Benjamin Graham Theory Of Diversification

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 $roulette1 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.


Margin of Safety: Secret of Sound Investment

Benjamin Graham's teacher and friend. Mr Graham used Mr. Market as the character to personify the behavior of the stock market. Photo: Wikipedia.
Benjamin Graham – Wikipedia

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.

Related post: Benjamin Graham’s theory of diversification

Benjamin Graham on stock selection for the defensive investor

The Intelligent Investor Chapter 14 – Stock Selection for the Defensive Investor

1.  Adequate Size of the Enterprise

The idea is to exclude small companies which may be subject to more than average vicissitudes especially in the industrial field.

(I) Not less than S$100 million of annual sales for an industrial company and, not less than $50 million of total assets for a public utility.

(Note:  These figures in 2015 are approximately $600 million and $300 million respectively. Veteran investment writer Jason Zweig in his accompanying commentary for Benjamin Graham’s The Intelligent Investor, Chapter 14 said: “Nowadays, “to exclude small companies,” most defensive investors should steer clear of stocks with a total market value of less than $2 billion.” Jason Zweig  also said: “However, today’s defensive investors – unlike those in Graham’s days – can conveniently own small companies by buying a mutual fund specializing in small stocks.”).

2. A Sufficiently Strong Financial Condition
According to Benjamin Graham, for industrial companies, current assets should be at least twice current liabilities – a so-called two-to-one current ratio. Also, long-term debt should not exceed the net current assets (or working capital). For public utilities, the debt should not exceed twice the stock equity (at book value).

3. Earnings Stability
Some earnings for the common stock in each of the past ten years.

4. Dividend Record
Uninterrupted payments for at least the past 20 years.

5. Earnings Growth
A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.

6. Moderate Price/Earnings Ratio
Current price should not be more than 15 times average earnings of the past three years.

7. Moderate Ratio of Price to Assets
Benjamin Graham said that current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. “As a rule of thumb,” he said, ” we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5 (this figure corresponds to 15 times earnings and 1.5  times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.).”

Investment versus speculation

Benjamin Graham's teacher and friend. Mr Graham used Mr. Market as the character to personify the behavior of the stock   market. Photo: Wikipedia.
Benjamin Graham – Wikipedia

In Chapter 1 of The Intelligent Investor, author Benjamin Graham (May 8, 1894 – September 21, 1976), the father of value investing, made a clear distinction between the term “investor” and “speculator“.

Benjamin Graham, as far back as 1934, said in Security Analysis (a book he co-authored): “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” This was an attempt for a precise formulation of the difference between investment and speculation.

Benjamin Graham then had to defend against the charge that the definition gave too wide a scope to the concept of investment when, in the aftermath of the great market decline of 1929-1932, all common stocks were widely regarded as speculative by nature. Then came a time when Benjamin Graham’s concern became one of people using the term “investor” as a common jargon to describe anyone and everybody in the stock market. An example was a journal in 1970 using the term “reckless investors”. Benjamin Graham said this “reckless investors” term could be regarded as a laughable contradiction in terms – something like “spendthrift misers”.

“The newspaper employed the word ‘investor’ in these instances because, in the easy language of Wall Street, everyone who buys or sells a security has become an investor, regardless of what he buys, or for what purpose, or at what price, or whether for cash or on margin,” said Benjamin Graham, the father of value investing whose most famous disciple is legendary investor Warren Buffett, the chairman of Berkshire Hathaway.

Benjamin Graham said that “the distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern.”

“Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be absorbed by someone. There is intelligent speculation as there is intelligent investing,” said Benjamin Graham.

“But,” warned Benjamin Graham, “there are many ways in which speculation may be unintelligent.” Examples that Benjamin Graham mentioned are “speculating when you think you are investing”, “speculating seriously instead of as a pastime, when you lack knowledge and proper skill for it”, and “risking more money in speculation than you can afford”.

In what he called a conservative view, Benjamin Graham said that “every non-professional who operates on margin should recognize that he is ipso facto speculating.” “And everyone who buys a so-called ‘hot’ common-stock issue, or makes a purchase in anyway similar thereto, is either speculating or gambling.”

Benjamin Graham said” “If you want to try your luck at it (speculation), put aside a portion – the smaller the better – of your capital in a separate fund for this purpose.”

His parting shot: “Never mingle your speculative and investment operations in the same account , nor in any part of your thinking.”

