These four simple investing rules from the father of value investing will get you started in stocks
If manic-depressive disorder were something you could catch, stock investors would have closets full of lithium.
Investors pile into stocks when times are good, with hot stock tips coming by everyone from Grandma to cabbies. It’s a totally different story when stocks aren’t doing so well. Suddenly stocks are ‘too risky’ for years after a market crash.
What’s an investor to do? How do you get beyond all the hype and just stick with stocks for the long-run?
Turns out, picking stocks in any market may be easier than you think. In fact, it may come down to four simple investing rules.
These four rules for investing were handed down by one of the most respected advisors of all time more than six decades ago. They outline the tenets of good investing and are just as applicable today.
Being an Intelligent Investor
We’ll get to those four simple investing rules for stocks pretty soon. First, a little about where the investing tenets came from and why they may be the best investment advice you can follow.
This article is the fifth in our chapter-by-chapter review of The Intelligent Investor. The book was first published in the early 50s by Benjamin Graham, widely-known as the father of value investing and a mentor to Warren Buffett.
I’m reading through the 2003 edition which includes the 1973 text from Graham and the updated commentary by Jason Zweig. Reading through Graham’s last edition, it’s amazing how relevant his commentary is for today’s investor.
Click to start at the beginning with our Introduction to The Intelligent Investor
Last week’s Chapter 4 Review of Creating a Portfolio Policy is available here
Chapter five is titled, “The Defensive Investor and Common Stocks,” and really gets into how investors can pick stocks for long-run returns. It’s the reason many investors buy the book and lays out simple investing rules that can help you avoid losing money in stocks.
Get your copy of The Intelligent Investor on Amazon and follow along with the reviews.
Four Rules for Stock Investors
Graham gets right to his four basic investing rules for stock investors. The rules are stated for the ‘defensive’ investor which is basically your average investor that just wants to see their money grow to provide for financial goals. The defensive investor doesn’t want to spend a lot of time researching stocks and doesn’t want to worry if the money will be there in 30 years.
If you are a ‘defensive’ investor, these investing rules could be the best investing advice you ever hear.
- Smooth out your investing risks by holding at least 10 stocks. Graham warns against holding too many stocks, putting the limit on around 30 companies.
- Invest in large companies with conservative financing.
- Invest in companies with a long history of paying dividends.
- Set a limit on the price you are willing to pay for a company’s earnings, noted by the price-to-earnings (P/E) ratio.
How Much Stock Diversification is Too Much?
The first investing rule is all about the concept of diversification, investing in many assets or stocks so that no one investment can affect your wealth too greatly. It’s probably the most important rule for investing and the best protection against a stock market crash.
Graham’s warning against too many stocks may not apply to some investors, particularly the ‘defensive’ investor. There are two problems with holding stocks of more than a few dozen companies.
- Your portfolio starts to look a lot like the overall market with stocks across all sectors and therefore your returns are going to follow the market…without much potential for market-beating returns.
- You are going to be buying more of your stocks for decades to come. That means paying trading commissions on each purchase of each stock…something that can get very expensive and eat away at your returns.
The first risk of over-diversification isn’t really too much an issue for most investors. The average investor made just 2.6% annually over the decade to 2013 against market returns of over 7% annually. On this news, getting the return on the market sounds pretty good.
The second risk can be balanced through buying exchange traded funds (ETFs) which hold many stocks but can be bought with one commission. You can also significantly decrease your investing costs by creating your own funds on Motif Investing. Motif allows you to group up to 30 stocks together and buy them all with one commission, saving hundreds compared to other online investing platforms.
Learn how investors are saving thousands a year on Motif – Get up to $150 when you open an account
Simple Investing Rules for Picking Companies and Dividends
Graham’s second two investing rules help to focus on exactly which stocks the defensive investor might want to look to fill their portfolio.
‘Large’ companies is pretty arbitrary and changes over time. Apple Inc (Nasdaq: AAPL) is currently the largest publicly-traded company in the world with a market size of $589 billion but you can certainly pick smaller companies than that and still be safe.
