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The Intelligent Investor Chapter 4

The Intelligent Investor Chapter 4

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Published by Michael Pullman

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Published by: Michael Pullman on Jan 29, 2011
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TheIntelligentInvestorChapter4:GeneralPortfolioPolicy:TheDefensiveInvestor
 
Thecharacteristicsofaninvestmentportfolioaredeterminedbythefinancialpositionandindividualcharacteristicsoftheowner
 
Conventionalwisdomsaysthattherateofreturnaninvestorshouldaimforisproportionatetotheamountofriskheiswillingtotakeon
 
Grahamdisagreeswiththisnotionandbelievesthatexpectedrateofreturnisdependentontheamountofintelligentefforttheinvestoriswillingtoapply
 
Thepassive,ordefensive,investorshouldexpectthesmallestrateofreturnduetohispreferenceforsafetyandfreedomfromconcern
 
Theenterprisinginvestorwhomaximizesskillandintelligenceshouldexpecttoachievethelargestrateofreturn
 
Acommonstockissuancepurchasedatabargainpricecanofferlessrealriskthanahighgradebondpurchasedatfullprice
 
Asestablishedinpreviouschaptersitisafundamentalrulethattheinvestorshouldneverhavelessthan25%ormorethan75%ofhisportfolioincommonstocks
 
Intimesofuncertaintyadefault50%allocationtoeachassetclassisrecommended
 
Iftheinvestorhasconvictionthatstocksaretradingatbargainlevelshewouldthenincreasehisallocation
 
Conversely,iftheinvestorbelievesstocksareovervaluedhewouldreducehisallocationtoequitiesandfavorbonds
 
Thisisadifficulttaskbecauseitrequirestheinvestortoincreasehisstockallocationafteramarketdeclineandreducehisstockallocationafteramarketrally
 
Inadditiontoconvictiontheinvestormustalsomakesurethathehasthecorrectemotionalcomposuretodealwithlargemarketdeclinesbeforeheincreaseshiscommonstockallocation
 
Theinvestormustalsorebalancehisportfoliotokeepthedesiredallocationintact
 
Grahamusestheratioofdividendyieldoncommonstocktocouponrateofhighqualitytaxablebondsasavaluationmeasure
 
Tokeephisportfolioin50%equilibriumhewantsthedividendyieldonacommonstocktobeattwothirdsofthecouponrateofahighqualitytaxablebond
 
Whenchoosingbondstheinvestorshouldhavetwomainquestions
 
Shouldhebuytaxableortax-freebonds?
 
Shouldheconsidershorterorlongertermmaturities?
 
Iftheinvestorisinahightaxbracketthatwillmakehisaftertaxyieldlowerthantaxfreebondsheshouldstickwithtaxfreebonds
 
Whendecidingonthecorrectmaturitylengthofhisbondstheinvestorshoulddecidebetweenthelossofappreciablevalueandalowerannualyield
 
Ashortertermmaturitybondwillyieldless,butbelesspronetoswingsinvaluation
 
Alongertermmaturitybondwillyieldmore,butbesusceptibletomorevolatilepricemovements
 
Typesofbonds(asof1972)
 
U.S.SavingsBondSeriesEandH
§
 
SeriesHBondspayinterestsemi-annually
§
 
SeriesEBondsarepurchasedat75%offacevalueandmatureat100%offacevalue
 
Interestisnotpaidoutuntilmaturity
 
OtherUnitedStatesBonds
§
 
IndirectobligationsoftheU.S.governmentoffermoreyieldthandirectobligations
§
 
Theseindirectobligationsareissuedbydepartmentsofthegovernment,liketheSecurityofTransportation,butarebackedbythefullfaithandcreditoftheU.S.government
 
§
 
ThisallowsCongresstostayundertheirdebtlimitsbecauseguaranteesarenotconsideredthesameasdebts
 
StateandMunicipalBonds
§
 
ThesebondsarefreeofFederalincometaxandincometaxinthestatewhichtheyareissued
§
 
Theyareeitherdirectobligationbondsorrevenuebonds
 
Revenuebondsarebackedbyaparticularprojectsuchasatollroadorabridge
§
 
Notalloftheseissuesaresuitableforthedefensiveinvestor
 
CorporationBonds
§
 
ThesebondsaresubjecttoFederalandStatetax
§
 
Theyareissuedbycorporationsandhaveahigherclaimonassetsinbankruptcythancommonstock 
§
 
Grahamrecommendsthatthedefensiveinvestoravoidhighyieldbonds
 
SavingsDepositsinLieuofBonds
§
 
Dependingontheinterestrateenvironmentsavingsdepositsmayyieldmorethanfirst-gradebondsofshortmaturity
 
Grahamalsowarnstheinvestoragainstcallprovisionswhichgivetheissuertherighttobuybackthebondslightlyabovematurityifpricesriseandyieldsdecline
 
Thisisunfavorabletotheinvestorbecauseduringtimesofpricedeclinestheinvestorbearsthelosses,butduringtimesofpricegainstheinvestorisnotabletoachievetheupside
 
Investorsshouldsacrificesmallamountsofyieldinordertoavoidcallprovisionsforatleast20years
 
PreferredstocksaccordingtoGrahamareaninherentlybadinvestmentform
 
Thepreferredholder’sdividendisdependentonthecompany’sabilitytopayadividendonitscommonstock 
 
Thepreferredstockholderisentitledtonothingabovehisfixeddividendrate
 
Thereforehelacksthelegalclaimofthebondholderandtheprofitpossibilitiesofthecommonstockowner
 
Theyalsosufferfromadisadvantageoustaxtreatmentforindividualinvestors
 
Apreferredstockalsohasnofixedmaturitydateatwhichtheprincipalmustbereturned
 
Bondholdersshoulddemandthefollowingtwofeatures
 
Unconditionalrighttoreceiveinterestwhenitisearnedbythecompany
 
Rightstootherformsofprotectionthanbankruptcyproceedingsifinterestisnotpaid
 
CommentaryonChapter4
 
“Whenyouleaveittochance,thenallofasuddenyoudon’thaveanymoreluck.”–PatRiley
 
Therearetwomethodstobeinganintelligentinvestor
§
 
bycontinuallyresearching,selectingandmonitoringamixofstocksandbonds
§
 
orbycreatingapermanentportfoliothatrunsonautopilotandrequiresnofurthereffort 
 
Thefirstapproachisactiveorenterprisinginvesting
§
 
Thismethodrequiresanabundanceofeffortandenergy
 
Thesecondapproachispassiveordefensiveinvesting
§
 
Thismethodrequireslittletimeandeffort,butdemandsemotionaldetachmentanddisciplinefromtheswingsofthemarket 
 
Graham’sdistinctionbetweenactiveandpassiveinvestingisareminderthatfinancialriskliesprimarilywiththeinvestorhimself 
 
WhenGrahamdiscussesportfolioallocationbetweenstocksandbondsnoticethathenevermentionstheinvestorsage

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