SummaryChapter4GeneralPortfolioPolicy:TheDefensiveInvestor

NotesonTheIntelligentInvestorbyBenjaminGraham
NotesbyJasonFernando
CreatedNovember20th2013
LastupdatedNovember20th2013
Referencedocument:Graham,Benjamin,andJasonZweig.TheIntelligentInvestor.Rev.ed.New
York:HarperBusinessEssentials,2003.

50WordRecap

Moreriskdoesnotnecessarilyimplymorereward.Rather,rewardincreasesinlinewiththe
intelligenteffortbroughttobearbytheinvestor.
Defensiveinvestorsshoulddividetheirfundsbetweenhighgradebondsandhighgrade
commonstocks.
Inselectingbonds,investorshaveanumberoffactorstoconsider.

Grahamnotes,thenrefutes,acommonnotion:Generally,peoplespeakofaratiobetweenriskand
returnwhereinincreasedriskisassociatedwithahigherexpectablerateofreturn(wewillhereignore
thefactthat,insospeaking,oneimplicitlyignorestheequalandoppositesideoftheequation).Inthis
manner,peoplespeaksuchnotionssuchasthattherateofreturnwhichtheinvestorshouldaimforis
moreorlessproportionatetothedegreeofriskheisreadytorun.
1

Ourview,heparries,isdifferent.
2

Therateofreturnsoughtshouldbedependent,rather,ontheamountofintelligenteffortthe
investoriswillingandabletobringtobearonhistask.

Accordingly,Grahamsetsoutrecommendationsfortwodistinctclassesofinvestors:The
defensive,orpassiveinvestor,whovaluesconvenienceandsecurityaboveprospectivesuperior
resultsandtheenterprisinginvestor,whohasthetime,competence,andinclinationtodelvedeeper
intotheartofinvestinginpursuitofincreasedperformance.

Therecommendationsofthischapterareforthedefensiveinvestor.

1
88.
2
Ibid.
TheBasicProblemofBondStockAllocation

ThebasicprinciplewhichshouldguidethedefensiveinvestoristhatHeshoulddividehisfunds
betweenhighgradebondsandhighgradecommonstocks.
3

Tothis,Grahamaddsthat[he]shouldneverhavelessthan25%ormorethan75%ofhisfunds
incommonstocks,withaconsequentinverserangeofbetween75%and25%inbonds. Asageneral
4
rule(i.e.barringsignificantperceivedpriceimbalances)thestandarddivisionshouldbeanequalone,
or5050,betweenthetwomajorinvestmentmediums.
5

TheProblem

TheapproachwhichGrahamoutlinesabovemakesperfectsenseintheory,butisnotoriously
difficulttoimplementinpractice(Or,inhiswords,Thesecopybookmaximshavealwaysbeeneasyto
enunciateandalwaysdifficulttofollow ).Thisisnotbecauseofanyextraneousortechnological
6
factors,butratherbecauseofthehumanfactor:Onesownindividualpsychology.Itisexceedingly
difficulttorefrainfrombuyingsecuritieswhenthepriceofthosesecuritiesisadvancingconversely,itis
equallydifficulttorefrainfromsellingsecuritieswhentheirpriceisindecline.However,itisprecisely
thisrestraintwhichisnecessaryforonetoavoidfallingintotheperiloustrapofbuyinghighandselling
lowthatcounterproductiveinstinctwhichisattheheartofmassmarketbehaviour.Thetrick,Graham
argues,istoprofitfromthatirrationalitynotcontributetoit.

TheBondComponent

Withregardtothebondcomponentofherportfolio,shouldtheinvestorbuytaxableor
taxfreebonds?Shortertermorlongertermmaturities? Thesearethefourprincipalquestions
7
whichtheinvestormustaskherself.

Taxableortaxfree?

Thetaxdecisionshouldbemainlyamatterofarithmetic,turningonthedifferenceinyieldsas
comparedwiththeinvestorstaxbracket.
8

3
89.
4
Ibid.
5
Ibid.
6
89.
7
91.
8
9192.
WhentoBuyTaxableBonds WhentoBuyTaxFreeBonds
Ifthetaxliabilityincurredontaxespaidonthe
taxablebondswillbelessthantheincreasedyield
offeredbythetaxablebondsrelativetotaxfree
alternatives.

Inotherwords,iftheyieldontaxablebonds
morethancompensatesfortheirtaxliability.
Ifthetaxliabilityincurredontaxespaidonthe
taxablebondswillbegreaterthantheincreased
yieldofferedbythetaxablebondsrelativeto
taxfreealternatives.

Inotherwords,iftheyieldontaxablebonds
doesnotcompensatefortheirtaxliability.

Shortertermorlongertermmaturities?

Thechoiceoflongerversusshortermaturitiesinvolvesquiteadifferentquestion,viz.:Doesthe
investorwanttoassurehimselfagainstadeclineinthepriceofhisbonds,butatthecostof(1)
alowerannualyieldand(2)lossofthepossibilityofanappreciablegaininprincipalvalue?
9
(Emphasisadded).

WhentoBuyShorterTermMaturities WhentoBuyLongerTermMaturities
Whenonevalues(generally)decreased
probabilityofdefaultmorethanannualyield.

Whenoneanticipatesthatinterestrateswill
riseinthemediumandlongterm.
Whenonevalueannualyieldmorethan
(generally)decreasedprobabilityofdefault.

Whenoneanticipatesthatinterestrateswill
fall.

9
92.