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The Intelligent Investor | Lesson 1: Invest don't speculate!
Mar 12, 2017  |  Kenelm Tonkin

 

Benjamin Graham

Congratulations!

You're a successful entrepreneur. All the expenses are paid, you have a working capital buffer and there's still cash leftover.

What do you do with it?

Choice is everywhere. You have to decide on your investment style, where to invest, your risk tolerance and asset allocation. Advisors offer conflicting approaches, frequently unable to clearly explain what they do but happy to charge their 'management fee' regardless of the result they produce for you.

After looking far and wide, I settled on Benjamin Graham's value investing principles because, to be blunt, I could understand them as a business owner and I think you will too. I recommend you read his work to protect your hard-won profits and generate fair returns on that wealth.

Alternatively, you can instantly access my 20 Part Series titled THE INTELLIGENT INVESTOR, faithful to Graham's work of the same name. It's a FREE mini course on value investing based on my extensive private notes of the book.

Start here with Lesson 1 which draws a clear distinction between investing and speculating.

Enjoy the series!


 

LESSON 1: INVEST DON'T SPECULATE!

Investing is thorough analysis promising a safety of principal and an adequate return. It involves risk, which is managed.

Speculating, a euphemism for gambling, is not investing. It is an emotional, herd activity. Day trading is a form of speculation. ‘Momentum investing’ is a form of speculation. Retail subscribing to ‘hot’ initial public offerings is a form of speculation. The purchase of any security without careful analysis of the security’s underlying assets, liabilities and likely future cash flows is a form of speculation.

The polar opposite of speculating is investing.

There are two types of investors: passive and active.

Passive investors want safety of principal and an adequate return, without the bother of frequent analysis and decision-making. Without frequent analysis and decision-making, they can achieve average returns at best, say 7%. For safety, they should place 50% in high quality bonds and 50% in long-established, leading companies with stable profits. Anything other than long-established, leading companies with stable earnings, like initial public offerings or “hot tips”, must be avoided. The stocks could be purchased through investment funds or trusts, or through the technique of dollar-cost averaging. 

Active investors are prepared to devote time to analysis and decision-making, in return for safety of principal and an adequate, though above-average, return. It is possible for active investors to achieve at best 20%, though this is exceedingly difficult to achieve.

There are two behaviors or practices that must be resisted at all cost and they relate to extrapolating from faulty assumptions.

First, some try to be active investors by short-term or long-term stock selection based on looking at historic performance and extrapolating a prediction. There are two problems with this ‘charting’ approach. First, future earnings of companies cannot be reliably predicted based on history. Second, even if they could be predicted this way, everyone else has this history and would act on it, thus factoring the predictions in the price at which you could buy.

Second, others look for formulaic patterns in the numbers and extrapolate, as if coincidental repetition is a substitute for analyzing a company’s products, distribution, people and profits. Both practices miss the point about investing. Stock investing is buying a business, or part of one. So, you need to value the business by analyzing it for real-world cause and effect like a business owner, not artificial earning predictions or mathematical patterns.

Therefore, the only sound way to invest is to look for discrepancies between price and value. Business valuation is a difficult art but can be mastered with proper training and temperament. For instance, there are some events which occur where such discrepancies exist, namely in liquidation workouts and sub-working capital situations. It used to be possible to find opportunities in merger arbitrage, though not anymore.

You should not bother becoming an active investor unless you think you can realistically obtain at least 5% more than passive investors.