As a relative newcomer to the incredibly diverse field of investing, the sheer amount of information available can be overwhelming at times.  With no formal training in investing or finance, it has taken me awhile to gain exposure to many of the investing strategies employed by speculators and investors alike.  During this time, one of the struggles has been defining the type of investing approach that fits my personality.  To outline my investing journey so far, I’m going to spend a few posts talking about various investing strategies I’ve looked into, and how I think I’ve finally found the one that ‘fits’.

Let’s Go Old School

If you walked up to someone on the street and asked them if they knew who Warren Buffett was, I would bet that the majority of them would answer yes.  Likely they would also be able to identify him as a great investor and then may mumble things about wishing they had invested with him earlier, and so on and so forth.  Because Buffett is one of the richest men in the world, he has a certain degree of notoriety.  How did he become one of the richest men in the world?  By exploiting inefficiencies in the stock market to generate investment returns well in excess of the market averages over very long periods of time.

Fewer people (outside of the investing world) may recognize the name of Buffett’s mentor, Benjamin Graham, who is largely credited with formalizing the field of value investing and who also delivered market beating returns to those invested in his fund over a 20-year plus time span.  As I have been gradually working my way through a number of investing books, I recently decided to read through Graham’s highly regarded book, The Intelligent Investor, to try to glean some wisdom from the master.

The Intelligent Investor was originally written in 1949 after the Great Depression and was periodically updated and re-released throughout Graham’s life.  After a trip to the local bookstore, I ended up with a revised release of the 1972 edition of The Intelligent Investor which had been updated in 2003 with commentary after each chapter related to changes and happenings in the capital markets from 1972 to the end of the tech boom & bust.  After reading the reflections of Graham and others on the past fluctuations in the market, the first thing that I was struck by is how the behaviour of the markets seems to repeat itself over long periods of time.  There are times of irrational exuberance and times of panic and fear, long bull markets and deep bear markets, interest rate increases and decreases, wars and major global events.  The constant through all of these events is the knowledge that “this too shall pass”.  Excesses are eventually removed and fears are eventually allayed.

Types of Do-It-Yourself Investors

The Intelligent Investor separates investors into two types:  defensive and enterprising.  Defensive investors are defined as people who wish to have a hand in their own finances, but do not wish to devote a significant amount of time to this activity.  Today’s defensive investors would typically be called passive or index investors.  Enterprising investors on the other hand, are people who are willing and able to devote time to the task of securities analysis to determine the suitability and merits of individual securities.  As the styles and strategies employed by these two types of investors is very different, I’m going to examine each of them in turn, starting with the defensive investor.

Defensive (Passive) Investors

For people who aren’t inclined to spend a lot of time on investment research, Graham recommends simply adopting an indexed approach to investing.  In plain language, this means that investors who don’t want to think about their investments should be happy to receive market returns less a small percentage for investment fees.  To accomplish this, Graham recommends placing a portion of your portfolio (from 25 – 75%) in a diversified stock fund, with the remainder placed in high quality bonds (or bond funds).  As stocks and bonds tend to perform well at different times, by placing money in both markets and rebalancing annually (which will be described later on), the total volatility (change in value) of the combined portfolio from year to year should be less than an all-stock portfolio.

Though standard advice is to maintain a 60% / 40% split between the equity and fixed income (bond) portions of a portfolio (which is good advice for many to adopt), Graham suggests altering this mix depending on the relative attractiveness of the equity markets and bond markets.  With interest rates currently at or near historic lows, I feel that the potential for achieving significant real returns in the bond markets (after inflation) over the next few years is low.  Therefore, I would currently contend that maintaining a slightly underweight fixed income holding (25% of the total portfolio) may be prudent.

As there is risk in losing purchasing power in the fixed income portfolio over time due to inflation and rising interest rates, adopting a slightly higher weighting (75%) in equities seems appropriate.  As the available field of index funds has exploded in recent years, it is now possible to own a piece of the entire global equity market in a single fund with a relatively low expense ratio.  By going this route, passive investors can be assured of catching the ‘next big thing’ as they own a bit of everything!

To ensure that the entire portfolio isn’t invested just as the equity (or bond) markets peak, investors should also look to invest (approximately) equal dollar amounts in the portfolio each month.  This strategy is known as dollar-cost averaging and it helps to smooth fluctuations in the portfolio as more shares (or units) are purchased when prices are low, and relatively fewer when prices are high.

Similarly, to help enforce the ‘buy low, sell high’ mantra, each year investors should perform a portfolio review to determine whether the portfolio as a whole is still at the target bond and equity allocations.  If the bond and equity portions of your portfolio are significantly different than their target percentages (due to market fluctuations during the year), a portion of the overweight component should be sold and reinvested in the underweight component to bring the target allocations in line.  This is known as ‘rebalancing’.  During this portfolio review and rebalancing act, investors should also determine if the target percentages for the bond and equity portions of the portfolio assigned at the beginning of the year are still appropriate based on current events (here’s where sticking with the less complicated constant 60% equity, 40% fixed income portfolio simplifies things).  Depending on the current market and interest rate conditions, increasing or decreasing exposure to either the bond or equity markets may be prudent (though remember to always maintain a 25% minimum or 75% maximum allocation to each).

Summary

In this first post about investing strategies, we’ve looked at what Benjamin Graham referred to as defensive investors, or those investors who would like to have a hand in their own finances, but who don’t have the time or the inclination to do their own market research.  In this case, I agree that adopting a passive or indexing strategy with both bonds and equity funds in a portfolio is the most prudent path forward.  In this way, the investor can be assured that they make a satisfactory return (based on the market performance) without being on the hook for significant investment fees.

In the next post, I’ll start to look at different types of enterprising (or active) investors and compare and contrast a few different investing styles.  As always, feel free to leave any questions or comments below or send me an e-mail and I’ll get back to you as soon as I can.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation. For more information, please see my disclaimer.