Investing Vs speculation

BOOK REVIEW

"An investment operation is one which promises safety of principal and an adequate return. Operations not meeting these requirements are speculative," writes Benjamin Graham.

The greatest investment advisor of the twentieth century, Graham never encouraged speculation. Naturally, The Intelligent Investor, considered by many as the stock market bible, is not addressed to speculators. Instead, it emphasises the virtues of a simple portfolio policy, involving purchase of high-grade bonds plus a diversified list of leading common stocks.

"The adventure beyond this territory is fraught with challenging difficulties, especially in the area of temperament. Before attempting such a venture the investor should have a clear concept of the differences between investment and speculation, and market price and underlying value," Graham counsels.

Most people who 'trade' in the market are guided by charts or other means of determining the right moments to buy and sell. The principle that applies to nearly all these 'technical approaches' is that one should buy because a stock or the market has gone up and one should sell because it has declined.

"This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success in the stock market," he asserts.

A majority of speculators believes they have odds in their favour when they take chances. Each feels that the time is propitious for purchase, or that his skill is superior to the crowd's. "But such claims are unconvincing. They rest on subjective judgment, unsupported by evidence," he reasons.

For Graham, investing is distinctively different from speculating. "To invest intelligently in securities one should be forearmed with an adequate knowledge of how the various types of bonds and stocks have behaved under varying conditions. Those who do not remember the past are condemned to repeat it," he pronounces.

Investing is also about managing contradictions. "The structure of stock-market quotations contains a built-in contradiction. Better the quality of a common stock, more speculative it is likely to be." The investor who is aware of this idiosyncrasy wouldn't be flustered when prices move erratically.

"Price fluctuations have only one meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall and to sell when they advance. At other times, he will do better if he forgets about the market and pays attention to dividend returns and operating results of the companies he invested in."

Whether you achieve outstanding results or not will depend on the effort and intellect applied to investments, as well as on the amplitudes of stock-market follies. "The sillier the market behaviour the greater the opportunity for a business-like investor."

Investors, too, fall prey to follies. "The investor's worst enemy, Graham writes, is himself. One needs proper mental and emotional attitudes towards investing.

The secret of financial success is inside yourself. If you are a critical thinker who takes no Street 'fact' on faith, and you invest with patient confidence, you can take advantage of even the worst bear markets.

However, caution and patience alone don't guard you from pitfalls. "No matter how careful you are, the one risk you can never eliminate is that of being wrong".

Only by insisting on what Graham calls the 'margin of safety' - never overpaying, no matter how exciting an investment seems to be - can you minimise chances of errors.

Ascertaining the asset value of stocks before buying them is equally important as the future value of an investment is a function of its present price. The higher the price you pay, the lower the return.

However, paying the 'correct' price is only the first step towards prudent share purchase. "A stock doesn't become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory P/E ratio, a strong financial position and the prospect that its earnings will at least be maintained."

Graham's arguments revolve around two themes - value investing and margin of safety. Value investing shields you from substantial error and teaches you how to develop long-term strategies.

The book teaches how to minimise the odds of suffering irreversible losses. It counsels how to control self-defeating behaviour which keeps investors from reaching their full potential.

Graham was not only a great investor; he was also the greatest practical investment thinker of all time. Before him, money managers were largely guided by superstition, guesswork and arcane rituals. Graham's principles transformed this into a modern profession.

"To invest successfully doesn't require a stratospheric IQ. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework," says Warren Buffett in the preface. This book prescribes the framework. You only need to supply the emotional framework.

GOLDEN TENETS

• A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that doesn't depend on its share price.
• The market is a pendulum that swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.
• Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.
• The future value of every investment is a function of its present price. The higher the price you pay, the lower the return will be.
• Obvious prospects of physical growth in a business do not translate into obvious profits for investors.
• Any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is too simple and too easy to last.
• Shares of second-line companies are likely to fluctuate more widely than the major ones. But this doesn't necessarily mean that a group of well-established but smaller firms will make a poor showing over a long period.
• You need not watch the companies you have invested in like a hawk; but you should give them a hard look from time to time.
• Have the courage of your knowledge and experience. If you have formed a conclusion from facts and if you know your judgment is sound, act on it - even though others may hesitate or differ.
• You are neither right nor wrong because the crowd disagrees with you. You are right if your data and reasoning are right.

The Intelligent Investor

Author: Benjamin Graham
Publisher: HarperCollins
Edition: 2003 (updated with commentary by Jason Zweig), paperback
Price: Rs 660
Book courtesy: Crossword