Some Reflections on Chapter 8 of The Intelligent Investor (Part 1)

Buffett has said that chapters 8 and 20 of The Intelligent Investor are the most important things ever written about investing. That’s pretty high praise and, given who its coming from, we should probably commit them to memory.

Today I offer a summary and a few thoughts on chapter 8.

Common stocks are subject to recurrent large swings in price. An investor should try to profit from these occurrences.

There are several approaches to try to profit from these prices swings.

The first approach is to time the market by attempting to purchase shares of a stock by anticipating when it will go up (or down). This approach is widely followed today by analysts who pick price targets and by cable television shows such as Fast Money and Mad Money. Graham is suspicious that this can be done on a consistent basis and thinks it will lead to speculation. The flaw with market timing – buying strictly on an anticipated price movement – is twofold: first, you must be right, and second, you are dependent on someone purchasing the stock from you at a higher price. You must rely on a greater fool to make money.

Graham believes that people are attracted to trying to time the market because they want quick profits. They abhor the idea of buying a stock and having to wait a year or more for the market to realize that the stock is undervalued and adjust the price upward.

Graham is equally suspicious of mechanical trading systems, which, in general, fail to work as well in the future as they did in the past. There are two reasons for this. First, mechanical systems have been backfitted to the data, even if unwittingly, and when the future changes, as it inevitably does, the system will no longer work as well as the backtest shows. Second, as the mechanical system becomes more popular, it will influence the behavior of those who use it and cause its performance to decline.

The Problem with Buying Low and Selling High

It would be nice to buy a basket of stocks during a bear market and sell them for a large profit at the peak of the ensuing bull market. Graham does not believe this can be done on a consistent basis because it is too difficult to recognize bear markets and bull markets with that level of precision. Simply put, there are too many variations from cycle to cycle to make this work.

For that reason, he believes it makes more sense to vary the allocation between stocks and bonds, never having less than 25% of your funds in stocks and never more than 75%. The allocation is adjusted based on the level of under or overvaluation of stocks. [Several modern value-oriented hedge funds such as Blue Ridge and Greenlight use shorts and options to adjust their long exposure.]

Graham is skeptical of formula invested programs, for example, systematically selling a portion of your stocks as the market rises. One problem with this approach is that a bull market can go on far longer than you might think, and you could end up selling all your stocks only to watch the market continue higher without any clear re-entry point.

Graham favors buying stocks as you would a business. Try to buy shares when they are undervalued in relation to their intrinsic value and then sell them when the price rises above fair value.

Investors should prepare psychologically for the probability that their stocks will advance 50% or more from their lows and decline 33% or more from their highs over the next five years.

Graham counsels investors to resist putting any importance on the day-to-day swings in market prices. When markets rise and investors feel good about themselves and their growing net worth, he cautions them against giving in to the urge to chase the market and invest additional fund when the market is overvalued.

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