This is Part 1 of our book review of The Intelligent Investor, Revised Edition, Updated with New Commentary by Jason Zweig (affiliate link). Part 1 covers Chapters 1, 2, & 3 with the topics being Investment, Speculation, Inflation, and Market History.
You may find the Introduction and relevant links at: The Intelligent Investor Book Review in 30 Minutes
Investment vs. Speculation – Chapter 1
One of the most important and basic rules is to keep the activities of investment and speculation totally separate. They should be kept in separate accounts and compartmentalized in your mind. If you must speculate, Graham admonishes investors to limit their allocation to no greater than 10% of investment funds.
Just as there is intelligent investing, there is intelligent speculation. Intelligent investing involves: 1) analysis of the fundamental soundness of a business 2) a calculated plan to prevent a severe loss and 3) the pursuit of a reasonable return.
Speculation involves basing decisions on the market price, hoping that someone will pay more than you at a later date. Unintelligent speculation would include speculating when you believe you are investing, speculating actively without the knowledge or skill to do so properly, and speculating with money you cannot afford to lose.
It is to the benefit of many on wall street to promote speculation because it produces money for the industry. Many trendy formulas and stock picking “systems” are promoted based on past performance. They may work for periods of time but almost always disappear as they become popular.
This means a successful speculator must constantly stay ahead of the latest trend. This is the opposite of intelligent investing which involves fundamental analysis that does not fluctuate with each passing trend.
The bottom line is that any speculation should be reserved for a small and separate portion of your funds (no more that 10%). This rule of separation protects your investment funds from catastrophic losses caused by speculation.
The Investor and Inflation – Chapter 2
Inflation must be a concern for investors because it lowers real wealth as it erodes the purchasing power of profits and principal. As the cost of living rises it especially hurts the principal of fixed income securities.
One of the benefits of equity investments is the possibility that dividends and capital gains can redeem the lost purchasing power. This is not to say there is a close connection between inflationary and deflationary conditions and stock prices. Graham is just pointing out that good quality companies have the ability to continue to grow and pay higher dividends versus a bond with a fixed payout.
Investors must be vigilant for the unanticipated. That means there is never a perfect time to be in only one asset category (don’t put all your eggs into one basket). The intelligent investor must minimize risk by anticipating the unforeseen. Diversification is the foundation of such a strategy.
In the commentary, Jason Zweig noted two relatively new investment options are available. Real Estate Investment Trusts (REITs) and Treasury Inflation Protected Securities (TIPS) provide some protection against inflation. Within a diversified portfolio, both of these may be appropriate for the intelligent investor concerned about inflation.
A Century of Stock Market History – Chapter 3
Every investor should have a satisfactory understanding of stock market history. In order to analyze stock investments you must have discernment pertaining to the relationship between stock prices and their earnings, cash flow, and dividends.
Zweig notes in the commentary that market fluctuations will be dependent upon real growth (increases of companies’ earnings and dividends), inflationary growth, and the amount of speculation (increase or decrease) the public is putting on stocks at the current moment.
Nobel Prize Laureate Robert Shiller was inspired by Grahams valuation approach when he developed the Shiller PE 10. The PE 10 ratio compares the current S&P 500 index price to an inflation adjusted average of profits over the past 10 years. It has provided additional proof that Graham was right on target that price is the biggest determinant of your investment returns.
In the coming chapter reviews you will learn about important Graham concepts such as the defensive investor, the enterprising investor, Mr. Market, and a margin of safety. Continue on to Part 2: