In Chapter 5 (The Defensive Investor and Common Stocks) of The Intelligent Investor, Benjamin Graham, the father of value investing, touched on various aspects of defensive investment, among which was dollar-cost averaging, an application of a “formula investment”.
Elaborating, he said: “The New York Stock Exchange has put considerable effort into popularizing its ‘monthly purchase plan’, under which an investor devotes the same dollar amount each month to buying one or more common stocks.”
“During the predominantly rising-market experience since 1949 the results from such a procedure were certain to be highly satisfactory, especially since they prevented the practitioner from concentrating his buying at the wrong times,” added Benjamin Graham.
The father of value investing cited a comprehensive study of formula investment plans in which the author Lucile Tomlinson presented a calculation of the results of dollar-cost averaging in the group of stocks making up the Dow Jones industrial index. The average indicated profit at the end of 23 ten-year buying periods was 21.5 per cent, exclusive of dividends received. There were of course some instances of a substantial temporary depreciation at market value.
The author of the study said: “No one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging.”
In investment, having a margin of safety itself is not sufficient. Why is this so?
Benjamin Graham, the founder of value investing, uses the simple basis of the insurance-underwriting business to explain the need for diversification. He said that diversification is the companion of margin of safety. In other words, margin of safety and diversification go side by side.
Benjamin Graham put it this way: “Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.”
The founder of value investor added that diversification is an established tenet of conservative investment.
Benjamin Graham uses the arithmetic of American roulette to explain when diversification is foolish. In American roulette, most wheels use “0” and “00” along with numbers “1” through “36”. There are therefore 38 slots. A person betting $1 on a single number will be paid $35 when he wins but the chances are 37 to one that he will lose. The player thus has a “negative margin of safety”. The more number he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel. Diversification in this case is therefore foolish. Suppose the winner received $39 profit instead of $35. In this case, he would have a small but important margin of safety. Therefore the more numbers he wagers on, the better the chance of gain.
Bottom line: What Benjamin Graham was saying is that margin of safety goes hand in hand with diversification.
Benjamin Graham (May 8, 1894 – September 21, 1976), the father of value investing, in his book, The Intelligent Investor, summed up the secret of sound investment in three words: margin of safety. Warren Buffett, Benjamin Graham’s most famous disciple, explained his mentor’s margin of safety concept this way (Source: The Superinvestors of Graham-and-Doddsville by Warren E. Buffett): “You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin (of safety). When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”
In Chapter 20 (“Margin of Safety” as the Concept of Investment”) of The Intelligent Investor, Benjamin Graham summed up the chapter by saying: “Investment is most intelligent when it is most businesslike”.
“If a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success,” said Benjamin Graham. In other words, view a corporate security as an ownership interest in a specific business enterprise.
Benjamin Graham listed four sound business principles and explained how they were related to the securities investor:
(1) “Know what you’re doing – know your business.” Benjamin Graham said that the investor should not try to make “business profits” out of securities – that is, returns in excess of normal interest and dividend income – unless “you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in”.
(2) “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor, it means understanding the conditions under which he will permit someone to decide what is done with his money.
(3) “Do not enter upon an operation – that is, manufacturing or trading in an item – unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” The enterprising investor should make sure that his operations for profit should not be based on optimism but on arithmetic. For every investor who limits his return to a small figure, such as in a conventional bond or preferred stock – he needs to ask for convincing evidence that he is not risking a substantial part of his principal.
(4) “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even others may hesitate or differ.” “In the securities world, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand,” said Benjamin Graham.