How to Become an Intelligent Investor

On April 30, 2022, Berkshire Hathaway held its annual shareholders’ meeting in Omaha, Nebraska — the hometown of its founder, Warren Buffett. (For a detailed report, please read “The 2022 Berkshire Annual Meeting in 28 Quotes: Munger Says China Is Still Worth Investing In.”)

At the meeting Buffett described his “epiphany moment”: at 19 or 20, after reading Benjamin Graham’s The Intelligent Investor, he completely changed the way he invested.

Buffett said: “I read that book, and I came to a passage, and it told me I’d been doing everything wrong. I’d simply had the whole approach wrong.”

What is it that this life-changing book teaches — the method by which we too might become intelligent investors?

Buffett’s investment philosophy comes chiefly from one of his teachers, Benjamin Graham. Buffett once said: eighty percent of the blood in my veins is Graham’s.

As the founding father of value-investing theory, Graham’s understanding of value investing and his analytical strategies for the safety of an investment influenced three whole generations of Wall Street fund managers. Today, every manager on Wall Street who lays claim to a value-investing approach calls himself a disciple of Graham. Graham thus enjoys the honorary title of “the dean of Wall Street.”

Graham wrote two widely loved works: Security Analysis, co-authored with David Dodd in 1934, and The Intelligent Investor, published in 1949. Compared with Security Analysis, The Intelligent Investor is simpler and easier to follow, and rather better suited to the general reader — though it too has won the favor and admiration of finance professionals.

There is also a true and delightful story about Buffett and Graham:

When Buffett graduated from high school, he set his heart on entering Harvard Business School — only to have his application rejected. He immediately set about researching other schools. One day, flipping quickly through the Columbia University catalogue, he came upon two very familiar names: Benjamin Graham and David Dodd. To him, these were two resounding names. He had read Graham’s book and been utterly captivated by it, reading it again and again, chewing it over and putting it into practice. And so, seeing his idol at this school, he at once wrote an application letter to the professor, saying: “Dear Professor, I thought you were no longer among the living. When I leafed through the faculty roster I was delighted to find that you were teaching at this school. I believe you must be standing somewhere on the summit of Mount Olympus, smiling down on the rest of us. If I could be admitted, I would be very glad. I know, of course, that this is not a routine application for admission — it may be a very personal one.”

Perhaps this written appeal left a far deeper impression than an interview would have. Whatever the reason, in the end Buffett was admitted to Columbia University without an interview, and became Graham’s student. Buffett’s classmates recalled that in class, whenever Graham posed a question, Warren was invariably “the first to raise his hand and the first to speak up.” The rest of the class became the audience to a “duet” between Graham and Buffett. And so, in the early part of Buffett’s investing career, he was a believer in Graham’s ideas and a staunch practitioner of them.

Before we come to this book, let us first get to know the man Graham himself.

Let me describe the Graham I have come to see through a few key phrases.

The first phrase is “a hard childhood.”

Graham was born in London in 1894, and when he was one year old the family moved to New York. His father was a dealer in porcelain tableware and small figurines. At first their life was comfortable: they had a maid, a cook, and a French governess, and lived in the upper reaches of Fifth Avenue. But Graham’s father died when he was nine, so the business went untended, and the family’s life gradually fell into hardship. Graham’s mother hit upon the idea of borrowing money to trade stocks “on margin.” For a woman who knew nothing of stocks to do such a thing — one can imagine how high the risk was — and in the crash of 1907 she lost all her capital. And so the straitened life of his childhood led him, after graduation, to choose the fast-money work of Wall Street rather than staying on to teach. That work on Wall Street also allowed him to build a set of core investing principles of his own, laying the foundation for what he would later achieve.

The second phrase is: top of the class.

During his years at New York’s public schools, Graham performed superbly. At school he read Victor Hugo in French, Goethe in German, Homer in Greek, and Virgil in Latin. After graduating high school he won a scholarship to Columbia University, and in 1914 he graduated second in his class. In his final semester, three departments at the university invited him to join their faculty. Clearly, he was a top student indeed.

The third phrase is: an excellent teacher.

Buffett said: he was skilled at keeping his ideas free of any trace of preaching or arrogance. Powerful as his ideas were, the way he expressed them was unmistakably gentle.

