Chapter 8: The Investor and Market Fluctuations

**Quick update** Thanks for reading, I’ve compiled this entire series into an electronic copy that you can take offline → here

Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, Graham delivers his thoughts on how an investor is able to handle market fluctuations in a way that limits his emotional exposure while positioning him for long-term gains. Here’s the list of preceding posts if you’d like to get caught up:

Capitalizing on market fluctuations

Graham begins by, making it clear to the investor that he must be comfortable with the fact that the market will swing over the course of time. He mentions that swings may be as high as 50% increases from an issue’s lowest price and 33% decreases of the issue’s highest price. He remarks that these fluctuations present opportunity for the investor in two ways. The first being Timing: the endeavor to anticipate the action of the stock market. The overarching theory that the investor will be able to buy or hold when the future seems promising, and sell or refrain from buying when the future looks bleak. However, Graham shares this information with a heavy dose of caution. He mentions that by trying to time the market, the investor is very likely to become a speculator, therefore reaping the results of a speculator as well.

“Timing is of no real value to the investor unless it coincides with pricing — that is , unless it enables him to repurchase his shares at substantially under his previous selling price.”

Buy-Low-Sell-High Approach

The second way the investor can make use of market fluctuations is, instead of trying to forecast, the investor would be wiser to choose instead to take advantage of buying after each major decline, and selling after each major advance. This advice isn’t without caveat, Graham indicates some concern that the bull market indicators he lists may no longer be valid given that, at the time of the text’s update, a demonstrated bear market had failed to appear for 20 years.

Bull market indicators

  1. A historically high price level
  2. High price/earnings ratio
  3. Low dividend yields as against bond yields
  4. Much speculation on margin
  5. Many offerings of new common stocks of pour quality

Graham takes time to remind us that even if one trend seems to be a “new-wave” of the market, it is likely to end. Inserting that the “new-era” cycle of 1921–1932 — lasted 11 years (compared with 4–6 year averages). If the prices seem too high, use the data to support your findings. Remind yourself that you must keep a strong emotional discipline to hold off buying at extremely high levels, and that a 50% decline fully offsets the preceding advance of 100%.

An investor may begin to feel tempted that he can mechanically handle his portfolio by watching only for large price increases then selling based on some percentage or amount of increase. Being able to incorporate this logic into a formulaic plan needs to be done with care. Remembering all the while that all “market formulas” are too simple and easy to last. Plus ça change, plus c’est la même chose. He can however, leverage the knowledge and use it as a datapoint to make more informed investment decisions knowing he will never be able to predict market fluctuations.

To Graham, focusing on policy that is void of emotion and doesn’t follow the crowd is preferred. It feels great to get an awesome increase, but the investor must then realistically evaluate the issue and determine if its value is no longer reflected in its price. To try and remove emotion, use mechanical balancing. As the market rises, rebalance by selling stocks to put proceeds in bonds, as it decreases and stocks become cheaper, reverse course. Thinking back to older chapters, Graham’s easy advice is to follow a 70/30 stock/bond split for someone comfortable with a fairly high level of risk. Continue to rebalance every six months, as to not drive yourself crazy.

Business Valuations vs. Stock Market Fluctuations

Unfortunately, as of late, investors are now more dependent on price rather than placing emphasis on merely being the business owner. Failing to recognize that the price of his current holding may be too high compared to its value. The problem is, this price is at the whim of the market, not just subject to its true value; as it would be if he were a private owner. This is because the shares he’d likely buy are at prices well above Net Asset Value (“book value”, “balance sheet value” or “tangible-asset value”).

From an Annual or Quarterly filing, take:

Net Asset Value

To prove his point that the investor that is handling public issues is exposed to the fantastical Mr. Market. Graham reiterates the paradox that the more successful the company, the greater the fluctuations in its price are likely to be.

The better the quality of the common stock, the more speculative it is likely to be — at least as compared with the unspectacular middle-grade issues.

Continuing further to his goal of turning the investor toward using the NAV as a good indicator of purchasability, he gives the advice that a conservative investor that pays attention to his selections may be best suited to concentrate only on issues that are selling close to a reasonable approximation of the tangible-asset value, and not more than 1/3 above that figure. This ties into all previously espoused logic of buying with the balance sheet, keeping independent of fluctuating market prices.

You must always remember that the NAV test is only an additional datapoint, we still need to consider :

  • Satisfactory P/E ratio
  • Sufficiently strong financial positioning
  • Prospects that earnings will be maintained over the years
The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets. As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high.

Morals From Market Fluctuations

  1. The stock market is often far wrong and sometimes an alert and courageous investor can take advantage of its patent errors.
  2. Most businesses change in character and quality over the years, sometimes for better, more often for worse.

Assuming you adhere to all this , you can be more confident you’ve made the correct buy, therefore: “That man[investor] would be better off if his stocks had no market quotation at all, for he would be spared the mental anguish caused him by other persons’ mistakes of judgement.

Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

In order to preserve readability of such a long chapter, Zweig’s comments are below. They pair well with Graham’s content and continue to offer solid advice for building out your evaluation model:

  • for a typical investor, it may not be worth the loss of dividends to wait for discount prices, but rather, may be better suited to buy when you have money, so long as market prices are not higher than can be justified by well established standards of value. He continues to search for value opportunities nonetheless.
  • “He should always remember market quotations are there for his convenience, either to be taken advantage of, or to be ignored.”
  • Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop
  • Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to.
  • Focus on the things you can control:

Your brokerage costs , by trading rarely , patiently and cheaply

Your ownership costs, by refusing to buy mutual funds with excessive annual expenses

Your risk, by deciding how much of your total assets to put at hazard in the stock market, by diversifying and by rebalancing

Your tax bills , by holding your stocks for at least one year and, when-ever possible, for at least five years, to lower your capital-gains liability.

As I continue to work through the chapters, my goal is to post on each chapter’s central tenets. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.

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