The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [45]
Both approaches are equally intelligent, and you can be successful with either—but only if you know yourself well enough to pick the right one, stick with it over the course of your investing lifetime, and keep your costs and emotions under control. Graham’s distinction between active and passive investors is another of his reminders that financial risk lies not only where most of us look for it—in the economy or in our investments—but also within ourselves.
Can You be Brave, or will You Cave?
How, then, should a defensive investor get started? The first and most basic decision is how much to put in stocks and how much to put in bonds and cash. (Note that Graham deliberately places this discussion after his chapter on inflation, forearming you with the knowledge that inflation is one of your worst enemies.)
The most striking thing about Graham’s discussion of how to allocate your assets between stocks and bonds is that he never mentions the word “age.” That sets his advice firmly against the winds of conventional wisdom—which holds that how much investing risk you ought to take depends mainly on how old you are.2 A traditional rule of thumb was to subtract your age from 100 and invest that percentage of your assets in stocks, with the rest in bonds or cash. (A 28-year-old would put 72% of her money in stocks; an 81-year-old would put only 19% there.) Like everything else, these assumptions got overheated in the late 1990s. By 1999, a popular book argued that if you were younger than 30 you should put 95% of your money in stocks—even if you had only a “moderate” tolerance for risk!3
Unless you’ve allowed the proponents of this advice to subtract 100 from your IQ, you should be able to tell that something is wrong here. Why should your age determine how much risk you can take? An 89-year-old with $3 million, an ample pension, and a gaggle of grandchildren would be foolish to move most of her money into bonds. She already has plenty of income, and her grandchildren (who will eventually inherit her stocks) have decades of investing ahead of them. On the other hand, a 25-year-old who is saving for his wedding and a house down payment would be out of his mind to put all his money in stocks. If the stock market takes an Acapulco high dive, he will have no bond income to cover his downside—or his backside.
What’s more, no matter how young you are, you might suddenly need to yank your money out of stocks not 40 years from now, but 40 minutes from now. Without a whiff of warning, you could lose your job, get divorced, become disabled, or suffer who knows what other kind of surprise. The unexpected can strike anyone, at any age. Everyone must keep some assets in the riskless haven of cash.
Finally, many people stop investing precisely because the stock market goes down. Psychologists have shown that most of us do a very poor job of predicting today how we will feel about an emotionally charged event in the future.4 When stocks are going up 15% or 20% a year, as they did in the 1980s and 1990s, it’s easy to imagine that you and your stocks are married for life. But when you watch every dollar you invested getting bashed down to a dime, it’s hard to resist bailing out into the “safety” of bonds and cash. Instead of buying and holding their stocks, many people end up buying high, selling low, and holding nothing but their own head in their hands. Because so few investors have the guts to cling to stocks in a falling market, Graham insists that everyone should keep a minimum of 25% in bonds. That cushion, he argues, will give you the courage to keep the rest of your money in stocks even when stocks stink.
To get a better feel for how much risk you can take, think about the fundamental circumstances of your life, when they will kick in, when they might change, and how they are likely to affect your need for cash:
Are you single or married? What does your spouse or partner do for a living?
Do you or