It is prevailing to the market that if we take a low risk then our return will be comparatively lower and we get a higher return with higher the risk. But actually, it is not always true. When we acquire a bargain situation with the proper margin of safety then we have a higher probability to get a higher return with the lower or controlled risk.
Mr. Graham has explained “Active” or “Enterprising” investor and “Passive” or “Defensive” investor –
When we have time to spare, competitive thinking then we need to select the active investment strategy and when we cannot spare time on investment, do not keep on thinking about money then passive investment strategy is suitable for us. So that we have to select what works for us, which strategy is suitable to us rather what has worked in the market. If we cannot spend time researching the companies, what was going on to the business, etc then we should select a passive style of investing.
As we have seen in the review of the second chapter that defensive investors have an allocation to the bond as well as common stocks. And they makeshift from common stocks to the bond when they found a higher valuation of common stocks. As per Mr. Graham, If we have chosen to have a 50-50% allocation to the bond and the common stocks. So, at that time, if our stock allocation goes to 55% then sell off of additional 5% and transfer it to the bond and if common stocks allocation goes to 45% then bring 5% by selling off of bonds. This is one of the simple formulae for the defensive investor. Defensive investors have a strategy to fall less than the market during the worst time. And such a strategy can be helpful to them.
One of the other strategies is recommended by Mr. Graham –
Example
If we have a dividend of Rs.720, SENSEX at 36000 and bond yield is 7% then we need to allocate 75% to the bond and 25% to the common stocks because 2/3rd of the 7% is 4.67% and we are currently getting a dividend yield of 2% on the SENSEX. Now, we need to wait for fall into the bond yield or reduction to the level of the SENSEX for increasing the allocation to the common stocks. It’s just a hypothetical example. The dividend yield in India has not reached at such a higher level, especially into the Index so that we can go for the earning yield.
*Red indicates exit and green indicate entry
As we see that Mr. Graham indicator suggesting overvaluation in the SENSEX. And for getting it fair value -1) Risk-free rate has to fall, or 2) Earning has to increase (At least by 10%) or 3) SENSEX has to fall (At least by 10%). Rate cuts have given a positive boost to the market but if earning will not pick up then the market has to fall. If anyone has invested 100% into debt fund in the red zone and invested 100% into the green zone then the person has earned ~15% CAGR compared to ~11% CAGR of SENSEX.
When investors select the lower quality of the bond then return on it will get increase compared to the high-grade bond. We need to focus on to the buying a bond at the discount for getting a higher yield on it but with the same level of quality.
Defensive investors also can deploy fund to the FD, liquid fund, bond, preference shares, convertibles, etc.
For the allocation to the bond and stocks by defensive investors, an old theory which was prevailing to the market was deducting age from 100 and remaining amount consider as a % to invest in the stocks. That is if age is 28 years then 72% (100-28) of the net-worth will be into the stocks. But age should not be a factor in considering the risk-taking ability of any person. If someone at the age of 80 also well settled and having a good fund for spending his life then he can take more allocation stock also and does not just have to deploy 20% (100-80) to the stocks.
It is also possible that 20 years old person saving money for his further education, marriage in future, house, etc. So, he may not be able to deploy 80% (100-20) to the stocks. Allocation to the common stock or the bond depends on everyone’s risk-taking ability. We should not generalize certain allocation percentage for everyone.
This is what happens to the market and keeps on repeating in the future also.
For allocating to the stocks and bond, we need to look at our life and situations where we require cash. We can ask a few questions to ourselves before making an allocation.
We need to allocate to the bond and stocks, after considering all the above point. But as Mr. Graham mentioned that we need to make a minimum allocation of 25% to the maximum 75% the bond. When we make an allocation decision, then we need to change that allocation only while our situation at life changes. Not when the market starts moving upward. If we need a constant fixed amount of cash-flow to spend for the household expenses, covering the cost of living then bond only provides those cash flow rather to common stocks. We only can put 100% to the stocks if we have enough money to support our spending, survived during a bear market, we can able to buy more stocks to the bear market, we do not need to sell stocks for survival, we can invest for at least 20 years.
Disclosure – Companies mentioned in the article is just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig