Thursday, March 24, 2011

The Intelligent Investor (part I)

I have been reading Benjamin Graham's book "The Intelligent Investor". Some thoughts of the first five chapters of the book that Warren Buffett has stated to be “by far the best book on investing ever written”:

Graham advices you never to have more than 75% of your total funds in stocks (the rest being allocated to bonds). His advice is probably valid for most investors and especially the ones who can’t afford to take significant losses or are in it for the short run (in which case you should not in my opinion be invested into stock market at all). One of the earliest books I read on investing stated “never to invest more money than you can’t afford to loose”. I live by that advice.
In my opinion, to be 100% invested into stock market you should:
• set aside pension etc. related investments that you can’t afford to lose (in Finland this is automatic – I have zero control over my work pension because of how our system works – unfortunately so in my opinion)

• set aside enough cash to cover any foreseeable sudden (unplanned) expense (e.g. broken car/refridgerator etc.). Our buffer is approximately what our family spends in three months. This has proved to cover even multiple large sudden expenses.

• have adequate protection in case of unemployment (in my case, I am guaranteed at least 6 months full pay + 500 days of partial salary – what happens after that is then up to combined income of me and my wife. However, in Finland everyone is guaranteed minimum amount of income for the very basic needs indefinitely)

• be debt free

• preferably own a house / apartment (i.e. limit your monthly payments and diversify your assets - a house is also a very long term investment like stocks should be)

• not be planning to use the money for anything in the foreseeable future

Graham advices you to “have adequate though not excessive diversification”. By this he means between 10-30 stocks. I don’t want to put myself any specific limit, but his advice seems like an excellent starting point. Even 20 stocks or so requires quite much work to select and manage. This I already know. I consider exchange traded index funds (ETF) to be an excellent way to diversify without having the need to do a lot of research.

However, if you have the interest and the time to do research then picking a few large cap stocks from inside an index fund may be a good idea. If you are in it for the long run, then you will save a lot of money. Total expense ratio of an average index fund ranges from 0,3% to 1% annually. On top of that, many ETFs have way larger spreads than most of their holdings. This means you pay additional 0.5-1% or so extra every time you buy or sell.

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