What Warren Buffett says we should be reading today.
Legendary investor Warren Buffett advised investors to read just three chapters from two books in order to understand the current market, so I decided to take a closer look at them.
Today I examine Chapter 8 of Ben Graham's The Intelligent Investor, which deals with market fluctuations.
Revised and updated several times, the book was first published in 1949, and was read the following year by Warren Buffett at the age of 19. "I thought then that it was by far the best book about investing ever written", wrote Buffett in his preface to the 1973 edition, "I still think it is".
Timing versus pricing
It's obvious that share prices bounce around, and the intelligent investor seeks to profit from these swings. There are two possible ways to do this:
- Timing: Trying to anticipate the market, buying or holding when the trend appears to be upwards, and selling or refraining from buying when the trend appears to be downwards; and
- Pricing: Attempting to buy stocks when they are below 'fair value', and to sell them when they rise above fair value. Or at the very least, making sure that you don't overpay.
Graham finds that strategies for market timing have never been successful over the long term, and have all resulted in being out of the market at the wrong time.
Graham makes the same distinction between 'investors' and 'speculators' as Keynes:
"The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices."
The psychological challenges of rising prices
Swings of as much as 50% in share prices should be expected, and they present a psychological challenge to the investor.
"A substantial rise in the market is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action. Your shares have advanced, good! You are richer than you were, good! But has the price risen too high, and should you think of selling? Or should you kick yourself for not having bought more shares when the level was lower? Or -- worst thought of all -- should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfidence and the greed of the great public (of which, after all, you are a part), and make larger and dangerous commitments? Presented thus in print, the answer to the last question is a self-evident no, but even the intelligent investor is likely to need considerable will power to keep from following the crowd."
Decisions to buy or sell should be based not on how we feel about a change in the share price, but on a more mechanical and value-based re-balancing. This will result in going against the flow of the market.
In the words of Jason Zweig in his commentary on the 2003 edition of the book: "Investing isn't about beating others at their game. It's about controlling yourself at your own game."
Dual role of the investor
An investor has two roles, one as the part-owner of a business, and one as the owner of a traded stock; in one role, the book value of the investment is most important, in the other the share price takes priority.
The more successful the company, the greater the premium over book value at which its shares will sell, so the greater the sensitivity of share price to market whims.
The premium can also be considered a payment for the ability to sell the shares on the market whenever you want, but the conservative investor should not pay too much more than book value for the shares, while taking other factors such as profitability and financial position into consideration.
Graham says it should not be hard to meet these criteria in "all but dangerously high market conditions".
Introducing Mr Market
At this point, Graham introduces the metaphor of Mr Market, a personification of the erratic stock market, continually telling you what he thinks your investments are worth and offering to do business at that price.
But you have the basic advantage of being able to think for yourself and decide whether or not to accept this crazy person's terms, and it is important to use that advantage, along with the vagaries of the market, to play the master game of buying low and selling high.
"The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment."
If we accept that attempting to time the market (i.e. 'speculating') is futile, then it may make sense to simply buy shares whenever we have the money. But to the extent that we can value the market (i.e. 'invest'), we should at least refrain from investing new money when it appears that "the general market level is much higher than can be justified by well-established standards of value".
A word on bonds
While most of this discussion related to investing in shares, Graham offers the following observation about bonds:
"If it is virtually impossible to make worthwhile predictions about the price movements of stocks, it is completely impossible to do so for bonds."
The other critically important chapter of this book, according to Buffett, is chapter 20, 'Margin of Safety', and I look at in the next article in this mini-series.