A game of Snap, of Old Maid, of Musical Chairs – John Maynard Keynes

John Maynard Keynes (5 June 1883 – 21 April 1946) – Wikipedia

“For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a  pastime in which he is victor who says Snap neither too soon nor too late, who passed the  Old Maid to his neighbour before the game is over, who secures a chair for himself when  the music stops. These games can be played with zest and enjoyment, though all the
players know that it is the Old Maid which is circulating, or that when the music stops  some of the players will find themselves unseated.”

This quote is from  The General Theory Of Employment, Interest, And Money
– Chapter 12 “The State of Long-term Expectation” (John Maynard Keynes, 1936).

Legendary investor Warren Buffett has also made reference to John Maynard Keynes’ General Theory of Employment, Interest, and Money Chapter 12 (“The State of Long-term Expectation”). In a November 2011 interview with Business Wire CEO Cathy Baron Tamraz, Warren Buffett said: “If you understand chapters 8 and 20 of The Intelligent Investor (Benjamin Graham, 1949) and chapter 12 of the General Theory (John Maynard Keynes, 1936), you don’t need to read anything else and you can turn off your TV.” This advice from Warren Buffett involves two milestone books on investing and economics

John Maynard Keynes made this  “game of Snap, of Old Maid, of Musical Chairs” remark in the context of saying that most professional investors and speculators were “largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the
conventional basis of valuation a short time ahead of the general public.”

Keynes went on to say: “They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’,
but with what the market will value it at, under the influence of mass psychology, three  months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed  propensity. It is an inevitable result of an investment market organised along the lines
described. For it is not sensible to pay 25 for an investment of which you believe the  prospective yield to justify a value of 30, if you also believe that the market will value it  at 20 three months hence.

“Thus the professional investor is forced to concern himself with the anticipation of  impending changes, in the news or in the atmosphere, of the kind by which experience  shows that the mass psychology of the market is most influenced. This is the inevitable
result of investment markets organised with a view to so-called ‘liquidity’. Of the maxims  of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the  doctrine that it is a positive virtue on the part of investment institutions to concentrate
their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing  as liquidity of investment for the community as a whole.”

Keynes then added: “The social object of skilled  investment should be to defeat the dark forces of time and ignorance which envelop our  future. The actual, private object of the most skilled investment to-day is ‘to beat the gun’,  as the Americans so well express it, to outwit the crowd, and to pass the bad, or  depreciating, half-crown to the other fellow.

“This battle of wits to anticipate the basis of conventional valuation a few months hence,  rather than the prospective yield of an investment over a long term of years, does not  even require gulls amongst the public to feed the maws of the professional; — it can be
played by professionals amongst themselves. Nor is it necessary that anyone should keep  his simple faith in the conventional basis of valuation having any genuine long-term  validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a
pastime in which he is victor who says Snap neither too soon nor too late, who passed the Old Maid to his neighbour before the game is over, who secures a chair for himself when  the music stops. These games can be played with zest and enjoyment, though all the
players know that it is the Old Maid which is circulating, or that when the music stops  some of the players will find themselves unseated.”

Keynes then put it another way: “Or, to change the metaphor slightly, professional investment may be likened to those
newspaper competitions in which the competitors have to pick out the six prettiest faces  from a hundred photographs, the prize being awarded to the competitor whose choice  most nearly corresponds to the average preferences of the competitors as a whole; so that
each competitor has to pick, not those faces which he himself finds prettiest, but those  which he thinks likeliest to catch the fancy of the other competitors, all of whom are  looking at the problem from the same point of view. It is not a case of choosing those  which, to the best of one’s judgment, are really the prettiest, nor even those which  average opinion genuinely thinks the prettiest. We have reached the third degree where  we devote our intelligences to anticipating what average opinion expects the average
opinion to be. And there are some, I believe, who practise the fourth, fifth and higher  degrees.”

Benjamin Graham’s The Intelligent Investor Chapter 8 (The Investor and Market Fluctuations)

Benjamin Graham’s The Intellingent Investor Chapter 20 (Margin of Safety As The Central Concept Of Investment)



Wall Street Crash of 1929 and the Great Depression

The Wall Street Crash of 1929, also known as Black Tuesday,   the Great Crash, or the Stock Market Crash of 1929, began on October 24, 1929, and was the most devastating stock market crash in the history of the United States,  when taking into consideration the full extent and duration of its fallout.  The crash signaled the beginning of the 10-year Great Depression that  affected all Western industrialized countries. – Wikipedia

The following video ( is worth watching for the events leading to the Wall Street Crash of 1929 and the subsequent Great Depression.