Sometimes beating the market isn’t all it’s cracked up to be. Just ask Ben Graham.
Graham set up his second fund, the Graham Joint Account, in 1926 (after closing down his first fund set up with Louis Harris, Grahar Corp., run from 1923 – ’25). Over the first three years, 1926 to ’28, Graham’s new fund would earn 25.7% annually against the Dow’s 20.2%. He handily beat the market on the way up.
And he beat it on the way down…
From 1929 to 1932, Graham’s fund lost 70% compared to the Dow’s 80% loss (a beating alright). If he was chasing relative returns, he succeeded.
But Graham knew he failed. He barely survived the worst four year period ever in the stock market.
Not surprising, it would leave a lasting impression on him. James Grant explained exactly what went wrong during a 2008 Graham and Dodd event:
Value investors were supposed to have a deep-rooted aversion to financial leverage, but Graham and his partners went into the crash in a highly encumbered position. He relates that he was operating with two and a half million dollars in capital and that two and a half million of longs was hedged with two and a half million of shorts. So far so good. But Graham had in addition, as much as four and a half million in unhedged long positions against which he had borrowed 2 million. “We were convinced,” he explains, “that all of our long securities were intrinsically worth more than the market price.” Mark that word intrinsically. Now forget it. “Although many,” he said, “although many of our issues were little known to active Wall Street hands, similar ones had previously shown a praiseworthy tendency to come to life in a decent interval after we bought them and give us a chance to sell out at a nice profit.” So, he had come into the crash levered and with the muscle memory of value redeeming itself because it was intrinsically value laden.
Then came the turn of the seasons… Graham’s fund was down 20 percent in 1929 … 50 percent in 1930, and 16 percent in 1931. By 1932, the year in which the Dow bottomed at 41 spot 22, Graham had managed to achieve a kind of moral victory by losing a mere two percent. Still, there was only thirty cents remaining of each dollar entrusted to a stewardship at the peak only three years before.
For comparison, the Dow lost 17% in 1929, 34% in 1930, 53% in 1931, and 23% in 1932. In total, an 80% loss over the four years.
Using leverage — margin debt — was common in the 1920s. Everyone used it. And the long bull market from 1921 to 1929 didn’t help slow its use (the Dow was up 450% over the period).
The big draw of leverage is that it makes great returns even better. The downside nobody advertises is that it makes losses even worse.
Graham would swear off using leverage after being burned from four years of losses. That, of course, is the first lesson.