Chapter 4 of The Intelligent Investor: General Portfolio Policy: The Defensive Investor
In this chapter, we will take a closer look at the essential takeaways from Chapter 4 of The Intelligent Investor. We will explore the concept of a ‘defensive’ investor, discuss principles of portfolio diversification, and explore how to reduce risk while still making money.
We will also discuss the importance of individual security analysis, how to set limits on your investments, as well as when to cut losses and move on. Finally, we will consider strategies for long-term investment success.
By following these recommended practices, you can create a successful portfolio management strategy that is tailored to fit your investing style and financial goals. So let’s start by taking a look at what makes an investor ‘defensive’ and the importance of diversification.
Benjamin Graham’s Defensive Investor
In Chapter 4 of The Intelligent Investor, Benjamin Graham outlines the core elements of a defensive investor’s portfolio policy. A defensive investor is someone who follows a strategy that promises the safety of capital and a satisfactory return, with nothing more than average intelligence and skill.
Graham’s core takeaways for defensive investors include:
- Only invest in stocks that are so strong and stable that you don’t need to worry about potential losses or volatility in the market.
- Invest in at least 20 different stocks for diversification.
- Limit your investing to large companies with established records of earnings and dividend payments.
- Set stringent criteria for buying and selling stocks and establish maximum acceptable risks.
- Do not buy stocks solely because they appear cheap — look for quality, not just price.
- Do not make frequent changes to your portfolio; only make changes when necessary or when opportunities arise.
25/75 Rule — Splitting Bond and Stock Allocations
One of the key takeaways from Chapter 4 of The Intelligent Investor is the 25/75 rule of thumb. This is a great starting point for a defensive investor — splitting your portfolio between 75% stocks and 25% bonds. This split allows you to capture some upside by investing in stocks while also protecting your investments with bonds.
The 25/75 rule of thumb is based on two simple principles:
- Stocks offer the potential for greater long-term gains but also come with greater risk.
- Bonds offer stability but fewer returns than stocks in the long run.
By following this 25/75 ratio, you can maintain a balance between risk and reward and thus make a better-informed decision when it comes to investing your hard-earned money.
U.S. Savings Bonds and Other Asset Types
In Chapter 4 of The Intelligent Investor, Benjamin Graham discusses the importance of diversifying investments and how to go about selecting the right asset types. He emphasizes the value of having a wide variety of investments, including U.S. savings bonds, but also warns investors of their potential risks — which include inflation, stock market fluctuations, and interest rate changes.
U.S. savings bonds are particularly popular because they offer a safe form of investment with minimal risk and can be used for long-term or short-term goals, such as college tuition or retirement savings. Along with U.S. savings bonds, Graham recommends an allocation of no more than 75% in “other asset types,” including common stocks, corporate bonds, real estate, and mutual funds. This mix will help protect against short-term losses and provide an overall portfolio balance that is diversified enough to withstand the volatility of the market.
Stocks: Low Risk and Long-Term Gain
When it comes to stocks, Benjamin Graham advises taking a low-risk, long-term approach. He outlines four key points to consider when creating a portfolio of stocks:
- The investor should select only those stocks with quality and value: those which have consistent earnings, pay dividends, and have low price-earnings ratios.
- The investor should focus on creating an income portfolio that includes diverse stocks from different industries, with the intention of generating a steady income from dividends.
- Investor should diversify their portfolio by buying stocks in different combinations and with different maturities in order to minimize risk while still generating the maximum return possible.
- Finally, the investor should ensure that they are not buying too much stock or over-exposing themselves to any particular company or industry.
By following these principles, investing in stocks can be profitable and relatively safe even during times of volatile markets. Furthermore, Graham insists that all investors should always look out for their own interests first and strive to limit their own losses as much as possible while still striving to maximize their gain.
Issues to Consider for the Defensive Investor
When it comes to successfully managing a portfolio of investments, the defensive investor must consider several factors.
Risk and Return
The defensive investor should focus on assets with moderate risk, as they offer a better balance between return and safety. Additionally, they should avoid high-risk assets, such as speculative stocks, which may offer higher returns but also expose one to large losses.
Diversification
Defensive investor should also diversify their portfolio across multiple asset classes and sectors. This helps to reduce overall investment risk as having all eggs in one basket could prove disastrous if that particular asset experiences an unexpected sharp decline in value.
Hedge Funds & Alternative Investments
Although hedge funds and alternative investments can pose potential risks due to their inherent illiquidity and complexity, they can be attractive for the more aggressive investor looking for higher returns. Still, the defensive investor should exercise caution when considering these investment vehicles as they can be quite volatile in nature and may not provide adequate returns when compared to low-risk offerings.
Comparing the Defensive and Aggressive Investor
The defensive investor and the aggressive investor are two key approaches outlined in Chapter 4 of The Intelligent Investor. There are both similarities and differences between the two investment strategies that bear consideration.
Similarities
Regardless of their strategy, each type of investor should focus on evaluating stocks based on their intrinsic value — not the price they might fetch in a market frenzy. Both investors should make sure they are investing only in securities they thoroughly understand, and one should be able to explain why they’ve invested in a particular stock and not another. Additionally, both types of investors should keep their emotions in check when engaging in decision-making regarding their portfolios.
Differences
The defensive investor should have a smaller portfolio than the aggressive investor, typically consisting of between 10–30 quality stocks or bonds for diversification purposes. Additionally, the defensive investor is not interested in leveraging gains with high-risk investments like derivatives or options contracts; this is more characteristic of the aggressive investor. Lastly, the interest return for a defensive investor is usually lower than that sought after by an aggressive investor, who may be comfortable sacrificing some security for higher yields over time.
By calculating expected returns against potential risks for both strategies, one can make an informed decision about which path to pursue when investing. By understanding these methods detailed by Graham in The Intelligent Investor, one can make sound choices when formulating a portfolio suitable to their financial goals
Growing Your Portfolio Carefully
The fourth chapter of The Intelligent Investor, “General Portfolio Policy: The Defensive Investor,” is all about growing your portfolio carefully. Benjamin Graham’s main message in this chapter is that it’s important to protect yourself against financial blows, as well as minimize taxes and expenses. Here are some key points to remember:
Diversification
The best way to protect yourself from a financial blow is to diversify your investments. By investing in different asset classes and sectors, you’ll be able to manage risk more effectively. This will also help spread out the costs associated with maintaining and managing a portfolio.
Timing & Market Conditions
Timing the market and trying to predict the future are two tasks that are almost impossible, yet many investors still try them anyway. Market conditions can change quickly, so it’s better to keep a close eye on what’s going on but not try to time any investments. It’s better to buy when the market is low and hold onto those investments until they increase in value over time.
Rebalancing Portfolio
It’s important to regularly rebalance your portfolio so that you maintain a predetermined risk level while maximizing returns. This means rebalancing at least once a year, or whenever there’s been significant price fluctuation in an asset class or sector within your portfolio.
