This article may contain affiliate links; there's a possibility I could earn income when you click through one of these links and sign up for an account, make a purchase, etc. This article is written for entertainment purposes only and should not be construed as financial or any other type of professional advice.
This article is part of a series on The Intelligent Investor and continues from the review of Chapter 7, “3 Stock-Picking Strategies that Work and 2 to Avoid” by Joseph Hogue, CFA.
Chapter 8 of The Intelligent Investor focuses on dealing with market fluctuations. Graham opens this chapter advising investors to know about the possibility of these ups and downs. He urges us to be prepared financially and psychologically.
To be clear about the nature of potential fluctuations, Graham describes a probable set of circumstances. Within the next five years, shares of a given security may experience a 50+% price increase from its low point or a 30+% decline from its high point. Such changes in stock prices may bear no relationship to changes in economic values.
While the rise in prices sounds great, the decrease seems scary. Still, it's this scenario for which Graham wishes to equip investors to withstand (and possibly profit from). He offers advice that I interpret in this way:
- don't put myself in the position of being forced to sell shares of stock when prices are down (that is, don't invest money that I'll need in the short term)
- make investment decisions based on established guidelines, which focus on financial stability, tangible asset value, and earnings prospects
- learn and recognize common psychological dangers associated with investing, so I can avoid making poor decisions because of market fluctuations
Graham doesn't see market fluctuations as desirable but he does see them as inevitable. His advice, then, focuses on making the best of market ups and downs.
Market fluctuations provide opportunities, not mandates, for making investing moves
Graham encourages investors to focus on the true value of a company and its shares. He discourages overreaction to pricing errors (whether in my favor or against) that result in market fluctuations.
Fortunately, Graham recognizes that investors (like me) are human. So, he arms me with specific advice that enables me to keep calm and continue investing. That advice includes general guidance on buying when quoted prices are below fair value and selling when they rise above this value — without making rash moves that turn a long-term investor into a speculator.
Here are some of his lessons:
Don't make investment decisions based on attempts at market timing.
Graham admits that investors could profit from market timing, which is buying or holding when the market seems headed upward and selling or refraining from buying when it's headed downward. The problem is that the average person (or even leading economists) can't forecast market movements with precise certainty.
For example, in the past few years, I've been hearing that the market is overvalued. Nobel Prize winning economist Robert Shiller has been warning — for a couple of years — that the stock market is overvalued and the bubble could burst any time. He points to his CAPE ratio (cyclically adjusted price-earnings ratio) as an indicator of overvaluation.
Graham also pays attention to price-earnings ratios. But he argues that pinpointing the exact timing of a market peak or correction is nearly impossible. In terms of actionable advice, Graham suggests the possibility of taking action after such a fall (or rise) happens. He discourages investors from plotting and executing trades by anticipating the moment of an across-the-board price decline (or jump).
Don't follow formula-based schemes because they 1) don't work or 2) if they worked in the past, they stop working after they become popular.
In addition to avoiding market-timing schemes, Graham states that investors should ignore trading strategies or theories based on historical market patterns. Demonstrating a subtle sense of humor, he says that such strategies show “excellent results when applied retrospectively to the stock market over many years in the past.”
Yes, it's easy to develop a formulaic system based on what's worked in the past. The trick is designing a system that works in the future.
A couple of reasons that such strategies may not work:
- current economic conditions may be similar but not exactly like the past
- when a theory becomes popular, more people start using this strategy, reducing the possibility of making a profit (for example, investors excited about buying stocks with certain characteristics may drive demand and increase their prices, making them unavailable at a bargain)
For me, knowing about historical fluctuations (and remembering those that I've experienced during my investing career) is useful. But to Graham's point, I shouldn't make major investment decisions based on predictions about the direction of the stock or bond markets.
Consider rebalancing during times of extreme fluctuations.
Graham suggests that investors may consider reducing the percentage of stocks in an investment portfolio when prices seem to be extremely high. For example, if I currently have an stock-bond asset allocation of 50%-50%, then I might adjust my allocation to 25% stocks and 75% bonds.
Taking this action would likely involve selling stocks that are priced high relative to their value (or reducing a concentrated holding) and purchasing bonds.
First, I need to know how to recognize a bull market. However, knowing that prices are unsustainably high may be more obvious in retrospect. Drawing on history, Graham offers these clues:
- Prices are high compared to historical levels
- Price-to-earnings ratios (P/E) are high
- Dividend yields are low compared to bond yields (indicating that prices for dividend stocks are relatively high)
- Many people are speculating on margin (buying stocks using borrowed money)
- There are many new offerings of common stock, either initial public offerings (IPOs) or additional shares of stocks and they are of poor quality
On the other hand, if I sense that conditions represent more of a bear market with prices very low in relation to the underlying value of businesses, then I might adjust my allocation to 75% stocks and 25% bonds.
