Thursday, June 23, 2011

A trip to the archives: Ben Graham, Behavioral Investor?

Given the recent spike in stock market related fears, we thought it would be timely to dig into our archives and re-visit the ideas of Ben Graham.  Long recognized as the founder of value investing, Graham also was an expert on market psychology and a critical observer of investor behavior. We have incorporated many of his core principles into our own investment process, and recognize in particular:
- the value of thorough research
- the importance of demanding a margin of safety (price in relation to value)
-Believe risk is also a direct function of investor sentiment (High expectations = High Risk).

While Graham and Dodd explain these ideas in detail in both Security Analysis and The Intelligent Investor, Graham's little known1963 town hall lecture, Securities In An Insecure World, perhaps expresses them most clearly.  The entire transcript is worth a read but we have included some relevant excerpts below:

On what it takes to outperform the market:
"Let me now make a general observation.  For obvious reasons it is impossible for investors as a whole, and therefore for the average investor or speculator, to do better than the general market.  The reason is that you are the general market and you can't do better than yourselves.  I do believe it is possible for a minority of investors to get significantly better results than average.  Two conditions are necessary for that.  One is that they must follow some sound principles of selection which are related to the value of the securities and not to their market price action.  The other is that their method of operation must be basically different than that of the majority of security buyers.  They have to cut themselves off from the general public and put themselves into a special category.
The value of contrary thinking:
"The investor needs common stocks in his portfolio; but these introduce hazards of wide fluctuations which he cannot expect to avoid more successfully than others unless perhaps he thinks independently from the crowd, that is unless he is constitutionally different from the average."
How market fluctuations affect risk:
 "As I see it, the real truth is the higher the stock market advances the more reason there is to mistrust it...  It is amazing to me how many people think the opposite.  That was brought home to me shortly after the May 1962 break when a savings-and-loan company representative came to me with questions.  The first question he asked me was 'Don't you think that common stock now are less safe than before because of the decline in the market?'  That hit me between the eyes.  Here were financial people who could seriously consider that stocks are less safe because they have declined in price than they were after they had advanced in price.  The policy I propose is to have more common stocks when the market seems to be low and less when it seems to be high by value standards is obviously opposed to the psychology of investors generally and to that of speculators always."
On risk management:
"can the intelligent investor follow any policies of common stock selection that promise better than average results?  I think it is possible for some strong minded investors to do this, by buying value rather than prospects or popularity...According to an old Wall Street story, when a certain broker was asked by a client to recommend issues to buy, he always asked in return, 'What is your preference?  Do you want to eat well or sleep well?' I am an optimist enough to believe that by following sound policies almost any investor---even in this insecure world---should be able to eat well enough without having to lose any sleep."

Even though 48 years have passed, it is clear that financial market dynamics have changed relatively little. The difference between investors and speculators, a distinction Graham spent quite a bit of his career examining, is just as relevant in today's marketplace. Look no further the average holding period of a NYSE stock, which has declined from around 7 years at the time of his 1963 speech to less 1 year today, for evidence that speculators make up a growing proportion of today's market participants.

Indeed, Graham's philosophy is built on the (behavioral) recognition that markets, and those that participate in them, will continue to be predictably irrational.  As he explains, "I don't see any change in human natures vis-a-vis the stock market which is sufficient to establish more restraints in the public behavior than it showed over so many decades in the past....These wide market swings underline the fact that the stock market is basically the same now as it always was, in the sense it is still subject to very substantial over-valuation at sometimes and undoubtedly substantial under valuations at others."

Further Reading:
-Benjamin Graham, Building a Profession: The Early Writings of the Father of Security Analysis