Benjamin Graham mentored Warren Buffet and is considered the founder of value investing.
Today, a quick summary on Benjamin Graham and his three key principles for value investing. While they may not turn you into the next Warren Buffett, these investment tips will make you a better investor.
Forbes and Investopedia combined to create, “Benjamin Graham: Three Timeless Principles”.
Always Invest With a Margin of Safety
Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities but also to minimize the downside risk of an investment.
Identify assets whose current market value is below its true (i.e., intrinsic) value. This is done through quantitative and qualitative fundamental security analysis.
Investment downside is limited due to safety cushions such as book value, replacement value, cash on hand, cash flow, earnings, etc.
Over time, other investors will realize the asset is trading below its true value. Demand for shares will increase causing the asset price to rise until market value reflects intrinsic value.
Value investing in a nut shell.
Well, except for that part about fundamental security analysis. It might require a little technical skill and investment experience to identify under-valued assets before other professional investors do.
Expect Volatility and Profit From It
Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments.
the market will fluctuate–sometimes wildly–but rather than fearing volatility, use it to your advantage to get bargains in the market or to sell out when your holdings become way overvalued.
Investors, and markets as a whole, can be emotional. At times investors irrationally fall in love with assets and pay more than they are worth. Investment bubbles result from irrational love affairs gone amok.
At other times, investors hate certain assets and refuse to buy even when they are undervalued. Or maybe not hate, but the industry is boring, the company dull, or the investment just not interesting enough for people to focus on.
For example, gold mining companies are extremely sexy right now. The industrial manufacturer who supplies the mining equipment probably much less so. Yet if the mining companies expand their operations, they will require mining equipment.
Also, small companies often fall below the radar of investors and analysts. This is due to minimum capitalization requirements for funds or analysts. Or there may be a lack of public information concerning small firms. When Bank of America sneezes, it makes the front pages of the New York Times and Wall Street Journal. When the Canyon Community Bank in Tucson makes an announcement, no one hears a word in the major press.
So how does one profit from market volatility? One way per Benjamin Graham is through:
Dollar-cost averaging: Achieved by buying equal dollar amounts of investments at regular intervals.
We have previously discussed dollar cost averaging. Dollar cost averaging is an excellent tool for small investors. It promotes a disciplined and consistent investing routine, while helping to minimize emotional mistakes.
When markets are depressed, dollar cost averaging allows you to buy assets that are “on sale.” When markets are overheated, dollar cost averaging curtails your purchases.
Graham also believed that one can profit from market volatility by:
Investing in stocks and bonds
When Benjamin Graham wrote his book in 1949, asset classes were more limited than today.
Today, there are many asset classes to include in investment portfolios. Depending on your risk profile, you can utilize other asset classes to effectively diversify your portfolio.
Also, dollar cost averaging can assist in developing a well-diversified portfolio. Just be sure to invest in quality assets. And review your portfolio on a periodic basis. If your actual asset allocation is out of alignment with your target allocation, then you may need to rebalance.
Know What Kind of Investor You Are
Graham believed that individuals need to understand who they are as investors.
You only have two real choices: The first is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn’t your cup of tea, then be content to get a passive, and possibly lower, return but with much less time and work.
If you have the expertise, available time, and commitment to spend analyzing investments, then be an active investor. But if you lack any of these traits, stick to a passive approach.
If you worry a passive approach will not provide the same returns as an active style:
The fallacy that many people buy into, according to Graham, is that if it’s so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.
Unless you have the time, energy, and expertise, you are better off investing in a well-diversified multi-asset portfolio of low-cost index funds.