When Graham returned to the school to teach, he used all manner of ingenious and effective “tricks” in the classroom. He would “lay an ambush” of two questions, asking one at a time. His students would think they knew the answer to the first; but when the second followed, they would realize they might not know the answer at all. Graham would describe two companies, one in terrible shape and near bankruptcy, the other in fine condition. After asking the class to analyze the two, he would reveal the result: they were in fact the same company at different points in time. Everyone was astonished. These were lessons in independent thinking, and they left a deep impression.

The fourth phrase is: a free and unrestrained life.

Graham had three wives — from a passionate, strong-willed teacher, to a Broadway showgirl eighteen years his junior, to his clever and lovable former secretary. Later, Graham’s son took his own life while serving in the French army; Graham hurried to France to gather his son’s belongings and there met his son’s girlfriend, Marie. From then on he began corresponding and keeping company with Marie, and he lived in France for part of each year. This may be somewhat hard for us to understand or accept — but it also speaks to differences in cultural values and to the many sides of a person.

The Core of The Intelligent Investor

Returning to Graham’s achievements in the field of investing: we can see that he was not merely the founder of value-investing theory. More importantly, he applied that theory to actual investing and achieved outstanding results. This is what Wang Yangming called “the unity of knowing and doing.”

Graham’s early return records have by now been lost, but from 1936 until his retirement in 1956, his firm Graham-Newman achieved an annual return of no less than 14.7% — a record that ranks among the best long-term returns Wall Street had ever seen up to that period.

So how did Graham do it? Through extraordinary intelligence, sharp judgment, and rich experience. Graham built a set of core principles of his own. These principles remain as applicable today as they were in Graham’s time, and they run throughout this book:

1. A stock is not merely a ticker symbol or an electronic blip; it is ownership of a genuine, real business, whose intrinsic value does not depend on its share price.

2. The market is like a pendulum, forever swinging between short-lived optimism and unwarranted pessimism. The intelligent investor is a realist who sells to the optimists and buys from the pessimists.

3. The future value of every investment is a function of its present price. The higher the price you pay, the lower your return.

4. However careful you are, every investor is bound to make mistakes. Only by holding to Graham’s so-called principle of a “margin of safety” — never paying too high a price, no matter how alluring an investment may seem — can you minimize the odds of error.

5. The secret of investment success lies within you. If you think about problems critically, disbelieve Wall Street’s so-called “facts,” and invest with lasting confidence, you will earn steady returns even in a bear market. By cultivating your own discipline and courage, you will not let the emotional swings of others sway your goals. In the end, the way you behave matters far more than the way you invest.

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These few core principles are worth reading, pondering, and turning over repeatedly — and worth transforming into important frameworks within our body of knowledge, to guide our investing behavior.

The author first defines investment and speculation, and distinguishes two types of investor.

An investment operation is one that, on the basis of thorough analysis, ensures the safety of principal and secures an adequate return; operations that do not meet these requirements are speculative.

Investors fall in turn into two basic types: defensive and enterprising. The defensive (or passive) investor’s primary aim is to avoid serious mistakes or losses; his secondary aim is to be spared much effort and vexation in making investment decisions regularly. The enterprising (or active, or aggressive) investor’s chief characteristic is his willingness to devote time and effort to selecting sound and more attractive securities, in order to earn a better-than-average return.

This book has twenty chapters in all; I will pick out a few themes to share.

The Investor and Inflation

At the time, many financial authorities held that bonds were an undesirable form of investment, and that one should hold stocks entirely to guard against inflation. To this view, the author writes:

Our readers must have enough intelligence to recognize that even high-quality stocks cannot, under all conditions, be superior to bonds. We must not suppose that, no matter how high the market has risen or how far the dividend yield has fallen below the bond rate, high-quality stocks are always a better investment than bonds. The opposite claim — that any bond is safer than stocks — is equally mistaken.

And so the author holds that stocks and bonds should be allocated in balance, so as to achieve the effect of guarding against inflation.

As for methods of guarding against inflation other than stocks and bonds, the author gives little credence to any of them.

Buying and holding gold, for instance, is the standard inflation-hedging strategy the world over. But the author holds that gold’s long-term appreciation falls short of stocks, and that over the holding period the holder receives no capital gain whatever, and must instead pay a certain maintenance cost for it every year.

