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This article is part of a chapter-by-chapter review of The Intelligent Investor.
In “Chapter 4: General Portfolio Policy: The Defensive Investor” of The Intelligent Investor, Benjamin Graham introduces the concept of a portfolio policy, which is a general guide for making investment decisions.
The reason to have a policy or investment decision-making process is to keep me from reacting emotionally (and wrongly) to stock market movements. For example, I might panic when the prices of the stocks I own drop suddenly and, on the fly, sell shares to prevent further decline in the value of my portfolio. Alternatively, I may get overly excited when prices rise and start buying shares of a security that seems attractive. (Note that typically I ignore market falls or buy stocks on sale but many investors underperform because they sell at inopportune times.)
By developing a portfolio policy when I'm calm and reasonable, and then forcing myself to adhere to this policy no matter the circumstances, I'm more likely to get better investment results compared to someone who makes irrational decisions based on emotional highs and lows.
The “defensive” investor as I described in my introduction to this series on The Intelligent Investor may also be called passive, conservative, or “lazy.” The idea of being a lazy investor sounds appealing on the one hand and doomed for failure on the other. But I can be both lazy and intelligent as an investor (if so desired). If I adopt this approach, Graham says it's likely I'll get minimum returns, unlikely that I'll get great returns … then reminds me that returns of any sort are never guaranteed anyway.
Graham suggests that the expected rate of return should be most related to intelligent effort
According to Graham, “The basic characteristics of an investment portfolio is determined by the position and characteristics of the owner or owners.” He states that the rate of return should depend on the amount of intelligent effort the investor is willing and able to apply.
Graham acknowledges that his views are in contrast to conventional wisdom, which holds that the rate of investment return is proportional to the risk the investor is willing to accept. Generally, I've been taught that taking on greater risk can mean greater returns. Graham believes that greater effort (if intelligent) can mean better returns and even the possibility of lower risk.
In his commentary, Zweig affirms Graham's statement that portfolio policy should be based on the “position and characteristics” of the investor. But while Graham focuses on intelligent effort as being integral to influencing portfolio policy, Zweig proposes that decision making could be based on an individual's 1) long-term portfolio goals, 2) investing time horizon (number of years until I'll need to sell investments to pay for college, retirement, etc.), and 3) risk capacity (that is, if I have a steady source of guaranteed income and few personal needs then I may be able to accept more risk and volatility in my portfolio).
Graham suggests a 50/50 stock-bond allocation as a starting point
A key component of a portfolio policy is the stock-bond allocation or how much, as a percentage, I should hold of each type of security in my investment portfolio.
Graham suggests holding high-grade bonds and high-grade stocks with a default allocation of 50-50 (50% stock and 50% bond). “A truly conservative investor will be satisfied with gains shown on half his portfolio in a rising market, while in a severe decline he may derive much solace from reflecting how much better off he is than many of his more venturesome friends.”
He says that investors could consider increasing stock allocation during periods of bargain prices and reducing it when prices are high. But he qualifies this statement by stating that it may be difficult for the investor to implement this policy in real life. The person who can act in this way is one that can both accept a market decline and maintain confidence in their stock positions.
Based on the investment climate and the temperament of the investor, Graham allows for a 25% to 75% allocation, meaning that the stock allocation could be as low as 25% and as high as 75%.
Whatever the allocation is, the portfolio policy should reflect that allocation. To maintain the allocation, an investor rebalances the portfolio periodically. Rebalancing can be done by buying more of whatever asset class is deficient or by selling shares of the heavier-weighted asset class and reinvesting them in the lower-weighted asset class to restore the portfolio to a desired allocation.
Types of Bonds
After providing guidance on establishing the stock-bond allocation, Graham discusses bonds. He divides the bond decision into two main choices: tax-free or taxable and shorter or longer term. For the tax concern, Graham suggests comparing the taxable yield with that of the tax-free yield; then determining whether your tax bracket would make investing in the tax-free bond more advisable. For example, if the tax-free yield is 30% less than the taxable yield, then investing in tax-free bonds would make sense only if you pay more than 30% of your income in taxes.
Graham defers the short vs. long term discussion to a later chapter. For now, he delves into types of bonds most suitable to the lazy investor at the time. In addition, he explains how the features and structure of certain bonds make them attractive.
Here are the bonds he discusses:
- United States Savings Bonds
- Other U.S. Bonds (such as those issued by the Department of Transportation)
- State and Municipal Bonds
- Corporate Bonds (high quality ones)
- Savings Deposits (not technically bonds but offering a similar yield or interest rate at the time of his writing)
and their prominent features:
- safety and risk: government-backed bonds are considered safest as they are guaranteed by the U.S. government; high-quality corporate bonds are considered less risky than speculative ones with higher yields
- return: the interest rate or yield (based on the price paid for the bond); how long the interest rate is guaranteed
- marketability: whether the bonds can be sold on the open market; whether minimums are affordable to the average investor
- income-tax status: bonds may be taxable or tax-free; yields are generally lower if bonds are tax-free
- special provisions, such as call provisions that allow a bond's issuer to buy back the bonds or features that allow the issuer to pay a lower interest rate
- general description: what the bonds represent, such as borrowing by the U.S. Treasury or a corporation
In the commentary, Zweig brings this chapter up to date by mentioning tax-advantaged accounts, which were introduced after Graham wrote The Intelligent Investor. On the topic of taxable vs. tax-free accounts, he says it could make sense to hold taxable bonds in a tax-advantaged account and tax-free bonds in a regular account.
The favorable conditions surrounding savings bonds that Graham discusses aren't as prevalent today as they were in previous decades. Still, the discussion of stock-bond allocation and close examination of bond features remain relevant.
Next up is the Chapter 5 review by Joseph Hogue, CFA: 4 Simple Investing Rules for Stocks.