Robert Hagstrom, CFA
Robert Hagstrom, CFA, is chief investment officer at investment advisory Equity Compass, Baltimore, and author of nine investment books, including The New York Times best-seller The Warren Buffett Way. EquityCompass.com
For almost a half-century, Warren Buffett, legendary chairman and CEO of Berkshire Hathaway, has been asked the same question at nearly every annual shareholder’s meeting—what is the secret to becoming a great investor?
His answer: Read The Intelligent Investor by Benjamin Graham. Buffett has called it, “by far, the best book on investing ever written.” In fact, Buffett was such an admirer of Graham’s work that he once offered to work for Graham for free, and he gave his first child the middle name “Graham.”
If you’ve never heard of The Intelligent Investor, don’t fret. It was written in 1949 by Graham, then a Columbia University business professor who taught Buffett as a student. The book provides small investors with an intellectual and emotional framework for investment success, including how not to panic over market fluctuations…protect your capital from losses…and reliably generate sustainable returns over the long run. More than just an academic, Graham also was also a talented investor. From 1936 through 1956, his investment fund earned a 14.7% annualized return versus 12.2% for the S&P 500 index.
What can you learn from Buffett’s idol even now? To answer that, Bottom Line Personal asked noted “Buffettologist” Robert Hagstrom to explain the appeal of this classic book. Here are four timeless takeaways…
Nothing rattles investors more than frequent and wild swings in stock prices. To address this, Graham created an imaginary character in The Intelligent Investor who personifies the behavior of the stock market and impulses of the crowds that drive market actions. Graham’s “Mr. Market” is a bipolar fellow, very charming but suffering from incurable emotional problems. Some days, he shows up feeling euphoric and will sell to you only at unreasonably high prices. Other times, he is panicked for no obvious reason and desperate to sell at any price. Mr. Market constantly moves between degrees of unsustainable optimism and unjustified pessimism, encouraged by Wall Street, which revs up the poor fellow and makes him even more manic.
Visualizing the stock market as a character this way—Warren Buffett has joked that Mr. Market is a “drunken psycho”—is a powerful tool to bolster your confidence and reduce your fears of market volatility.
Graham’s advice: There’s nothing you can do about Mr. Market’s mood swings, so don’t let them sway you into making foolish decisions. Treat Mr. Market’s offers with skepticism, and instead focus on the underlying value of the companies you are interested in. This helps you to view volatility not as a debilitating handicap but as an opportunity. You can decide when to sell to the optimists…buy from pessimists…or just ignore Mr. Market until he returns the next day.
Graham popularized a phrase that I consider the three most important words in investing—margin of safety. You can never eliminate the risk of loss since it’s hard to know how a company will fare in the future—but you can minimize your risk if you invest at a share price significantly below what you think the company is worth. According to Graham, every security has an underlying true or intrinsic value that can be determined through diligent study of the company’s assets, earnings and business prospects. Requiring a margin of safety helps ensure that you don’t overpay for an investment. Many investors today do exactly the opposite—they take exorbitant risk, investing in companies that won’t earn profits for many years.
Important: One aspect of Graham’s work that has not survived well over time is his extremely conservative methods for determining a company’s intrinsic value. Graham lived through the massive uncertainty of the Great Depression. He prioritized not losing money in an investment, and that often led him to very out-of-favor stocks. Warren Buffett likened Graham’s investments to “cigar butts” on the street that had just one puff left, but that puff was all profit. Buffett determines a company’s value differently—he isn’t looking to buy cigar butts at dirt-cheap prices. Instead, he seeks wonderful, dominant businesses with predictable future earnings, and he is willing to pay a fair price for them.
Even if you consider yourself a long-term investor, it’s difficult not to be affected by the market’s day-to-day noise or the financial media dramatizing daily events. Graham offers two effective ways to avoid a short-term perspective…
Stop thinking of a stock purchase as a bet on a flashing ticker symbol on your computer screen…the reality is that you now are part owner of a real business. If that business and its prospects are exactly the same tomorrow as today, then it’s irrelevant if the share price is higher or lower.
Remember that “over the short term, the market is a voting machine but in the long run, it is a weighing machine.” This is one of the most famous quotes from The Intelligent Investor. What Graham means: In the short term, prices are driven mostly by the collective whim of the masses, A stock’s daily price is a popularity contest “voted” on by investors. In the long term, prices are driven by something you can measure more concretely—a company’s actual performance and financial results.
As much as Graham stresses in The Intelligent Investor the importance of analyzing businesses, he was clear that the real secret of intelligent investing had more to do with understanding your own temperament and the psychology of interacting with the stock market. Graham wrote that, “investing isn’t about beating others at their game, it’s about controlling yourself at your own game.” Two ways Graham suggests you can control your own game…
Invest only if you would be comfortable owning a stock even if you had no way of seeing its daily share price. This mindset helps enforce patience and self-control in deciding what stocks you select. Warren Buffett expressed the same advice when he told Berkshire Hathaway shareholders to buy a stock “on the assumption that they could close the market the next day and not reopen it for five years.”
Keep a mad-money account. It’s human nature to want to bet on exciting investments. Instead of trying to suppress that urge, Graham advocated speculating with restraint. “If you want to try your luck,” he wrote, “put aside a portion—the smaller, the better—of your capital in a separate fund for this purpose. Never add more money to this account just because the market has gone up and profits are rolling in. (That’s the time to think of taking money out of your speculative fund.) Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.”
