The Defensive Investor - Pros and Cons

The defensive investor is unwilling, or unable, to put in the time and effort required to be an enterprising investor. Instead of an active approach the defensive investor seeks a portfolio that requires minimal effort, research, and monitoring.

An inactive approach means the defensive investor will seek conservative investments that require little effort in portfolio management, research, and selection of individual investments. Unlike the enterprising investor he or she will not expand their potential universe beyond stable conservative choices.

General Portfolio Policy: The Defensive Investor – Chapter 4

The popular view is that investors should tailor the amount of risk they are willing to take to their risk tolerance. Graham has a different outlook: the amount of risk one should accept should depend on the amount of intelligent effort the investor is able and willing to expend.

In other words, the defensive or passive investor, must be willing to accept an average return. Greater returns can be achieved by the enterprising investor who makes the additional effort to intelligently manage his portfolio and select individual investments.

The defensive investor can divide his portfolio equally between stocks and bonds/cash. Portfolio rebalancing can be reserved for times when valuations bring asset allocations significantly out of the 50-50 target.

Graham uses the example of rebalancing when values shift to 55-45 or greater. For example, if stocks increase by 10 % and are now 55%, you would sell 5% of your stocks and buy 5% more bonds to achieve the desired 50-50 split.

There are two main questions concerning bonds: Taxable or tax-free, and short or long maturities? The tax question is basically a mathematical calculation based on the investors tax bracket. The question of maturity should be based on the investors perceived need for yield and risk/opportunity of a change in principal value.

In the commentary, Jason Zweig notes Graham never mentions the word age when discussing asset allocation. The amount of risk you assume should have nothing to do with your age.

The Defensive Investor and Common Stocks – Chapter 5

The two main advantages of stocks are that they provide protection against inflation and offer a higher rate of return than bonds/cash in the long run. These advantages can be squandered if the investor pays too high a price for his stock.

Graham suggested four rules for the defensive investor:

1. Adequate diversification

– Graham suggested between 10 and 30 different issues

2. Stick to large, outstanding (top 1/3 of industry group), conservative companies.

3. Each company should have 20 years of continuous dividend payments.

4. Limit the price you are willing to pay to

– 25 times average earnings over the last 7 years and

– 20 times earnings for last 12 month period

The defensive investor will most likely have to abandon growth stocks. Growth stocks will usually be too expensive; and consequently, excessively risky for the defensive investor.

The beginning investor should not try to beat the market, but instead concentrate on learning the difference between price and value with small sums of money. In the long run an investor’s rate of return will be determined by his or her knowledge, discipline, and skill in paying a reasonable price for investments.

Stock Selection for the Defensive Investor – Chapter 14

In Chapter 14, Graham provides a set of standards by which a defensive investor can obtain quality and quantity.

1. Adequate Size of the Enterprise