Toward other precious objects the author is more critical still. He says:

Over the years, the market prices of many precious objects — diamonds, paintings by the masters, first editions of books, rare stamps or coins — have risen sharply. But in many, indeed most, cases, their quoted prices tend to be artificial, unreliable, even untrue. To pay $67,500 for a coin dated 1804 can hardly be imagined as an “investment operation.”

And so the author advises: before making any investment, first make sure you are familiar with the field. This advice is very important — it is what Buffett often says about investing only within your circle of competence.

On the subject of guarding against inflation, the author offers a small conclusion at the end: precisely because the future is uncertain, the investor cannot put all his funds in one basket — neither entirely in the bond basket, though interest rates have lately reached unprecedented heights; nor entirely in the stock basket, though inflation is expected to continue.

The Defensive Investor’s Portfolio Strategy

For most ordinary investors, who generally lack the energy, experience, and expertise for active investment management, it is more realistic and reasonable to lean toward defensive investing.

We often hear the view: if you cannot bear risk, you should be content with lower returns. This is a long-standing principle, and it sounds entirely reasonable. From it one draws the conclusion that the return an investor can hope for is, to some degree, proportional to the risk he takes on.

But the author offers a different view. He holds that an investor’s target return is determined more by the intelligence he is willing and able to devote to his investing. The passive investor who seeks ease and safety deserves the lowest reward, while the shrewd and experienced investor, because he brings to bear the greatest intelligence and skill, deserves the greatest reward.

I find this a truly wise view. We often say that risk and return are proportional — high risk, high return; low risk, low return. But the correct view should be that return is positively correlated with your intelligence, your professional skill, and the effort you put in. As the old Chinese saying goes: plant melons and you reap melons, plant beans and you reap beans.

As for the defensive investor’s portfolio strategy, the author’s advice is: the money invested in stocks should never be less than 25% of total funds, nor more than 75%; correspondingly, the proportion invested in bonds should lie between 75% and 25%. But as a standard allocation, the two should each account for half of the funds.

When should the ratio be adjusted? A sound reason to increase the weighting of common stocks is that a sustained bear market has produced “bargain prices.” Conversely, when the investor judges that market prices have risen to dangerous heights, he should reduce the proportion of stocks to below 50%.

This rule of fund allocation carries real, substantive meaning for the defensive investor. It is very simple, but the direction in which it operates is unquestionably correct. It makes the investor who follows it feel that he is at least making some response to market changes; and, more importantly, it keeps him from continuing to increase his stock holdings as the market climbs ever higher, to the point of danger.

Moreover, the truly conservative investor will be content with the returns his half-allocation earns in a bull market; and when deep in a bear market, comparing himself with the plight of the more adventurous investor, he will draw comfort from his relatively better position. Is that not a fine thing?

The Basic Rules for Selecting Common Stocks

1. Adequate but not excessive diversification: your holdings should be limited to a minimum of 10 and a maximum of 30 different stocks.

2. Each company you choose should be large, prominent, and financially sound.

3. Each company should have a long record of continuous dividend payments.

4. The investor should limit the price he pays for a stock to a certain range of price-to-earnings ratio, taking as his reference the average per-share earnings over the past seven years.

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These are the four principles by which the defensive investor selects common stocks.

The fourth of these selection principles excludes growth stocks. What is the reason?

A “growth stock” is one whose per-share earnings have grown, in the past, markedly faster than the average of all stocks, and are expected to continue doing so in the future. Clearly, such a stock is worth buying and owning — provided its price is not too high. There is, of course, a problem: relative to current earnings, growth-stock prices have always been high; relative to earnings in some past period, their price-to-earnings ratios are higher still. This introduces a large speculative element into growth-stock investing, making such operations very hard to carry off successfully.

