This is the third in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the third chapter, which is on pages 65 to 79, and the Jason Zweig commentary, on pages 80 to 87.
“Past performance is not a guarantee of future results.”
That phrase (or variations on it) is something you read over and over and over again if you read much about specific investments in the modern era. In fact, it’s printed so often that many people simply breeze on past it, not giving the phrase a second thought.
Yet virtually everything we can know about the stock market comes from past performance. Believing that the stock market will jump when the Federal Reserve cuts rates? It’s based on past performance. Believing that the stock market will fall on poor economic numbers? It’s based on past performance. Believing that a certain stock is undervalued compared to the rest of the market? It’s based on past performance.
That’s why it’s so valuable to look in detail at the history of the stock market. How has the market typically reacted to certain events? How have individual stocks reacted to certain events? How have things gone when the economy is thriving … and when the economy is slow?
This study is never a guarantee of what will happen, but it’s a pretty good guide. And that’s why Graham spends twenty pages or so delving into the past here.
Chapter 3 – A Century of Stock Market History
Graham spends this chapter drawing on a century’s worth of stock market history to come up with some general investment principles as to how to invest in the stock market in early 1972.
Now, at first glance, that might seem incredibly boring. “Why do I need to know how to invest in the 1972 stock market? Tell me what I need to know now.” If that’s your perspective and you’re merely seeking a specific investing recipe to follow, I suggest that you put this book down immediately and pick up a good book of investing recipes, like The Lazy Person’s Guide to Investing.
What’s actually worth studying here is the process. How does Graham come to the conclusions that he does about the stock market in 1972? He walks step by step through the logic, showing how the market in 1972 is very similar to earlier bull markets and patterns. He concluded that the bull run was likely somewhat near the top – he didn’t worry too much about actually guessing the specific top – and thus one should invest with that situation in mind.
Another thing worth noting is that Graham’s advice for the 1972 market really applies well to any stock market that’s riding a year- long bull market. His advice is basically don’t go into debt to invest right now and also don’t have more than half of your investment money in stocks – the rest should be in bonds, cash, real estate, etc.
Graham’s advice is conservative, but he doesn’t hide the fact that he doesn’t want investors to lose principal – that’s a constant theme throughout the book. Graham vastly prefers very conservative moves and patience, waiting carefully for a great investment opportunity instead of throwing the farm at any old piece of fool’s gold.
Commentary on Chapter 3
Zweig deftly takes Graham’s arguments about the 1971-1972 stock market and applies them to the stock market of 1999 and 2000. In both cases, that peak was followed by a drop and, if one had followed Graham’s general advice of how to invest conservatively at the peak of a stock market, you would have rolled right through it without much loss.
Zweig also makes the argument that, based on Graham’s calculations and the numbers in the stock market from 1993 to 2003, one could reasonably expect the 2003 to 2013 stock market to return roughly 6% – or 4% after inflation. Looking at the first half of that range, from January 2003 to October 2008, the stock market (by most metrics) is roughly back to where it started, with most of the gains coming in the form of dividends.
I couldn’t help but speculate, while reading this chapter and Zweig’s commentary, that this same exact “peak investing” philosophy applies very well to 2006 and 2007. I know that if I had gone very conservative in late 2007 with my investments – even if I just left what I had in stocks and merely started buying bonds instead – I’d be in a much better place financially right now. My retirement accounts wouldn’t be hurting nearly as much.
Next Friday, we’ll look at Chapter 4: General Portfolio Policy: The Defensive Investor.