Benjamin Graham Lesson 1 Definition of Investing

Benjamin Graham´s definition of investing is:

”An investment operation is one which, upon thorough analysis, promises safety of a principal and a satisfactory return”.

Investing is not an exact science, as we can see from the definition. Different components of the definition, promising safety of a principal, a satisfactory return, and a thorough analysis are interwoven. It is hard to achieve safety of a principal and a satisfactory return without a thorough analysis. Safety of a principal means protecting yourself from losses, which obey the reasonable probabilities. Graham thought that the most important function of investing is keeping your principal safe. Avoiding serious losses is the most important thing for an investor. Graham preferred investing in bonds and stocks. Company´s ability to make profit and its relation to its financial responsibilities told Graham how safe were the investor´s principal. Graham also thought that the paid price had to be reasonable. Graham also thought that individual investments could deliver losses. This is one reason why he favored diversification.

Graham defined a satisfactory return as ”Any investment return that an investor is willing to accept, when he functions with a reasonable intelligence”. A satisfactory return depends on the security. An intelligent investor cannot aim to reach for the moon. The historical real stock market returns have been annually around 7 per cent on average, when dividends are invested in stocks. All the other asset classes have even lower average annual returns. When you think about satisfactory returns, you have to consider historical returns too. Unreasonable expectations for investment returns will eventually lead to losses of principal.

The safety of a principal and a satisfactory return are related to the price you pay. This price is defined with a thorough analysis. Defining this price is not an exact science. You need to define the price range. For example, a price range between 15 and 20 dollars a share. This is important. A thorough analysis means you need to think about many variables. You cannot be sure about the future. You need to have a range for the price. A thorough analysis means investigating all the essential facts. I will get back to this process after the next lesson.

I have a question for you to think about: ”What kind of annual real returns would be satisfactory for you in the next ten years? Think about the historical 7% annual returns in stocks and consider what you can get. Use any clues you can and want to find.

- Tommi Taavila ©2018