In this chapter, Graham examines the methodology of choosing an investment fund. This chapter holds an incredible amount of importance today as people lose the time to actively manage their portfolios, and sets a foundation for what most investors should aim to provide for their customers.
First, Graham discusses the difference between open-end and closed-end funds. While the number of shares in open-end funds is constantly fluctuating because of clients buying and selling off shares, closed-end funds maintain a constant number of shares. Additionally, open-end funds are more likely to charge substantial fees for managing client's dollars. This creates a distinct disadvantage for the client, not only in the beginning when the fee is charged, but throughout their time with the fund. Closed-end funds, on the other hand, both cost less for the client and provide a higher ending return because of their lack of a commission.
Graham also discusses "performance funds", which I feel like have risen in prominence in the modern day. These funds, typically managed by young and relatively inexperienced people, only aim to beat the market substantially using growth stocks. Growth stocks, however, are often extremely risky and speculative, which causes the incredible crashes that we have seen throughout history. In addition to speculation, these funds also carry with them the threat of fraud and counterfeit.
Overall, individual investors seeking professional management for their portfolios should look toward small, closed-end funds that have a strong track record and have stopped taking in capital.
This second chapter delineates the argument that the intelligent investor should hold both stocks and bonds at all times. Benjamin Graham sets up the scenario of inflation, which begins the argument why stocks are necessary in a portfolio. When inflation goes up, the earnings that you receive on bonds (other than TIPS) goes down, and if the inflation rate outpaces the interest rate on the bond, investors may even lose money. Stocks, on the other hand, are not affected by inflation.
Changes in the market price generally trend with the growth of business earnings, and many believe that inflation must change the earnings rate of a corporation. Graham has found, however, that these two are not correlated, and even proves that earnings rates can go down even when inflation is increasing. Because of this, stocks offer a relatively effective hedge for inflation.
Investors must, however, also be weary of maintaining an all-stock portfolio. While stocks do tend to earn more than bonds, they are less safe because they are unsecured by the government. By including bonds in a portfolio, you are adding a significant amount of safety, which can potentially enable you to make steadier earnings. In addition, those with all-stock portfolios may get caught up in the whims of the market, and make biased and ineffective investment decisions because of it.
In this first Chapter of The Intelligent Investor, Benjamin Graham first sets out to examine the differences between investors and speculators. During this time (the early 1970s), Wall Street began to erase the distinction between these two groups, ultimately leading investors to believe that investing in the stock market was risky and purely speculative. Graham states that while investors make sound and profitable decisions through thorough research, speculators are driven by their own bias, which causes inaccurate valuations. The fact that most of the market is made up of speculators creates large market swings, which investors can then take advantage of and wait for the price to return to its intrinsic value.
Distinguishing yourself from speculators, however, is only half of the battle. To effectively be a profitable investor, you must overcome the obstacles of human fallibility and the inherent competition that exists in investing. Human fallibility is one of the largest problems that investors face. If you find a strategy that is reliably profitable for you, chances are that another investor has already found and used that strategy before (the same also applies to undervalued companies). Therefore, intelligent investors must choose companies that are unpopular in the larger market. The second obstacle, the nature of competition, deals with the difficulty in accurately projecting things like growth and interest rates. This especially applies when making long-term investment decisions, when predicting these rates becomes more difficult. Because of this obstacle, research and sound logic are required when making investments.
Finally, to be a successful value investor, one must avoid trading along the market, making investments based off of earnings reports, and hopeful predictions of the future.
Synopsis (Taken from Goodreads)
The greatest investment advisor of the twentieth century, Benjamin Graham taught and inspired people worldwide. Graham's philosophy of "value investing" -- which shields investors from substantial error and teaches them to develop long-term strategies -- has made The Intelligent Investor the stock market bible ever since its original publication in 1949.