Intelligent Investor Ch.4&5 -General Portfolio Policy Defensive Investor and Common Stocks

General Portfolio Policy: The Defensive Investor

Bond vs Stock allocation

A defensive investor wants, first of all, to protect the downside, i.e. minimize the risk of losing money in the portfolio. According to Graham, the best way is to "divide" your portfolio between high-grade bonds and high-grade common stocks.

The guiding rule is that the investor should never have less than 25% or more than 75% in common stocks or vice versa! So either 25% high-grade common stocks and 75% high-grade bonds, or 25% high-grade bonds and 75% high-grade common stocks or anything in between these ranges.

The standard and probably simplest is, of course, doing 50-50, 50% high-grade common stocks and 50% high-grade bonds. In bear markets more leaning towards buying more "bargain-priced" common-stocks and in bull markets sell more of the high-grade common stocks for high-grade bonds!

The Bond component

There are two considerations to be made when it comes to buying bonds

1. Taxable or tax-free bonds
2. Shorter- or longer-term maturities

The first choice, between taxable and tax-free is more or less simple math, or "arithmetic" (addition, subtraction, multiplication and division). It is very individual and depends on your taxable income, if you are single or married, etc.

The longer versus short-term maturities choice is based on if "the investor wants to assure himself against a decline in the price of his bonds, but at the cost of

1. a lower annual yield
2. loss if the possibility of an appreciable gain in principle value"

This is closely connected to what you think the future markets will develop into

The book list following bonds

• U.S. Saving Bonds
• Other United States Bonds
• State and Municipal Bonds
• Corporate bonds

U.S. Saving Bonds are the best secured one (as the USA is securing the interest payments) but normally have the lowest rates, there can be some exemption from tax (federal or state).
The Corporate bonds are generally riskier but give higher returns - in a normal working market! To get the credit rating of a bond, turn to S&P or Moody's ratings, such as AAA (Aaa)!

The book mentions as well other Higher-Yielding Bond Investments, Saving Deposits, Convertibles (bonds that you can turn into common stocks), etc.

Then you have Straight, Nonconvertible - Preferred Stocks - which according to the book are almost never recommended for an individual investor - as they mainly give only tax advantages for corporations!

The Defensive Investor and Common Stocks

Finally, we are entering the interesting world of Common Stocks. There are two main arguments for choosing common stocks:

1. They offer a good protection against inflation - whereas bonds offer no protection at all
2. They offer higher average returns over the years (dividends and increase of market value)

But be aware, you lose this advantage if you pay too high price for the common-stocks!

Rules for the Common-Stock Component

Following four rules has been suggested to follow:

1. Adequate diversification, i.e. minimum 10 different issues and max 30!
2. The company selected should be large, prominent and conservatively financed
3. Each company should have a long record on continuous dividend payments
4. An upper limit on the price, the book suggests 25 times average 7-yr earnings (P/E 25) or 20 times earning of the last twelve-month period (P/E 20 TTM)!

Growth Stocks for the Defensive Investor?

Growth stocks are shares which have increased its per-share earnings (EPS) in the past well above the rate for common stocks generally and are expected to do so in the future! The example given in the book was a rate of earning increases of over 7.1%! 

The problem here is that normally, growth stocks are sold at high prices and/or high multiples (P/E)! 

Again and again, the book reminds you, do not pay too much of a high price! 

The strategy for the Defensive Investor is generally to stay away from growth stocks, as these easy can turn in an act of speculation - especially at high earnings multipliers (P/E)!

Dollar-Cost Averaging,  a monthly purchase plan, is recommended for those who can put away once a month or once per quarter money to invest in a companies shares! A lot of studies have shown very good results, the book talks about probably the best formula for investing with such good results!

Of course the Investor Personal Situation, mainly when it comes to time and skills are limiting factors how much research and time can put into the investment decision. The investor's financial resources and his knowledge, experience, and temperament will play a big role in the returns he will achieve!

Risk and safety

Are bonds safe and common stocks risky? The term "risk" is first of all the probability that you might lose all your money or if you have (or if you are forced) to sell your common stocks way below what you bought them for! You do not lose money because of the market price of your holdings declines.

The clear statement here is that bonds can be risky or unsafe when it defaults its interest or principal payments and common-stocks can be considered safe if the overall return over a number of years is satisfactory! many common-stocks involve risks of going to zero and those should be avoided, but that does not mean that all common-stocks are seen as risky merely because of the price fluctuation!