In recent years, there has been a growing upheaval in investing as we throw out overused theories and reintroduce behavior, redefine risk, and question labels that have been used for decades.
Yet, none of this is new. It was simply ignored or written off for decades thanks to a faulty belief in efficient markets. Ben Graham offered up behavior’s role in 1949 with the story of Mr. Market. Almost 100 years before that, Charles Mackay outlined the dangers of herd mentality and bubbles in Extraordinary Popular Delusions and The Madness of Crowds (1841).
Let’s not write off the EMT dark ages completely. It brought index funds and low-cost investing to the masses. There’s the tiny issue that masses bring more emotion to the markets, but hey, academia isn’t perfect. Still, index funds have only add to the list of labels used at a time when it should be simplified.
How Graham Defined Investors
Ben Graham broke investors into two simple categories:
The defensive investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his skill and effort, in the form of a better average return than that realized by the passive investor. – The Intelligent Investor
Notice, there’s no mention of styles, strategies, or risk profiles. Instead it’s broken down by our behavior and willingness to do work. Here’s what we can learn from Graham’s two investors:
- Avoid mistakes and losses
- Ignore annoying daily market swings
- Keep your decisions to a minimum
- Focus on the long term
That said, there is a defining line between Graham’s two investors. One can play both roles, while the other can’t or won’t.
The defensive investor has limitations. When freedom from effort, annoyance,… is in the definition, you include anyone who sees investing as a chore or only wants to know enough to deal with it a few times a year. Fair enough. That doesn’t make them lazy or stupid, but smart. They understand their limitations and except it. Why waste time doing something you don’t enjoy when there are simpler solutions.
These days, index funds make things easier for the most avid defensive investors. It’s perfect for anyone more interested in anything other than the daily swings of the market. Relying on diversification and allocation become key to avoiding big losses.
Most people, admittedly or not, fit his defensive definition. I’d bet 95% (maybe more) fit the mold, leaving 5% or less capable of being an enterprising investor. They have more important or fun things to do than deal with the daily market news. It’s better for them to tune it out, visiting infrequently.
That’s not to say they are all indexing. There are different degrees of defensive, like there are different degrees of sports fans – not a fan, fair weather fan, bandwagon fan, everyday fan, and fanatics. Each puts a different amount of effort into their team. It’s the ones who are lying to themselves that have a problem.
Certain academic circles attack the possibility that enterprising investors even exist, that they belong with Nessie and Bigfoot. This is where the chorus of Do you think you’re the next Warren Buffett? chimes in. Of course, not. But for fund companies, it’s a great marketing tool. Take an extreme example and throw the impossibility in your face.
It’s not that people aren’t capable of being enterprising investors. They are. The problem lies with people who fool themselves to be enterprising when they’re simply imitating one on CNBC.
They either won’t put in the time and effort needed or don’t have the temperament to do it. Graham covers this too:
For indeed, the investor’s chief problem – and even his worst enemy – is most likely himself. - The Intelligent Investor
That is an often repeated topic that leads to a hard look in the mirror moment. The best investors, defensive and enterprising alike, understand their tendencies better than anyone. That’s not to say they’re impervious to mistakes. Rather, each one is carefully reviewed and filed away in their head. Over a lifetime it becomes dozens or hundred of ribbons tied around their finger.
His definitions are a far better way to define investors than by a styles. Styles, by default, pigeonhole investors, especially those that take on the enterprising role. If you’re willing to put in the time and effort, you should learn the basics of every strategy. Agility across multiple styles allows you to see more opportunities. Specialization can come later.
Most important, Graham’s description defines how we should invest. In my view the perfect investor takes from both camps by keeping big mistakes and losses to a minimum while putting in the time to find attractive investments. Even so, freedom over the effort is enticing.