better idea than individual bonds as they offer an easy way to diversify and reduce risk.
A defensive investor can follow two approaches to stock selection. First, they can rely on a diversified cross-section of the market through an index fund. Second, they can create a quantitatively tested portfolio of reliable stocks.
Mutual funds are a fantastic way for a defensive investor to capture the upside of diversified stock ownership without the effort of actively monitoring one's portfolio. A defensive investor's best long-term bet is to invest in index funds that own all stocks in the market without trying to select the "best" stocks. The low trading costs and operating expenditures mean that an index fund will outperform most mutual funds over the long run. Both Graham and Warren Buffet recommend index funds as the best choice for individual investors to own stocks. Take advantage of dollar-cost averaging by investing the same amount every month in a portfolio of index funds. This simple practice ensures that you buy more shares when the markets are low than when it is high.
If you enjoy the intellectual challenge of picking stocks, you can make the index fund the foundation of your portfolio and experiment with a small portion of funds (~10%) on stocks. Here are Graham's rules for the defensive investor's stock portfolio:
Investors must not look for better than average returns by investing in growth stocks. They carry too much risk due to the high speculative element in their prices. Instead, they must confine themselves to large established companies with a history of profitable operations, stable financial conditions and reasonable profit/earnings ratio.
Wall Street calculates the Price/Earnings ratio primarily on next year's earnings. However, Graham insists on calculating the Price/Earnings Ratio based on a multi-year average of past returns, which lowers the odds that an investor will overvalue the company simply because it had an odd profitable year or has high revenue projections. Let's say a company has earned $0.50 per share over six years but earned $3 over the last 12 months. At 25 times the P/E ratio (based on the last year), the stock would be valued at $75. In contrast, valued at 25 times the average earnings over the past seven years, and the stock would be valued at just $21.43.
Here are Graham's criteria for stock selection:
Choose companies with at least $2 billion in annual assets to ensure they are large enough to avoid high volatility in stock prices.
The company's current assets must be twice the current liabilities to ensure a cushion for difficult times. Long-term debt must not exceed working capital. In 2003, about 120 of the S&P 500 companies met this ratio.
There must be some earnings for the common stock over the past ten years. 86% of companies in the S&P index had positive earnings every year from 1993 to 2002.
They should have processed uninterrupted payments for at least 20 years. Over 255 companies had paid dividends from 1993 to 2002.
The company should show a minimum increase of at least 33% in per-share earnings over the past ten years. Over 260 companies met this standard as of 2002.
The stock's current price should not be more than 15 times the average earnings of the past three years. This multiple, adjusted for 2002 levels, is 22.5 times the average earnings of the past three years.
The stock price must not be more than 1.5 times the last book value. If the multiplier of earnings is below 15, it can justify a higher multiplier of assets.
Graham's rule of thumb is that the company's total multiplier of earnings and multiplier of book value should not exceed 22.5. The overall portfolio of stocks must have an earnings/price ratio at least as high as the current bond rate. If you find this degree of analysis difficult, avoid stock picking and invest entirely in index funds.
Graham designed this approach to create a core portfolio that requires minimal maintenance and a maximal chance of a steady return. After curating the initial portfolio, if the investor is trading more than twice a year, it is a clear sign something has gone wrong. The defensive investor wins the race by sitting still. By sticking to an autopilot formula for investment decisions, the defensive investor gives up the risk of speculating on stock movements and worrying about market swings.
An investor must insist on a margin of safety in every investment to absorb negative changes. This margin of safety is the difference between the percentage of earnings at the price paid and the interest rate on bonds. The price at which you acquire the stock is the crucial determinant of being a good or a bad buy. You should skip even the best company if the price goes too high and consider even the worst company if its stock goes low enough to create a substantial margin of safety.
Assume an investor buys a stock that can grow at 10% per year at a time when the market grows 5% annually — but it's at the height of a bull market, and the stock drops by 50% the following year. Even if the stock continues to perform at 5% above market value, it will take the investor more than 16 years to overtake the market. All because they bought at the wrong price. By refusing to overpay, you minimize chances of wealth destruction.
With value investing, you can achieve satisfactory investment results over the long run with reduced risk and without losing sleep over periodic market fluctuations. All it requires is the discipline to never purchase far above tangible asset value, resist the urge to invest in glamorous growth stocks and replace the mindset of a speculator with the investment approach of a partner.
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