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The Surprising Thing I Learned From Rereading Benjamin Graham's "The Intelligent Investor"

By John Maxfield - Dec 12, 2014 at 3:03PM

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Most people associate Benjamin Graham with value investing. But you might be surprised to learn that he was an early and adamant proponent of indexing.

To many investors, Benjamin Graham's seminal 1949 book on investing, The Intelligent Investor, stands for the idea that the individual investor can beat the market by focusing on undervalued stocks. But what's less appreciated is his advice that most investors should not actually try to do so.

The siren song of market-beating returns
Graham made this point when discussing stock selection for the "enterprising investor" -- that is, a person who is willing and able to dedicate time and energy to the task of outperforming the broader market. "It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits," Graham wrote.

He based his opinion on the fact that beating the market has proven to be an often-insurmountable objective even for investment professionals of the highest order. A study cited by Graham, for example, found that random portfolios of blue-chip stocks on average performed better than actively managed mutual funds in the same risk class.

In Graham's estimation, "The failure of [mutual] funds to better the performance of a broad average is a pretty conclusive indication that such an achievement, instead of being easy, is in fact extremely difficult."

Graham is in good company
Graham is not alone in advising individual investors to resist the siren song of market-beating returns when they lack adequate training and experience. In fact, most of the greatest investors and speculators in history have written variations of the same theme.

Here's Bernard Baruch, one of the most successful stock operators of the Gilded Age:

Success in speculation requires as much specialized knowledge as success in law or medicine or any other profession. It never would occur to anyone to open a department store in competition with Macy's or Gimbel's or to make motor cars against Ford and General Motors without prior training or preparation. Yet the same man will cheerfully toss his savings into a market dominated by men who are as expert in their line as Macy's and the auto makers are in theirs.

Here's Jesse Livermore, a famed speculator who made and lost half a dozen fortunes during his time on Wall Street:

The one game of all games that really requires study before making a play is the one he goes into without his usual highly intelligent preliminary and precautionary doubts. He will risk half his fortune in the stock market with less reflection than he devotes to the selection of a medium-priced automobile.

Here's Henry Clews, the "sage of Wall Street" in the decades after the Civil War:

Speculation is a business that must be studied as a specialty, and though it is popularly believed that any man who has money can speculate, yet the ordinary man, without special training in the business, is liable to make as great a mistake in this attempt, as the man who thinks he can act as his own lawyer, and who is said "to have a fool for a client."

Finally, here's Philip Fisher, an author and investor who served as one of the main inspirations behind Warren Buffett's multipronged investment philosophy:

I am aware that most investors are not in a position to do for themselves much of what is needed to get the most from their investment funds.

The scourge of disappointing returns
Recent research backs up the Graham's assertion that individual investors are better off settling for the more certain returns of the broader market rather than the uncertain, generally inferior returns achieved by attempting to beat it.

Every year, Dalbar, a Boston-based consulting company that focuses on the financial industry, publishes a quantitative analysis of investor behavior that is designed to assess, among other things, how well the typical investor performs compared to the S&P 500. And every year, Dalbar has reached the dismal conclusion that most investors come up short.

According to Dalbar's latest analysis, the average equity fund investor earned 5% per year over the last two decades. By contrast, the S&P 500 achieved an average annual return of 9.2% over the same period -- nearly twice that of the typical investor.

The good news is that this gap has narrowed since Dalbar began tracking it in 1998. That year, Dalbar estimated that the gap between the average annual return of the typical investor and the S&P 500 over the previous two decades was 10.7%. However, the bad news is that not only does the discrepancy persist, but the behaviors underlying it -- namely, trading in and out of the market at inopportune times -- seem impervious to education.

"Attempts to correct irrational investor behavior through education have proved to be futile," the authors noted. "The belief that investors will make prudent decisions after education and disclosure has been totally discredited."

A superior approach to individual investing
It's for these reasons that Graham urged investors to consider alternative strategies that don't include trading in and out of individual stocks. One approach is to hire an investment advisor. A second approach recommended by Graham is to index -- that is, to structure your portfolio in such a way that it tracks the returns of the broader market.

At the time Graham wrote The Intelligent Investor, indexing was a manual process that required investors to purchase a "diversified list of leading common stocks." Today, it's much simpler: All you have to do is buy an exchange-traded fund. The one that comes immediately to mind is the Vanguard S&P 500, which, as its name implies, tracks the returns of the S&P 500.

Graham also suggested that investors combine indexing with a strategy known as dollar-cost averaging, in which a person invests the same amount of money every month, quarter, or year regardless of stock prices. By doing so, one can insulate his or her portfolio from the natural tendency to buy when everyone else is buying (i.e., when prices are high) and sell when everyone else is selling (when prices are low).

As Graham himself noted, "No one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as dollar-cost averaging." For the record, he attributed this quote to Lucile Tomlinson, who had conducted a comprehensive study of formula investment plans.

In defense of indexing
When I reread The Intelligent Investor, along with an assortment of other classic books on investing, the last thing I expected to come away with was a ringing endorsement of index investing. Yet that is exactly what the father of value investing recommended for most investors, if not all investors, who choose to go it alone.

This is a powerful insight. And it's one that individual investors would be wise to adopt. In sum, not only is it simple, but if followed judiciously, it protects the individual investor from the emotional impulses that would often otherwise wreak havoc on his or her returns.

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