Ben Graham believed the great 1920s bull market would end disastrously, yet kept investing as though it wouldn’t happen.
You might think that’s worthy of praise, somehow. He stuck to his guns and never strayed from his strategy.
Well, you’d be wrong. One of the brightest minds on Wall Street strayed from his strategy and couldn’t follow his gut.
Graham explained everything, even questioning his reasons, in his memoirs:
In the meantime Bernard Baruch came into my picture in an unexpected way. A year or so before I had been privileged to meet the great man and to suggest to him a number of Graham-type investments — all of which appealed to his keen sense of security values. These included such issues as Plymouth Cordage, which sold at about 70, earned and paid a handsome dividend, and had $100 per share in working capital alone. Others of the same type were Pepperell Manufacturing Company, long a household name in sheets and pillowcases, and Heywood & Wakefield, a leading maker in baby carriages. All were selling well below their minimal value as judged by the ordinary standards of a private business, and at ridiculously low levels in comparison with the prices of most popular stocks at the time. These discrepancies illustrated the peculiarly unreasonable character of the stock market of the late 1920s, where all the emphasis was laid on an industry’s promise (favorites were electric utilities and chemicals), dominant size (companies in the Dow Jones Industrial Average), or else a record of recent growth, accompanied by speculative and manipulative ballyhoo. Many substantial companies with excellent long-term records which fell outside the favored categories, like Plymouth Cordage and Pepperell, were neglected and sold for years on end at bargain-counter prices…
We had several general conversations in his office far up in the forty-nine-story Equitable Building at 120 Broadway (our fund was destined to be part of a group that controlled that enormous structure). We both agreed that the stock market had advanced to inordinate heights, that the speculators had gone crazy, that respected investment bankers were indulging in inexcusable highjinks, and that the whole thing would have to end one day in a major crash. I recall Baruch’s commenting on the ridiculous anomaly that combined 8 percent rate for time-loans on stocks with dividend yields of only 2 percent. To which I replied, “That’s true, and by the law of compensation we should expect someday to see the reverse — 2 percent time-money combined with 8 percent dividend on good stocks.” My prophecy was not far wrong as a picture of 1932 — and it was borne out precisely, under a different set of market circumstances, some twenty years later. What seems really strange now is that I could make a prediction of that kind in all seriousness, yet not have the sense to realize the dangers to which I continued to subject the Acount’s capital.
The “Account” was the Benjamin Graham Joint Account he was running at the time. He split the portfolio between a long-only and a hedging strategy. Of course, all of this involved margin.
Had he stuck with the strategy, his returns in 1929 would have been better than the 20% loss he incurred. But he switched up his hedging strategy to save on trading costs. I covered his strategy previously, so here’s the short version.
Typically, he bought convertible preferred stock and sold short the related common stock. He covered the short and sold the preferred once prices aligned. But to save on trading costs, he only covered the short, while holding onto the preferred shares because he noticed that the market often offered him multiple opportunities to profit off the same trade. In other words, he would often play the same hedged positions again, a few months after he closed them.
So in September 1929, believing the market was headed for disaster, Ben Graham decided not selling a long position was a better idea than closing out the hedge entirely.
It’s much easier to believe something than follow through on it in investing. Looking back, Graham should have followed his gut, but that wasn’t obvious at the time.
First, he thought the worst was the over:
Practically everyone was pleased with the account’s results for the year, in fact, I heard myself referred to more than once as a “financial genius” for not having lost more. The year 1929 ended in a period of some price recovery and of relative calm; most of us believed that the worst was over.
Turned out, his clients’ investments outside the Account, lost more than he did.
But because Graham had covered most of his short positions in 1929, he was left with mostly long positions and a pile of margin debt to cover. It was a sticky situation. He thought the longs were undervalued but any further declines and margin compounded the losses. That’s exactly what happened — a 50% loss in 1930.
Second, had he followed his gut, and was wrong, he risked underperforming and losing clients. Another option was to reduce his use of margin. Doing so would require selling positions, possibly resulting in a near term loss, to pay back the debt. Taking a loss wasn’t in his best interest for the next reason.
Third, career risk was a thing back then too. Graham was living large. He signed a 10-year lease on an $11,000-month apartment in the newly opened Beresford, with a full-time manservant, and a pressing need to furnish it. The family moved in October 1929.
To make matters worse, under the agreement of the Joint Account, Graham only got paid when the Account made money. Any losses had to be made back in full before he was compensated. In other words, Graham made nothing from managing the Joint Account from 1929 to 1933 (the agreement was rewritten in ’33). It’s hard to pay bills with no income. He turned to side jobs — teaching at Columbia and writing — as his only source of income during that time.
Graham admitted to regretting his lavish lifestyle and the impact it had on him:
I blamed myself not so much for my failure to protect myself against the disaster I had been predicting as for having slipped into an extravagant way of life which I hadn’t the temperament or capacity to enjoy.
But he also learned that being less lavish affected him too:
It became my firm resolve never again to be maneuvered into ostentation, unnecessary luxury, or expenditures that I could not easily afford. The Beresford lease was a bitter but salutary lesson, and in the ensuing thirty-five years, I have avoided any and all real estate white elephants. But on another plane, that of purely personal spending, I must own that I carried ecomony much too far, and began once more to worry about dimes and quarters when tens of thousands of dollars were actually at stake.
All of this is meant to say — external factors impact our decisions, sometimes in ways we don’t realize until later, if at all.
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