Sunday, September 28, 2008

Fourth chapter: General portfolio policy, the defensive investor

There is an old principle out there that low risk takers should be content with a matching low returns on their investments. However, Ben Graham says that the rate of return depends on the intelligent efforts an investor is willing to undertake. Passive investors, who want both safety and freedom, should expect minimum return. An active investor with intelligence and skill can realize maximum return.

A defensive investor should allocate his funds in 2 areas : high-grade bonds and high-grade stocks. He should not have less than 25% or more than 75% in common stocks with the rest in bonds. Therefore, a common medium point would likely be 50%-50%. The percentage in stocks can go up if the market goes down and the investor sees bargains.
In real life though, most of the investors face a tough time buying bargain stocks during a bear market because they would have to go against the very human nature that produces market bulls and bears. Due to this reason, Ben Graham recommends a 50%-50% oversimplified investment portfolio.

Bonds : as far as bonds go, there are many considerations that need to be accounted for. For instance, should an investor buy taxable or tax-free bonds, long term maturity or short term? The decision can be based on the difference in yields compared to the investor's tax bracket. As an example, if the investor is in the maximum tax bracket, he will be better off buying tax-free municipal bonds than corporate bonds which will be subject to taxes.

The choice on long term to short term maturities depends on factors such as a steady, but lower annual yield (for long term) and the opportunity cost for a possible gain in principal value (again for long term).

Ben Graham has provided examples of savings bonds such as Series E and Series H and I will not elaborate them on this article since bonds may have drastically changes after so many years.

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