In January 1949, Ben Graham spoke before the New York State Bankers Association to encourage bankers to advise customers on sound investment policy. What surprised people then was his push for simplicity.
You can make investing as simple or complicated as you want. Simple strategies tend to require less knowledge, fewer decisions, and generally easier to manage. Complicated strategies tend to bring added costs (higher fees and behavioral costs) and can introduce unknown, often uncompensated, risks.
Graham’s simple strategy: divide your portfolio between government bonds and a diversified basket of common stocks or “investment — fund shares — instead of a selected common stock list.” He purposely left out corporate bonds, preferred stocks, and the like, as unneeded risks for a defensive investor.
If you’re not familiar, Graham divided investors into two categories — defensive and aggressive — defined like this:
I have here classified investors into the defensive kind…and the aggressive kind… The real distinction here is between those who invest to put only their money to work, and those who invest to put their training and abilities to work in the field of security values. The latter person is at least a quasi-professional; he has embarked on a peculiar and exacting business; and he needs more equipment than the ordinary layman is able to bring into the area of investment.
Thus the first function of the commercial banker is to dissuade his friends from trying to act as aggressive investors, unless they know securities about as well as a good banker knows banking or a good plumber knows plumbing. This means that, since the great majority have merely their money to put up, they would be making a fundamental business error in trying to earn more than a conventional or “passive” rate of return on their investable funds. The second function of the commercial banker, then, should be to guide this large group of defensive investors into the path of sound and simple activity.
Graham’s simple advice has something for everyone, even though it’s tilted toward the defensive investor:
Individual investment policies are often greatly influenced by the real or fancied need for a certain rate of return. Many people put some of their funds in lower-grade bonds and in preferred stocks, “to sweeten the yield” of their entire portfolio. My long experience leads me to warn strongly against this practice. It is bad business for the rank-and-file investor to trade quality for yield, even if the overall result happens to work out all right. Such securities are peculiarly subject to market vicissitudes, and to corresponding chills and fevers in the minds of their owners. Nearly all of them sell at big discounts at various times in their history. They may then present good opportunities for shrewd bargain hunters — but that very fact is an argument against their purchase in ordinary times, and at full prices, by the lay investor.
Let me adapt an old investment saying to this type of securities: To the extent they help you eat better they are likely to make you sleep worse…
You may well ask how, with my conservative approach, I am willing to recommend a substantial component of leading common stocks for the defensive investor. Undoubtedly these carry with then an assortment of financial and psychological hazards. But to compensate for these they offer a goodly array of advantages — substantial income yield, probability of ultimate rise in value, and some protection against future inflation. As I read our financial history of the past 50 years, it strongly vindicates a common stock purchase policy based on the investment approach — just as it strongly discouraged all forms of common stock speculation. Furthermore, this history demonstrates clearly that high-grade common stocks bought at reasonable prices are much more satisfactory investments than second-grade bonds and most preferred stocks.
If you agree with my prescription, your advice on common stocks will contain the following factors: (a) They belong in conservative portfolios, (b) provided they are limited to a diversified list of first-line or leading companies, and (c) provided they are bought a reasonable general market level, and (d) provided the buyer is ready and able to take an investors attitude towards his holdings.
Let me define such an attitude. A common stock investor is one who regards his common stock holdings as a proprietary interest in various businesses, not as a series of quotations in a newspaper. He has rational standards of common stock value which are independent of market fluctuations, and he buys and sells in accordance with such standards. The only significance of stock market gyrations to the true investor is that they give him an opportunity to buy good common stocks when they are cheap — or at least reasonably priced — and at times offer him an invitation to sell out at temptingly high levels.
The chief hazard of a careful common stock program is not that it may bring unexpected losses, but that its profits will turn the investor into a speculator greedy for quick and bigger gains — and therefore headed for ultimate disaster…
My experience teaches me that by far the largest losses have been sustained by investors through buying securities of inferior quality under favorable general conditions. These prove to be “fair-weather investments” only, and at the first breath of adversity, their prices tend to collapse. (It is then that the disgusted holder sells them out — often at ridiculously low figures — to shrewd and sophisticated operators.) Next to this, as a source of loss, is the purchase of really good common stocks at the inflated values engendered in the upper reaches of a bull market. It is difficult to say exactly when the market level first moves into a dangerously high area. But your own experience is undoubtedly broad enough to tell you — at some stage of the proceedings — that the stock market’s enthusiasm is outstripping its prudence.
Thus you are as well qualified as anyone to warn your people against “bull market investing,” which is motivated largely by speculative momentum, and which justifies itself by undue emphasis on current favorable conditions…
Once we have established the proper psychological approach to common stock investment, it is possible to deal more rationally with the problems of “the required rate of return.” If the fund really needs an overall 4% instead of the more usual 3 to 3½%, the way to obtain it is by increasing the component of high-grade common stocks and not by throwing in lower-grade senior securities. This is untraditional, and it may seem unconservative to some of you. But it is an axiom of investment that securities should be purchased because the buyer believes in their soundness, and not because he needs a certain income. If Government bonds, good tax-exempts, and first-line common stocks comprise the sound ingredient of a security portfolio, then logic requires that the investor obtain the yield he wants by mixing these ingredients only…
Let me recur now, briefly, to the field of aggressive investment, without detailing its principles and techniques. The aggressive investor should look for security opportunities the way the businessman looks for business opportunities. In both cases training, experience and native ability are requisite to success. In neither case is the main emphasis placed on speculative anticipations. Bonafide investment opportunities are frequent, and they provide a fascinating field of study. They include business analysis requiring insight and foresight, also special situations of many types, and also a wide variety of “bargain-basement” issues… I am in fact skeptical as to whether anyone can with propriety profess to tell someone else how to make money — whether in securities or elsewhere. In the vast majority of cases, the aggressive investor must stand on his own feet and make his own decisions.