Intelligent Investor #7 – How to Start Buying Stocks without too much Risk

Buying stocks as an investor is exciting and can be quite profitable. In The Intelligent Investor*, Graham recommends defensive investors to have at least 25% of stocks in their portfolio.

The best way to boost your return on investment.

Stocks are most of the time more profitable than bonds.

This article teaches defensive investors how to buy stocks. There are several principles you must know in order to increase profits from your portfolio.

Consider yourself as are a defensive investor, if you do not want to put time and energy in your investments.

How to Buy Stocks

Buy Stocks for the First Time

Before deciding to buy stocks for the first time, you need to be aware of a principle: the concept of reasonable price.

We commonly believe that investing on the stock market is safe when stock prices are high. I do not know the exact reason but expensive stocks are reassuring, even though that’s wrong.

Perhaps, we think that because prices are high more people want to buy stocks. Conversely, we are reluctant to invest in stocks when prices are low. It makes us fearful.

Actually, it is the opposite. We should buy cheaper stocks.

Graham often repeated that prices must be reasonable before we decide to buy some stocks. If you spot a company that makes you eager because you love the business, you should look at its stock price—and its financial sta

1. Do not buy popular stocks

The concept of reasonable price means that the best stocks to buy are overlooked stocks because they are cheap. Popular stocks are often overpriced, overvalued.

Of course, we can sometimes be mistaken when we avoid stocks that seemed too expensive.

If stock prices soared after we decide not to buy, we should try to learn from this failure. What information did we miss? Be happy, it might be better to miss an opportunity rather than to buy stocks whose price dropped just after because the company was overvalued.

Overvaluation is a symptom of coming bubble. The dot-com bubble led the Internet companies’ stocks to become really expensive. Everyone was eager about the Internet and wanted to be part of the gold rush. Stock prices were at the top. When the bubble burst, many investors were ruined.

How to Buy Stocks: Graham’s Recommendations for Defensive Investors

1. Diversify your portfolio

Adequate diversification means buying 10 to 30 stocks. By diversifying your portfolio, you are spreading the risk of volatility on different investments (Investopedia). If a company goes bankrupt, part of your saving will still be safe. Why investing in 10 to 30 different stocks? More than 30 is too difficult to follow. Less than 10 does not enable you to have a diversified portfolio.

2. Invest in large, prominent and conservatively financed companies

These companies are less likely to collapse. They have a good track record. And also past performance does not guarantee future performance, these companies’ stocks are a safer investment than growth stocks.

3. Look at the record of dividend payments

Dividends should be taken into account. Although dividend interest rate is often inferior to bonds’ interest, dividends are part of the return you can expect when you buy common stocks.

4. Put limit on stocks prices

Price must be inferior to 20-25 average earnings on the past several years. If the price is higher, it means that the company borrows a lot and then takes risks in order to grow. Basically, Graham’s advice is to banish growth stocks (e.g. tech companies) from your defensive portfolio.

As a Defensive Investor, Avoid Growth Stocks

Investing in growth stocks is regarded as too risky for defensive investors. They include speculative elements. Their prices are high in relation to the average earnings.

Growth stocks include stocks of companies that borrow a lot, such as tech companies. Borrowing reduces their earnings in order to finance their growth, which make growth stocks investment riskier.

Moreover, tech companies are vulnerable to adverse development. An overnight innovation can turn upside down an entire industry. Recent examples such as Kodak or RIM (Blackberry) confirm Graham’s prudent recommendation.

Spotting profitable growth stocks requires experience and time. Such stocks are rare. Since defensive investors do not want to be bothered, it is preferable to be focused on large companies that are overlooked and can, therefore, be bought at reasonable P/E ratios.

Take Away

1. Buy stocks at reasonable price
2. Diversify your portfolio
3. Avoid growth stocks and risky investment

*To get more information on how to buy stocks in a defensive portfolio, I recommend you to read The Intelligent Investor by Ben Graham. Successful investors such as Warren Buffet consider this book as a must-have. Do not miss any opportunity and buy it now.