By: Ryan P. Dolan
With stock markets down a jarring 25% in less than a month, I thought I’d dust off an investing piece sent to clients in 2018. I believe in proactively working to educate clients on sound investment principles and the recurrent rhythms of financial history. When this is augmented with an understanding a client’s unique behavioral investment tendencies, the chances are very good that we can improve investment decision-making and outcomes.
When markets get frenetic and highly emotional, investor’s can be coerced into making mistakes. I believe it is essential to take a deep breath, step back, and return to core investment fundamentals in an attempt to reorient yourself. Warren Buffett has routinely extolled the influence that his mentor, Ben Graham, had on his career. In particular, he cited two specific chapters in Graham’s book “The Intelligent Investor,” as having a profound impact on his investment philosophy. Here is a synopsis of both chapters and some of my thoughts.
Financial Education Series:
Book Review: “The Intelligent Investor” by Benjamin Graham
“Chapters 8 and 20 (of “The Intelligent Investor”) have been the bedrock of my investing activities for more than 60 years. I suggest that all investors read those chapters and reread them every time the market has been especially strong or weak.”
“To invest successfully over a lifetime does not require stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. You must supply the emotional discipline.”
“The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.”
Warren Buffett
Chapter 8: The Investor and Market Fluctuations
“Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market-to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean to endeavor to buy stocks when they are quoted below their fair value and to sell them when above.” Ben Graham
Graham warns against market forecasting or having opinions about future market direction. While he admits a small minority of professional investors can successfully time markets, most cannot. Graham points out that an investor need not time markets to be successful.
Most timing-based investors seek short-term trading profits, and “want to make their profit in a hurry.” It is a material advantage for an investor to elongate his time horizon and to focus on longer-term returns and investment decisions.
It is critical to put a valuation approach at the center of your investment philosophy. Only when you have an estimate of fair value can you make educated investment decisions.
“Every investor who owns common stocks must expect to see them fluctuate over the years. A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer.” Ben Graham
This can’t be stressed enough. For clients with a natural short-term orientation, this must be given particular focus. Investing, when done right, is about making intelligent long-term decisions for long-term results. It’s about delayed gratification. Always strive to look at portfolio outcomes over an extended period of time. Short-term portfolio volatility is largely noise.
“Even the intelligent investor is likely to need considerable will power to keep from following the crowd. It is for these reasons of human nature, that we favor some kind of mechanical method for varying the proportion of bonds to stocks in the investor’s portfolio. The chief advantage, perhaps, is that it will give him something to do. As the market advances he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the procedure. These activities will provide some outlet for his otherwise too-pent-up energies. If he is the right kind of investor he will take added satisfaction that his [actions] are exactly opposite from those of the crowd.” Ben Graham
Everyone thinks they are a contrarian, and yet when the rubber hits the road few really are. We have to work to build our resistance to the investment crowd, particularly when the herd is at its largest and most convincing. We must not overestimate our ability to resist the crowd.
Graham’s recommendation, and the action I take in your portfolio, is to rebalance your portfolio periodically. The vast majority of individual investors don’t rebalance at all, resulting in “passive drift” where their risk allocation peaks at market peaks, and bottoms at market lows. Rebalancing offsets this drift, results in better outcomes, and helps build emotional balance.
Graham uses an analogy of a private business, in which you own 1 share worth $1,000. A partner in the business, Mr. Market, obligingly offers to give you his opinion of the shares value on a daily basis, and buy or sell your share at that price.
“If you are a prudent investor, you may be happy to sell to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of value.
The true investor is in the very same position when he owns a stock. Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply, and to sell wisely when they advance a great deal. At other times, he will do better if he forgets about the stock market.” Ben Graham
While daily liquidity is a gift for the sound investor, it is a curse for the unsound one. We must never let the market dictate what we think value is. Stock market valuations have far wider swings than the valuations of the underlying businesses, because daily liquidity can compel investors to create dramatic and emotional price swings. Fear and greed are contagious human emotions, and cause many investors to get carried away and make emotion-based decisions. Our goal is to view these swings as opportunities to take advantage of, and not to be instructed by.
In the financial crisis many homeowners likely dramatically underestimated how much their home value had fallen, precisely because there was no daily pricing or liquidity. Do not make the mistake of underestimating the volatility of illiquid assets. Just because you don’t have a daily mark doesn’t mean the asset value is static. Similarly, stocks and stock markets are far more volatile that the underlying fair value of the asset. View this excess volatility as an opportunity, not a rational appraisal of the underlying value.
Chapter 20: “Margin of Safety” The Central Concept
“In the old legend, wise men boiled down history into the single phrase, ‘This too will pass.’ Confronted with a like challenge to distill the secret of sound investment, we venture the motto, ‘Margin of Safety.’”
“The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.” Ben Graham
As the old saying goes, there are no risky stocks, only risk prices. Price paid dictates how wide the margin of safety is. This relates back to the centrality of value investing. Without a sense of fair value, the investor has no idea of the magnitude of his margin of safety.
Warren Buffett describes the concept best.
“You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. That same principle works in investing.” Warren Buffett
“The Washington Post Company in 1973 was selling for $80 million in the market. At that time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Washington Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.” Warren Buffett
Valuing a business is necessarily imprecise, but we don’t need precision. We are looking to buy assets that we can value that trade at material discounts to their estimated fair value, of which private market value is one metric.
At times like these, it is critical to act less and think more. Do you have a clear financial roadmap for your life? Do you know where you are trying to go, what you are trying to achieve? Only when you have a clearly defined, well-articulated and personalized understanding of your financial life, needs and aspirations, can you begin to understand what role your investments play in that. Now more than ever, it is critical to have a map along with a seasoned, experienced and trusted trailguide who is there to calmly and rationally steer you through what is very challenging terrain.
About Dolan Partners:
Dolan Partners is a holistic financial life planning and investment management firm, working hand in hand with professionals and business owners. We dive deeply into clients' financial lives, working to align their money with their unique vision, values and goals.
We offer complimentary introductory calls with prospective clients, which are always completely confidential and judgment-free.
Learn more at www.dolanpartners.com
Ryan P. Dolan
Managing Partner
Dolan Partners LLC
100 School St.
Danville, CA 94526
ryanpdolan@dolanpartners.com
www.dolanpartners.com