The Intelligent Investor by Benjamin Graham is considered the bible of investing.
Speculative formulas like the January effect, O’Shaughnessy’s patented strategy, Foolish Four strategy were all the result of a simple mistake. Looking at large quantities of past financial data for a long enough period will produce some coincidental patterns. These strategies stopped working soon after they were published. The January effect is still there, though much less pronounced. Speculating is closer to gambling, and those pursuing it should put a hard limit on how much they are going to spend on speculation.
Stocks protect against inflation. Bonds provide partial protection against inflation. REITs and TIPS are other bets against inflation. TIPS are better off in tax-protected accounts since the IRS treats an increase in their paper value as taxable gain.
Never try to predict the future solely by extrapolating the past. Stocks don’t outperform cash/bonds significantly once all the companies which went bankrupt are taken into consideration. Shiller index, a ratio of current price to average profits over the past ten years, is inspired by Graham’s valuation approach. If the index goes about 20, stock market returns are usually poor. The real growth of earnings and dividends is about 2%; inflation runs about 2%, the dividend yield is about 2%. Thus, the total return on stocks is 6% (4% adjusted for inflation) in the long run.
The book does not prescribe the standard “(100 - age) % of the portfolio in stocks” since people at the same age can have different investment horizons. For anyone, putting a minimum of 25% in stocks is a safe bet and beyond 75% is too risky. Research shows that we are bad at predicting our reaction to an emotionally charged situation (stock market crash, in this case) in the future. Depending on one’s life situation, which determines the investment horizon, the stock component can be chosen between 25 and 75%. Taxable bonds should only go into tax-sheltered accounts like 401(K). If interest rates rise, a short-term bond falls far less than the long-term and vice versa. The simpler bet is to buy intermediate-term bonds instead.
An individual investor can great common stocks just based on companies he is familiar with. Unfortunately, this familiarity breeds complacency. An individual investor should not invest without doing further research into the financial statements of the company. Index funds with dividend reinvesting leading to Dollar-cost averaging are the best bet for individual investors.
Junk bonds are usually a bad bet. Day-trading is a crime; it only makes the broker rich. IPOs are bad for individual investors. VA Linux went public at $30 a share in 1999, the stock then went up to $320 in a single day, and in 3 years, it was trading at $1.19 a share.
A great company is not a great investment if you pay too much for the stock. Bargain opportunities arise with big company stocks from time to time when the stock crashes due to bad news with a temporary effect. Investing in foreign stocks is important for diversification. In 1989, the Japanese stock market had made 21% annually on average for a decade against 17.5% for the USA. Japanese companies were booming, but then in the next decade, Nikkei lost two-thirds of its value.
Mr. market knocks on your door every day and tells you a price at which you can buy more shares of companies you own or sell your shares. His behavior is erratic; sometimes you feel he is offering too much and sometimes asking too much. Most people lose by imitating Mr. market. Most people fear losing money more than gaining, so, when the market tanks, they end up selling at the bottom. When stocks fall in price, they are actually on sale, whether the sale is worthy of it is not, is to be judged by the buyer.
Index funds are good bets. Finding good mutual funds to invest in is hard, good ones are usually closed to new investors and most likely not even taking new money. Be careful of high turnover leading to excessive taxes.
An adviser assists in developing a comprehensive financial plan regarding earning and investing (asset-allocation) and take care of the emotional health of the client during difficult times.
Five important factors for a long-term prospect
Signs of trouble
Good signs
If you are reading financial reports, read them backward. Bad things are usually at the end or in the footnotes.
A low-cost total stock market is the best of a defensive investor. Keep 90% of the money in that and play around with 10% picking stocks. For stock picking, focus on the strong financial condition of the underlying company, its earnings stability, dividend record, earnings growth, moderate P/E (< 15), and moderate Price-to-book (< 2.5).
A convertible bond can be converted to stock at a conversion ratio. So, while they pay interest like a bond, they can be converted into a stock, which makes sense if the stock does well. They are more correlated with the stock market than the bond market. Another common thing that some investors do is selling covered calls, which effectively puts a ceiling on their gains while still giving the same exposure to losses. Hence, it’s a bad idea.
It can take a long time to recover from large losses; therefore, losing is a dangerous proposition. Consequences should always dominate probabilities. So, rather than wondering about what’s the likelihood of equity going down 50%, first focus on how would you react when you face those losses. The value of any security is proportional to the square of its earnings and is inversely proportional to its market value.
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