Identify stocks for potential acquisition based on value.
To equip investors to ignore price moves and market fluctuations that have nothing to do with true value of an underlying business, Graham suggests applying the following guidelines to stock selection:
- The stock price is close to the company's asset value (that is, if I bought the entire company and then sold its assets at their face value, I'd recoup the cost of my investment).
- The P/E ratio (price to earnings ratio) is satisfactory.
- The company has a strong financial position.
- The business should be able to maintain its earnings records (and its record of growth) over many years.
Graham suggests focusing on stocks that sell at a reasonably close price compared to tangible asset value, or at least not one-third above the value. For example, if the market capitalization is $30 billion, then the asset value should be between $20 billion to $30 billion. Using this approach, when the market seems bearish, there may be opportunities to buy stocks at a fair price.
Look for sound, not brilliant, prospects.
On the flip side, during bullish markets when prices are relatively high, I may have difficulty finding candidates that meet my criteria. Graham says: “The better a company's record and prospects, the less relationship the price of its shares will have to their book value.”
Still, if I wait until perfect conditions and extreme bargain prices, I may wait a long time. In the meantime, Graham indicates that I may suffer from loss of dividend income and missed opportunities. So, instead of unearthing brilliant buys (underpriced stocks of companies with better than average growth), he suggests purchasing shares of reasonably priced companies with sound businesses — in most economic conditions, except when the market seems extremely overpriced.
In the commentary, Jason Zweig offers a couple of excellent insights in regard to investing when the market seems overpriced. First, he mentions that even when the market was significantly overvalued in 1999-2001 due to technology stocks, there were still bargains. Old-school, brick-and-mortar type companies (like Berkshire Hathaway run by Warren Buffett) reported significant growth, yet their stock prices declined in this time period. After tech fell, the stock prices of these companies recovered and grew.
Control investing costs.
Zweig says investors can strive to control costs in all market conditions. These include:
- controlling stock and ETF trading fees and other brokerage-related costs by paying attention to fees and purchasing or selling shares infrequently
- keeping mutual fund fees low by focusing on funds with low expense ratios
- paying attention to taxes associated with investing (and holding stocks for at least one year in order to take advantage of favorable rates associated with long-term capital gains)
The point of this chapter is that there are more and less favorable times to buy and sell. But because I can't be sure of the perfect time to buy and sell, I should focus on making good decisions, not necessarily perfect ones.
How to Deal with Market Fluctuations Emotionally
Graham also gives advice for managing one's emotional or psychological state during market ups and downs. Here are some ideas:
On a personal note, I've never panicked when prices plunged and sold investments when my shares were at all-time lows. This scenario is one that Graham warns investors about.
Graham says that the best decision may be to do nothing. I excel in this regard and have even gone so far as to ignoring paper statements of my investment values during past recessions.
By the way, it's much easier to refrain from action if you don't have an immediate need to sell holdings in order to pay expenses; so I'll repeat the advice not to invest money needed for day-to-day bills.
For those aching to do something, Graham suggests portfolio rebalancing to adjust asset allocation.
More to the psychological point, when the price of my shares are down, Graham advises that I shouldn't let someone else's mistake in valuation cause me anguish. If I'm reasonably confident that I've made a good decision in purchasing a security at a fair price, I shouldn't be distraught when others disagree.
Still, if prices fall, Graham says that it can make sense to reevaluate my position. I might do another analysis of a company's stock price based on more recent financial statements and continue to monitor a company's financial performance.
Remember not to overreact to market drops and price increases.
Though I'm not likely to make rash moves, I'll admit that I have suffered from the psychological affects of market fluctuations. I've alternated from feeling smart and enthusiastic to feeling stupid and pessimistic.
Here's an example: Earlier this year, I bought 100 shares of a company that makes microchips for gaming systems. It's also one of the players in the self-driving car and drone business. At this writing, my shares have increased more than 100%. Realistically, I expect the price to stagnate for a while after this major jump, though I don't know what's next with certainty.
In The Intelligent Investor, Graham writes uncannily about how I feel:
- Congratulate myself for the price increase.
- Wrestle with selling.
- Kick myself for not having bought more when prices were lower.
I find comfort in knowing that I'm not alone in my feelings.
The bottom line is that the prices of investments I want to buy are going to be aligned with their value, too high for their value, or well below their value. My jobs as an investor are to 1) acknowledge that prices will fluctuate and align my other finances accordingly; 2) take advantage of low prices when they exist instead of fretting about them and vice versa when they're high; and 3) keep calm and continue investing.
Disclosure: I am long on Berkshire Hathaway.