The Intelligent Investor - critical summary review

“The Intelligent Investor” was first published in 1949, revised four times before Benjamin Graham’s death in 1976, and republished four decades later as an annotated edition with thorough commentaries by Jason Zweig and forewords by either Warren Buffett or John Bogle. Its durability isn’t the only testament to its excellence: many of the investors you know and admire – including the three just mentioned – are adherents to Graham’s simple and reasonable investment philosophy. 

So, get ready to learn what’s the difference between investing and speculating and prepare to discover why you should ignore the whims of Mr. Market if your goal is to earn some money from him!

Dr. Jekyll and Mr. Market

Let us start in medias res, with Warren Buffett’s favorite parable, deservedly described by Zweig as “probably the most brilliant metaphor ever created for explaining how stocks can become mispriced.”

Imagine that you own a small share in some private business that cost you $1,000. And imagine that one of your partners is a very obliging fellow named Mr. Market. Every day he calls you at your house or place of employment and offers you a price to either buy your share or sell his. This price is never the same, and Mr. Market never minds if you ignore or snub him: he always comes back the next day with a new offer. Sometimes, he is in a jubilant mood and makes ridiculous offers; other times, he is frustrated and isn’t as generous; and from time to time, his ideas of value appear plausible and justified by what you know of the business climate. 

Let’s say that Mr. Market calls you on Monday with an offer of $800, on Tuesday with one of $1,200, and on Wednesday with yet a third offer of $900; let’s say that – on the weekend – he offers to sell his shares to you for just $300. The question isn’t just if you’d consider that man reasonable but also if you’d let his daily communication determine your view of the value of the $1,000 interest in the imagined enterprise. 

Of course, it’d be wrong on your part to not buy Mr. Market’s shares when his price is nonsensically low or sell yours if he quotes you a ridiculously high price. But other times, it’d be far wiser to just ignore him and “form your own ideas about the value of your holdings, based on full reports from the company about its operations and financial position.” This is the essence of value investing.

Investment vs. speculation

So, at heart, value investing is all about not allowing Mr. Market to influence your behavior. The best – if not the only – way to do this is by developing a strategy for creating your own price for a stock, based not on market fluctuations, but on the company’s intrinsic value. In other words, if a company boasts stellar past performance, good management, and promising future prospects, Mr. Market’s opinion should mean nothing to you.

Unfortunately, investors ignore Graham’s very sensible advice today even more than the original readers of his excellent book. According to John Bogle, the creator of the first index fund, today’s investors do about 1,500 times as much business with Mr. Market as they did a half-century ago. If you are one of them, we’d hate to burst your bubble, but you’re not really an investor: you’re a speculator. And since you’re in partnership with a manic-depressive, you’re basically playing Russian Roulette with your money. 

True, just like betting on horses, speculating can be far more rewarding (not to mention exciting) – but only if you get lucky. Chances are you won’t because the odds are stacked against you; otherwise, Wall Street wouldn’t have been Wall Street. Investing is all about reversing the odds and putting them squarely in your favor by detecting the real value of a business and calculating what its stocks are intrinsically worth. Only then you will know when to sell and when to buy. 

Speculators are nothing short from gamblers: they expect to earn from guessing right whether somebody will have an interest in a stock or not. They “base [their] standards of value upon the market price,” as opposed to investors who judge “the market price by established standards of value.” As a result, investors almost always make money for themselves; speculators, on the other hand, make money for their brokers.

Graham’s fundamental principles of intelligent investing

Graham defines investment as “an operation which, upon thorough analysis, promises safety of principal and an adequate return.” In other words, an investor is someone who carefully studies a company before buying its stocks and who aspires for an adequate – rather than extraordinary – performance, while protecting themselves against serious losses. Throughout the book, Graham explains the best ways to achieve this, and Zweig nicely summarizes his suggestions in the introduction to the book:

• Buy stocks as if you would buy companies. “A stock is not just a ticker symbol or an electronic blip,” writes Zweig, “it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.”
• Be a realist. Since Mr. Market is bipolar, his offers are sometimes too good to be true and sometimes unjustifiably pessimistic. Usually, you should ignore him, but you should also be a realist and take advantage of his irrational behavior. Sell to him when he’s optimistic and buy from him when he’s despondent. Of course, the only way to discern his swings is if you have a standard against which you could detect what a swing is.
• Don’t overpay. The higher you pay for a stock today, the lower your return in the future will be. No matter how exciting an investment might look like – and how quick its price seems to rise – remain sensible and refuse to overpay.
• Minimize losses by using margin of safety. “The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control,” warns Zweig. The good news is that you do have control over the consequences of being wrong. Simply by keeping your holdings permanently diversified – regardless of crazes and fashions – you’re minimizing the risk of losing all your money. Graham calls the difference between the intrinsic value of a stock and its market price margin of safety and suggests buying only when it is positive, – that is, only when the stock seems to be worth more than its market price. Otherwise, you’re overpaying and you’re risking losing your money in a bubble.
• Your behavior is much more important than the behavior of your investments. You should never allow your financial success to depend on price fluctuations – you know you’re an investor when it depends solely on your behavior. If you’re thorough in your investigations, disciplined, patient, and brave only when necessary – you should take steady advantage of any type of market. “In the end, how your investments behave is much less important than how you behave,” concludes Zweig.

Two types of investors

According to Graham, there are two types of intelligent investors: defensive and enterprising. Your investment strategy will depend a lot upon your decision which one of the two you want to be.

• Defensive investors. Defensive investors are preservers of capital – their chief objectives are to avoid serious losses and to make as few decisions as possible. In other words, they want safety and freedom from effort and annoyance, and they attempt to achieve this by creating a good permanent portfolio and putting it on autopilot. If you want to become a defensive investor, you should learn to be happy with average market returns and be prepared to resist urges and temptations. Falling only once for the folly of your emotions might result in wiping out the long-term benefits of your conservative strategy. 
• Enterprising (or aggressive) investors. Enterprising investors are aggressive but not senseless. Quite the contrary: their determining trait is the “willingness to devote time and care to the selection of securities that are both sound and more attractive than the average.” In other words, they are in the investment game to earn above-average market returns. Since they are not speculators trying merely to beat the market, they know they can achieve this only by putting a lot of time and effort into researching companies, determining intrinsic stock values, and making difficult decisions. If being a defensive investor is emotionally taxing, being an enterprising investor is physically and intellectually taxing: you need a lot of knowledge and skill to continuously monitor and select the right stocks. 

Over many decades, Graham notes, an enterprising investor should expect “a worthwhile reward for his extra skill and effort, in the form of better than average return realized by a defensive investor.” However, not everybody can dedicate the necessary amount of time, energy, and intellectual understanding to becoming a successful aggressive investor; on the other hand, most defensive investors, if patient, are successful.

Some basic rules for defensive and enterprising investors

“The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter,” Graham writes before suggesting four fundamental rules to follow:

1. Be adequately diversified. Aim for a minimum of ten different issues and a maximum of about 30.
2. Buy stocks from large companies. As a defensive investor, you shouldn’t be interested in startups, but in “large, prominent, and conservatively financed” companies.
3. Search for long records of continuous dividend payments. Past behavior is not always a good indicator of future performance, but long records of continuous dividend payments are. Insist on at least ten years of uninterrupted dividend payments.
4. Set a maximum price-to-earnings ratio. Set the limit of the price you’re willing to pay for a stock at about 25 times its average earnings over the past seven years, and not more than 20 times such earnings of the last year.

It’s a bit more difficult to set similar rules for enterprising investors – due to the very nature of their endeavor – but Graham suggests the following four ways they can outperform the market:

1. Market timing. Buy during bear market lows and sell during bull market highs. As attractive as this might sound, timing the market is dangerous because you will constantly have to make accurate calls.
2. Growth stocks. It’s easy to find which stocks have outperformed in the past, but it’s difficult to forecast their future performance. Moreover, if you overpay for growth, the eventual returns may be disappointing.
3. Buying bargain issues. Bargains are stocks that sell for a considerably lower amount than their intrinsic worth. Discovering them is your best bet at outperforming the market.
4. Special situations. Be on the lookout of possible bankruptcies, mergers, and reorganizations – they can offer profit opportunities. 

Final Notes

To Warren Buffett, “The Intelligent Investor” is by far the best book on investing ever written. So, it is, undoubtedly, the first book you should read if you want to get into investing. 

If you are like many others before you, then it can even be the only book on investing you’ll ever need to read. It’s that good.

12min Tip

Ignore Mr. Market and focus instead on the inherent value of the company. This is the essence of value investing.