The smallest company in the S&P 500 index, representing ‘the stock market’ of largest U.S. companies, is Diamond Offshore Drilling (NYSE: DO) at $2.7 billion.
The idea is that very large companies have the financial power to make it through recessions and other problems. They may not jump higher like small-cap stocks but will be around for decades when you start withdrawing your investments.
Many investors classify stocks within five groups by size:
- Mega-cap companies are those over $200 billion and include Apple, Microsoft and Google
- Large-cap companies are between $10 billion and $200 billion
- Mid-cap companies are between $2 billion and $10 billion. This is probably about where you want to draw the line if you only want to invest in ‘large’ and relatively safe companies.
- Small-cap companies are between $500 million and $2 billion. These can offer higher returns but may be more risk than a defensive investor wants. If you invest in small cap stocks, do so through a diversified fund that holds many companies.
- Nano- or Micro-cap companies are those under $500 million and are way too risky for most investors
‘Conservative’ financing is another relative concept within Graham’s simple investing rules. You can find a company’s financing by measuring its debt-to-equity ratio, or the amount of debt it uses compared to how much of the company is financed by investors.
It’s a relative term because conservative financing in consumer goods companies is very different than conservative in another sector like information technology. A food processor like General Mills has very stable sales and will be able to manage much higher debt while a company in another sector will want to limit interest payments on debt because sales are not as stable.
When you come across relative terms like this in picking stocks, you absolutely must compare stocks of the same sector or industry. An expensive P/E value or high debt ratio in one sector may be very different in another. Simply looking at these measures across all stocks is going to lead to the following:
- You’ll end up only in a particular group of stocks. (i.e. picking only low stocks with P/E of less than 15 means you’ll end up with a bunch of banks and telecom stocks.)
- Your investment returns will depend on those sectors and your portfolio could crash if something happens to the specific group of stocks
Instead, whenever you look at a P/E ratio or look for stocks with low debt financing, make sure you do it in several steps comparing the stocks in each sector separately.
Should the Intelligent Investor Invest in Growth Stocks?
Graham’s final investing rule is tricky not just because you have to pick an arbitrary price-to-earnings (P/E) ratio to buy ‘cheap’ stocks but also because you could miss out on a future growth.
Within the stock market, another distinction can be made between ‘growth’ stocks and ‘value’ stocks.
- Growth stocks are companies that have grown their sales and earnings rapidly because of new products or a newer market. Investors tend to pay more for these stocks on a P/E basis because it’s assumed future growth will be worth more.
- Value stocks are typically older companies with slower sales and earnings growth. They are cheaper on a P/E basis because investors are not expecting much growth in the future.
Value stocks of S&P 500 companies have returned an annualized 5.7% over the last decade including dividends. Investing only in these would miss out on the 7.5% annual return in the entire S&P 500 group of stocks.
I wouldn’t specifically avoid growth stocks when picking investments. When figuring out the limit you want to pay on a P/E basis, just make sure you use different limits for each sector. Pick four or five stocks from each sector with lower price-to-earnings ratios and lower debt financing.
Can Investing Rules Change Depending on Your Personal Situation?
Graham also goes into how to pick stocks around your own personal situation and how your tolerance for risk can affect your investments. I’ve already written detailed articles on both these topics so will just link to them instead of making this post longer than it already is.
Learn how to create a personal investment plan and pick stocks right for your return needs
Follow this 10-question survey to find your risk tolerance in stocks and keep from being freaked out by the stock market
Next week, we’ll look at Chapter Five of The Intelligent Investor which gets into investing decisions for investors that want to make a little higher return on their money.
Investing doesn’t have to be something you lose sleep over or worry that you’ll never be able to retire. Some of the simplest investing rules have proven to be the most enduring and best for a reason, they work. We’ve highlighted these stock market basics as the key tenets of the blog and you’ll see them in some of the most timeless investing books.
