My quest of figuring out how to sensible invest my money continues with [cached]The Intelligent Investor by Benjamin Graham. Regarded as a fundamental work by many, I decided I should read it sooner than later.
It presents Graham's philosophy of [cached]value investing, along with comments from a modern point of view. It became clear very quickly that picking stocks according to these principles is actually quite a bit of work, more than I'm willing to do. Nevertheless, there are a few important principles that hold true for any kind of investment activity.
Portfolio Policy: The Defensive Investor
Start from a 50:50 split between stocks and bonds, then slightly increase one side if it's particularly favorable. The more risk you can are able to face the higher proportion of stocks you can include.
As for picking stocks, Graham recommends: - Diversify. Owning only very few stocks exposes you to high volatility and the risk of any single stock doing badly will unduly impact you. - Buy bargain issues - currently undervalued by at least 50%. This is a central point of value investing, buy above average companies (high return on capital) at below average prices (low p/e ratio). - Buy large, conservatively financed companies with a long track record of paying dividends. - Hold your stocks for a long time - frequent trading incurs high fees and takes that will eat any returns.
While the naive obvious thing to do, buying low and selling high is not actually feasible - trying to predict general market movements is just speculating. In general, the market price is only a signal that gives you the option to buy/sell - feel free to ignore it if it seems silly!
Graham has the analogy of the stock market as Mr. Market, a crazy guy that sometimes gives you a ridiculously low price (buy if you are convinced a company actually has a much higher value) and sometimes a ridiculously high one (sell if you think it's not worth that much). But just as you wouldn't the crazy ramblings from a guy in the street influence your evaluation of a company, you shouldn't let Mr. Market influence you too much.
Play the long game
The book also includes very wise advice:
If you investment horizon is long - at least 25 or 30 years - there is only one sensible approach: Buy every month, automatically, and whenever else you can spare some money. The single best choice for this lifelong holding is a total stock-market index fund. Sell only when you need the cash.
This strategy is also known as [cached]dollar cost averaging
Don't check prices too often:
Did I call a real-estate agent to check the market price of my house at 1: 24 P.M.? Did I call back at 1: 37 P.M.? If I had, would the price have changed? If it did, would I have rushed to sell my house? By not checking, or even knowing, the market price of my house from minute to minute, do I prevent its value from rising over time?
Investment Funds
Graham argues that large funds won't be able to beat the market, simply because they make up such a large part of the market:
- the average fund does not pick stocks well enough to overcome its costs of researching and trading them;
- the higher a fund's expenses, the lower its returns;
- the more frequently a fund trades its stocks, the less it tends to earn;
- highly volatile funds, which bounce up and down more than average, are likely to stay volatile;
- funds with high past returns are unlikely to remain winners for long
This does not apply to index funds, as they don't have any need to research stocks and are available with very low fees. Still, watch out for [cached]tracking error! BlackRock, Fidelity and Vanguard tend to have good (cheap) index funds.
$## Later Chapters
The second half of the book is primarily concerned with security analysis and picking stocks. This is probably way too much trouble for a part-time investor - just buy index funds instead. I'll therefore skip these chapters.
If you really do want to pick your own stocks, practice first (at least a year) using online portfolio trackers, e.g. Google Finance. Compare your results to how the index has done over the same period.
One important principle to always keep in mind is the 'margin of safety':
If I’m right, I could make a lot of money. But what if I’m wrong? Based on the historical performance of similar investments, how much could I lose?