Benjamin Graham’s Three Principles of Value Investing

Have you read The Intelligent Investor and Security Analysis by Benjamin Graham? These two books are considered as must read for value investing, but they are all pretty heavy books, especially the Security Analysis. If you just want to grab the essentials of the books, then  there’s on article on Forbes about Graham’s three timeless principles of investing.

1. Always Invest With a Margin of Safety

According to Investopedia, margin of safety is “a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value.” If the asset is worth $1, then Graham would buy the stock at $0.50. With the margin of safety in mind, investors buy stocks at discount to minimize downside risk.

This concept is very important for investors to note, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and raises its price to fair value. It also provides protection on the downside if things don’t work out as planned and the business falters. The safety net of buying an underlying business for much less than it is worth was the central theme of Graham’s success. When stocks are chosen carefully, Graham found that a further decline in these undervalued equities occurred infrequently.

2. Expect Volatility and Profit From It

Measured by CBOE Volatility Index (VIX), the stock market is as volatile as it can be since last September. The investing strategies used by Graham to deal with market volatility, which are still valid today, are:

  • Dollar-cost averaging: With DCA, you buy a fixed dollar amount regularly, taking advantage of dips of the market without having to worry about when to get in and out of the market. Though DCA has its limitation in an up market, it is proven to be the winning method in the long term.
  • Invest in both stocks and bonds: Investing isn’t just about what assets to buy, but also how these assets are mixed in your portfolio based on a thorough evaluation of investing time horizon, risk tolerance, and expected returns, etc. Having the right asset allocation mitigates the risk.

3. Know What Kind of Investor You Are

Are you a passive investor (defensive investor) or active investor (enterprising investor)? Being an active investor requires a lot of hard work to achieve the kind of return that’s proportional to the effort. If you don’t have the time and energy to actively research on what to invest, then take the passive approach and accept market returns.

In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market’s return and avoids doing worse than average by just letting the stock market’s overall results dictate long-term returns.

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6 Responses to “Benjamin Graham’s Three Principles of Value Investing”

  1. Jay |  Mar 27, 2009 at 11:36 am

    great recommendations as those are two of the first books listed in our recommended reading lists for investors: http://www.marketfolly.com/2008/11/investing-trading-books-recommended.html

    also, we recently went through and posted up a list of “what would benjamin graham buy today” and here’s what we came up with: http://www.marketfolly.com/2009/02/what-would-benjamin-graham-buy-today.html

  2. Matthew |  Mar 27, 2009 at 2:13 pm

    I’m concerned about these index funds that mirror the major indexes. They contain tons of terrible companies (like Exxon, Monsanto, Nike, etc.) that are causing massive problems in the world. Why are we giving our money to corporations that are causing deaths, global warming, tainting the food supply, using child labor and unsafe labor practices in the developing world, etc.?

    While I very much respect Benjamin Graham’s investing strategies, I think we need to find ways to follow his guidance without investing in these horrid companies.

  3. Sun |  Mar 27, 2009 at 3:51 pm

    @Jay Thanks for sharing. Those two books are my favorites as well. Since now is kind of an extreme time, I am not sure if the result you got by using Graham’s criteria will be different if the screening were done at a different time under a more normal market condition.

    @Matthew Yes, there some bad companies (but I somehow don’t think those you mentioned are particularly bad) in indices. Actually, the strategy of simple index investing is to own the entire stock market so you don’t have to pick and choose which index funds to buy. To do that, you only need to own four funds: a U.S. equity fund, a U.S. bond fund, a world (ex-US) equity fund and a world (again ex-US) bond fund.

  4. Writer's Coin |  Mar 28, 2009 at 8:35 pm

    The Intelligent Investor should be required reading before anyone is allowed to buy a stock.

    This would solve so many problems…