For most investors, the best approach to owning stocks is through low-cost, broadly diversified index funds, dollar-cost averaging, and reinvesting dividends. Experienced investors, professional money managers, and institutions often prefer to select individual stocks, building a portfolio brick-by-brick based upon an analysis of the individual firms.
For those few do-it-yourself investors, the father of value investing himself, Benjamin Graham, identified five categories of common stock investing that could conceivably result in better-than-average returns.
Benjamin Graham and His Philosophies
Benjamin Graham was an investor and author. He is considered the father of value investing because he was one of the first people to use financial analysis to invest in stocks—and he did so successfully. Graham created many of the standards and principles that many modern investors are still using today.
Graham goes on to address the specific quandary every active investor will face in determining how to manage his or her portfolio, saying:
"Whether the investor should attempt to buy low and sell high, or whether he should be content to hold sound securities through thick and thin—subject only to periodic examination of their intrinsic merits—is one of the several choices of policy which the individual must make for himself. Here temperament and the personal situation may well be the determining factors."
He argues that someone close to the business world may be comfortable with an active, buy-low, sell-high strategy. However, for the rest of us, simply taking a long-term view and investing in funds that track the market is a more sensible investing strategy.
Let's dive into the five categories of investing Graham first shared in his 1949 version of "The Intelligent Investor."
General trading involves anticipating or participating in the moves of the market as a whole, as reflected in the familiar averages. This strategy is in line with dollar-cost averaging, which involves spreading out investment purchases to reduce the impact of market volatility and ensure you don't put lump sums of money into an investment while its price is unreasonably high.
Selective trading involves picking out stocks that will do better than the market over a period of a year or less. Of course, this is easier said than done, but an investor can examine factors such as market changes or pending government regulation changes to make educated decisions. For example, a company that was recently granted a patent may be in a better position to flourish in the short term due to the new competitive advantage they've developed.
Buying Cheap and Selling Dear
"Buying cheap and selling dear" may not sound familiar, but perhaps the phrases "buying the dip" and "buying low and selling high" ring a bell. Investors are infamously irrational; many choose to buy while prices are rising and sell while prices are dropping. Value investors, however, follow the opposite approach. They enter the market and purchase investments when prices are low and sell when the prices are high.
Understanding the importance of intrinsic value and long-term growth, value investors avoid many of the pitfalls that come along with acting based on a stock's fluctuating price.
Long-pull selection involves picking out companies that will prosper over the years far more than the average enterprise, often referred to as growth stocks. These companies are typically newer companies and startups that have significant room for growth in their business model and activities.
Bargain purchases involve selecting shares that are selling considerably below their true value, as measured by reasonably dependable techniques. The most common measurement used to determine if a stock is undervalued or overvalued is its price-to-earnings (P/E) ratio, which can be found by dividing a company's share price by its earnings per share (EPS). The EPS is found by dividing a company's profits by its outstanding shares.
For example, a company that made $1 million in profits and has 100,000 outstanding shares would have an EPS of $10. If the share price is $40, the P/E ratio would be 4. To get a better perspective of the value of a stock, compare its P/E ratio to similar companies in its sector; a technology startup's EPS should not be compared with an agriculture company's EPS.
Alternatives to Graham’s Strategies
We have shared five categories of common stock investing that Benjamin Graham stood by. While he is the "father of value investing," here are a few alternatives that investors can look into.
When Benjamin Graham first wrote "The Intelligent Investor," index funds weren't yet created. Though, this investing style is something he praised in interviews later in his life.
Index funds are passively managed funds that hold securities based on the same securities an underlying index holds.
For example, the Vanguard 500 Index Fund (FVIAX) aims to have the same composition as the S&P 500. Index investing is attractive because it requires minimal work, has low fees, offers diversification, and achieves returns similar to the market any particular fund tracks. You simply purchase shares of the index while following some of Graham's other philosophies including dollar-cost averaging and holding for the long-term.
Simply put, momentum investing involves purchasing securities that are rising and selling securities that are performing poorly. The idea is similar to catching and riding a wave. The strategy is fairly straightforward to implement. An investor can buy stocks that have had above-average returns for the past three to 12 months and sell those that underperformed during the same time frame.
Socially Responsible Investing
This investing strategy has been growing in popularity in recent years. Investors choose companies who look to create a positive change in society by tackling social issues such as climate change, hunger, gender equality, racial equality, and more—all while earning positive returns. Companies are now scored with Environmental, Social, and Governance (ESG) ratings. A rating could land a company in a socially responsible investing (SRI) index such as the ones Morgan Stanley Capital International (MSCI) offers.
The Bottom Line
In this particular area of portfolio management, there is no right or wrong answer as long as you are behaving rationally, using facts and data to back up your practices, and continuously striving to reduce risk while maintaining liquidity and safety. You have to decide for yourself what kind of investor you are going to be.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.