In The Intelligent Investor*, Graham emphasized a distinction between two types of investors: defensive investors and enterprising investors.
The distinction is very important. Making sure that you are a defensive or enterprising investor helps you determine the right investment strategy.
This is the first thing that advisers try to figure out when they meet a new client.
Emerging asset management FinTech companies—like Wealthfront or SigFig—have made a science out of this question. These FinTech startups provide robot investment services. Your money is invested in index funds and ETF. So their main job is to shape your asset allocation strategy and they base their suggestion on your risk tolerance.
Defensive investors want to limit taking risks when they invest. They also want to spend as little time as possible on managing their assets.
Defensive investor = Safety + Freedom from bother
Defensive investors create a portfolio that does not require constant attention. They let it runs on auto-pilot.
Passive investing nowadays the most common strategy for defensive investors. Index funds and ETF are preferred over choosing specific companies. Instead of investing in Apple and Facebook in particular, a defensive investor will buy ETF that reproduces the S&P500.
Advice for Defensive Investors
1. Diversify between bonds and stocks (except when the interest rate is too low).
Bonds are safe choice when you invest. Lending money to well recognized institutions is a way to ensure safe investments.
However, when the interest rate is low (very low since 2008), you will not earn a lot from your investment. Balancing by allocating part of your savings in stocks will compensate the low return on interest of the bonds.
2. Confine yourself to the shares of important companies with a record of profitable operations and in strong financial conditions.
When you invest in companies’ stocks, you should prefer highly recognized companies. It will make your investment safer. Of course, the stocks have to be bought at reasonable prices.
3. Other method for defensive investors: the dollar-cost averaging.
Enterprising investors have high expectations for their investments. As they want high returns, they are willing to spend more time to do analysis and research.
Enterprising investor = Expectation of doing better than the average + Willingness to spend time
Enterprising investors constantly monitor their portfolio by researching and selecting stocks and bonds. They are actively looking for great deals. Their approach is quite similar to what speculators do. Cf. How to Speculate like Jesse Livermore.
Advice for Enterprising Investors:
1. Avoid popular ideas
Follow investment strategies, which are inherently sound and promising. If they not popular among professional/amateur traders, it is often a good idea.
This principle highlights Graham’s reluctance to follow popular policies. Most of the time, the majority is wrong.
This idea is not surprising when you remember one of Warren Buffett’s famous quote: “Be fearful when others are greedy and greedy when others are fearful”. Graham was Warren Buffett’s first mentor.
2. Identify undervalued companies
Invest in companies’ stocks that suffer from temporary lack of interest or unjustified popular prejudice. These companies should have strong businesses and assets.
By identifying a gap between value and price, you will take smaller risks when you invest.
Before you start investing, you should define which type of investor you are. So are you a defensive investor or an enterprising investor.
*The Intelligent Investor is the first step of becoming an intelligent investor. I will continue to refer to this book in the next articles. Seasoned investors such as Warren Buffett or Peter Flynch consider this book as a must-have. Do not miss any opportunity and buy it now.