Monday, March 5, 2012

Benjamin Graham on Asset Allocation


Ben Graham is generally perceived to be the dean of modern security analysis.  His seminal work was titled Security Analysis, and was used for decades as the bible for all those wishing to invest in common stocks and bonds.

Graham was a very successful investor in his own right, but teaching was his true love.  For years he taught the class on investing at Columbia University, where he taught a student by the name of Warren Buffett, among hundreds of others.

Ben Graham's The Intelligent Investor was first published in 1949.  Graham was determined to try to get the average investor interested in common stocks at a time when it was widely accepted that Wall Street was a place where money went to die.

Indeed, the jacket cover of Graham's book indicated that more than 80% of Americans surveyed in 1948 thought that investing in common stocks was too risky for most people.

I first read The Intelligent Investor 30 years ago, when I was in business school.  However, I picked up the book again a few days ago, after Buffett mentioned it in his annual letter, and have been thoroughly engrossed ever since.

Graham started on Wall Street in 1914.  He mostly managed what we would consider today a hedge fund, focusing on taking large positions in undervalued companies and waiting patiently for true value to be realized.

(Graham's physical appearance, by the way, was a little like the actor Edward G. Robinson, who gain widespread fame by portraying gangsters in the movies.  You can well imagine how intimidated company managements must have been when Graham met with them in order to force strategic moves to try to unlock hidden value.)

Graham was on Wall Street for more than 50 years, which meant that he survived two World Wars and the Great Depression.  Understandably, he was obsessed with a concept called "margin of safety"; he was well aware of the risks inherent in both stocks and bonds, and would not make any investment unless he felt the odds were greatly tilted in his favor.

What I have found interesting is how Graham's approach to asset allocation differs from modern thoughts.

Most advisors today preach "stocks for the long run" and the perils of market timing.

Graham disagreed.  He felt that while most investors needed to be fully invested at all times, they should vary their asset allocation considerably based on what was available in the market.

Graham's guidance was that percentage allocation that any investor should have in stocks could range from 25% to 75% of their investment portfolio.  The remainder should be invested in high quality bonds - either corporate or municipal bonds, depending on the investor's tax situation.

In 1972, when the last version of The Intelligent Investor was published, Graham wrote that he felt that the stock market was overvalued, and that investor allocation to stocks should be close to 25% of their portfolio, or near the bottom of the allocation range.

Since corporate bonds were yielding more than 9% in the early 1970's, and municipals offered more than 5% for intermediate maturity bonds, Graham felt that investors would be better served by a portfolio mostly focused on bonds.

Interestingly, Buffett was also out of the stock market in the early 1970's.  He had closed his investment vehicle Buffett Partners in 1969, believing like his mentor Graham that stocks were overvalued.  It was not until 1974 that Buffett returned to the public markets, after the Dow had plunged more than -40%.

I believe that if Graham were alive today he would be skewing his portfolios more towards stocks than bonds.  The yields on bonds are too low, and the potential capital risk is too high, to have one's investment portfolio focused on fixed income.  Stocks, on the other hand, continue to be largely unloved, and the relative valuation of most common stocks favors equities.