The author gives an example. For a long stretch of that era, IBM was the leader among growth stocks, and it did indeed bring handsome returns to investors who bought it years earlier and held on. But we can see that this so-called “best of common stocks” lost half its value in a six-month decline in 1961–1962, and fell by nearly the same margin in 1969–1970. Other growth stocks fared worse in adversity; sometimes not only was the market falling, but these companies’ profits were falling too, dealing a double blow to those who held such stocks. Texas Instruments is another good example that bears this out: over six years the stock rose from $5 to $265 without ever paying a dividend, while its per-share earnings rose from 40 cents to $3.91. But note that the rise in its share price was five times the rise in its earnings — a common feature of such hot stocks. Two years later, its earnings fell by nearly 50%, and its share price fell by 80%, down to $49.

From these examples we can see why we hold that, for the defensive investor, growth stocks carry too much uncertainty and too much risk. Of course, if the stock is chosen correctly, bought at a reasonable price, and sold after a great rise and before the possible fall, a miracle can occur. But for the average investor, this is a thing one may chance upon but cannot deliberately seek. By contrast, we believe that the less fashionable large companies, whose earnings multiples are therefore more reasonable, are actually a more suitable choice for most investors, even though they look less dazzling.

Can I Become an Enterprising Investor?

Now, someone may say: I may not be that professional, but I still want to take a step in the direction of the enterprising investor — might I become some intermediate state between the two?

To this idea, here is how I see it:

In fact, the enterprising investor must possess a great deal of knowledge about valuing securities before he can treat his securities activity as a business. Between the passive position and the active position, there exists no intermediate concept or series of concepts.

Many — perhaps most — investors want to place themselves in just such an intermediate position; but we believe this compromise stance is more likely to bring, not gains, but a disappointing result.

As an investor, you cannot become a better “half-businessman” and thereby expect your investment to bring you profits equal to half of a normal business.

By this reasoning, most owners of securities should choose the category of defensive investor. They lack the time, the decisiveness, and the energy to conduct investing as one runs a business. They should therefore be content with the superior return (or even the lower return) they now obtain from a defensive portfolio; and they should firmly resist the recurring temptation — the temptation to stray onto some other path in order to increase returns.

And so I feel that, for the great majority of investors, unless you have an enormous passion and love for investing, and can devote most of your time and energy to it — running your investing as you would run a business — becoming an enterprising investor is not for you. If you cannot do the above, then you should be clear about positioning yourself as a defensive investor, adopt a relatively steady approach, hold reasonable expectations about returns, and at the same time seek out a reliable professional adviser to provide sensible recommendations for your investing — though those recommendations, too, should not stray from the positioning of your own investing identity.

Market Fluctuations

First, the stock market often makes serious mistakes, and the sharp, bold investor can sometimes take advantage of the errors that plainly exist. Second, the character and operating quality of most businesses change over time — sometimes for the better, but more often for the worse. The investor need not watch a company’s performance constantly; he need only observe it closely from time to time.

Very rarely does one see a true investor forced to sell his shares; and for the great majority of the time, he can simply ignore the current share price. He pays attention to his stock and takes some action only in order to make it fit his own accounts, for no other purpose. Therefore, if the investor himself blindly follows the crowd, or worries excessively, because the market price of his securities has fallen unreasonably, then he has, incredibly, turned his basic advantage into a basic disadvantage. For such a person, it might be better if his stocks had no market quotation at all — for then he would not suffer mental torment over other people’s errors of judgment.

This actually explains very well how a value investor should respond to market fluctuations, and we do indeed see the master value investor Buffett doing precisely this. Buffett has said many times that he does not even use a computer and does not care at all about real-time share-price movements. If the price of a stock he has invested in is falling, and its underlying value has not changed, then a good thing has simply become cheaper — which is his happiest moment, not his moment of worry.

The most realistic difference between the investor and the speculator lies in their attitude toward stock-market changes. The speculator’s main interest is in predicting market fluctuations and profiting from them; the investor’s main interest is in buying and holding suitable securities at suitable prices. In fact, market fluctuations matter to the investor because, when the market offers low prices, he can rationally make a decision to buy; and when the market offers high prices, he will necessarily stop buying, and may even make a decision to sell.

To succeed in investing over a lifetime does not require a genius-level IQ, nor a superhuman gift for business insight, nor inside information known only to you. To succeed in investing over a lifetime requires only two factors — a sound and reasonable framework of thinking that lets you make correct investment decisions, and the ability to control your own emotions so that they do not wreck that framework.

I hope that everyone, through their own efforts, can become an intelligent investor.