Chapter Sixteen

What Would Benjamin Graham Have Thought about Indexing?

A Confirmation from Mr. Buffett

 

 

 

 

THE FIRST EDITION OF The Intelligent Investor was published in 1949. It was written by Benjamin Graham, the most respected money manager of the era, and coauthor (with David Dodd) of Security Analysis, a scholarly tome originally published in 1934. The Intelligent Investor is regarded as the best book of its kind—comprehensive, analytical, perceptive, and forthright—a book for the ages.

Although Benjamin Graham is best known by far for his focus on the kind of value investing represented by the category of stocks he describes as “bargain issues,” he cautioned, “the aggressive investor must have a considerable knowledge of security values—enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise. . . . It follows from this reasoning that the majority of security owners should elect the defensive classification.”

The majority of investors should be satisfied with the reasonably good return obtainable from a defensive portfolio.

Why? Because “[the majority of investors] do not have the time, or the determination, or the mental equipment to embark upon such investing as a quasi-business. They should therefore be satisfied with the reasonably good return obtainable from a defensive portfolio, and they should stoutly resist the recurrent temptation to increase this return by deviating into other paths.” While the index fund was not even imagined in 1949, he was certainly describing the very approach that this precedent-setting fund would later follow. (Coincidently, it was also in 1949 that an article in Fortune magazine introduced me to the mutual fund industry, inspiring me to write my 1951 Princeton senior thesis on mutual funds, in which I even hinted at the index fund idea: “Mutual funds can make no claim to superiority over the market averages.”)

For the defensive investor who required assistance, Graham originally recommended professional investment advisers who rely on “normal investment experience for their results . . . and who make no claim to being brilliant (but) pride themselves on being careful, conservative, and competent . . . whose chief value to their clients is in shielding them from costly mistakes.” He cautioned about expecting too much from stock-exchange houses, arguing that “the Wall Street business fraternity . . . is still feeling its way toward the high standards and standing of a profession.” (A half-century later, the quest remains far from complete.)

He also noted, profoundly if obviously, that Wall Street is “in business to make commissions, and that the way to succeed in business is to give customers what they want, trying hard to make money in a field where they are condemned almost by mathematical law to lose.” Later on, in 1976, Graham described his opinion of Wall Street as, “highly unfavorable . . . a Falstaffian joke that frequently degenerates into a madhouse . . . a huge laundry in which institutions take in large blocks of each other’s washing.” (Shades of Harvard’s Jack Meyer and Yale’s David Swensen, from whom we heard earlier.)

In that first edition of The Intelligent Investor, Graham commended the use by investors of leading investment funds as an alternative to creating their own portfolios. Graham described the well-established mutual funds of his era as “competently managed, making fewer mistakes than the typical small investor,” carrying a reasonable expense, and performing a sound function by acquiring and holding an adequately diversified list of common stocks.

But he was bluntly realistic about what fund managers might accomplish. He illustrated this point in his book with data showing that from 1937 through 1947, when the Standard & Poor’s 500 Index provided a total return of 57 percent, the average mutual fund produced a total return of 54 percent, excluding the oppressive impact of sales loads. (The more things change, the more they remain the same.) Graham’s conclusion: “The figures are not very impressive in either direction . . . on the whole, the managerial ability of invested funds has been just about able to absorb the expense burden and the drag of uninvested cash.” In 1949, fund expenses and turnover costs were far lower than in the modern fund industry. That change explains why, as fund returns were overwhelmed by these costs in recent decades, the figures were impressive only in a negative direction.

By 1965, Graham’s confidence that funds would produce the market’s return, less costs, was somewhat shaken. “Unsoundly managed funds,” he noted in a later edition of The Intelligent Investor, “can produce spectacular but largely illusionary profits for a while, followed inevitably by calamitous losses.” He was describing the so-called performance funds of the mid-1960s Go-Go era, in which a “new breed that had a spectacular knack for coming up with winners . . . (managed by) bright, energetic, young people who promised to perform miracles with other people’s money . . . (but) who have inevitably brought losses to their public in the end.” He could have as easily been presciently describing the hundreds of risky “new economy” mutual funds formed during the great bull market of 1998 to 2000, and their utter collapse in the subsequent 50 percent market crash that followed.

“Unsoundly managed funds can produce spectacular but largely illusionary profits for a while, followed inevitably by calamitous losses.”

Graham also would have been appalled, not only by the enormous (100 percent-plus) increase in those once-reasonable fund expenses, but also by the incredible increase in stock trading in mutual fund portfolios. During Graham’s era, portfolio turnover ran to about 15 percent per year. It now averages more than 100 percent. Graham would surely, and accurately, have described such an approach as rank speculation that flies directly in the face of his deeply held investment principles.

Graham’s timeless lesson for the intelligent investor, as valid today as when he prescribed it in his first edition, is clear: “the real money in investment will have to be made—as most of it has been made in the past—not out of buying and selling but of owning and holding securities, receiving interest and dividends and increases in value.” His philosophy has been reflected over and over again in this book, exemplified in the parable of the Gotrocks family in Chapter 1 and the distinction between the business market and the expectations market in Chapter 2.

The real money in investment will be made not out of buying and selling but of owning and holding securities.

Owning and holding a diversified list of securities? Wouldn’t Graham recommend a fund that essentially buys the entire stock market and holds it forever, patiently receiving interest and dividends and increases in value? Doesn’t his admonition to “strictly adhere to standard, conservative, and even unimaginative forms of investment,” eerily echo the concept of market indexing? When he advises the defensive investor “to emphasize diversification more than individual selection,” hasn’t Benjamin Graham come within inches of describing the modern-day stock index fund?

Late in his life, in an interview published in 1976, Graham candidly acknowledged the inevitable failure of individual investment managers to outpace the market. (Again coincidentally, the interview took place at the very moment that the public offering of the world’s first mutual index fund—First Index Investment Trust, now Vanguard 500 Index Fund—was taking place.) He was asked, “Can the average manager obtain better results than the Standard & Poor’s Index over the years?” Graham’s blunt response: “No.” Then he explained: “In effect that would mean that the stock market experts as a whole could beat themselves—a logical contradiction.”²³

Then he was asked whether investors should be content with earning the market’s return. Graham’s answer: “Yes.” All these years later, the idea that earning your fair share of the stock market’s return is the winning strategy is the central theme of this Little Book. Only the classic index fund can guarantee that outcome.

Finally, he was asked about the objection made against the index fund—that different investors have different requirements. Again, Graham responded bluntly: “At bottom that is only a convenient cliché or alibi to justify the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results.”

“I see no reason why investors should be content with results inferior to those of an indexed fund.”

The name Benjamin Graham is intimately connected, indeed almost synonymous, with “value investing” and the search for undervalued securities. But his classic book gives far more attention to the down-to-earth basics of portfolio policy—the straightforward, uncomplicated principles of diversification and rational long-term expectations, two of the overarching themes of the little book you are now reading—than to solving the sphinxlike riddle of selecting superior stocks through careful security analysis.

Graham was also well aware that the superior rewards he had reaped using his valuation principles would be difficult to achieve in the future. In that 1976 interview, he made this remarkable concession, “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, but the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

It is fair to say that, by Graham’s demanding standards, the overwhelming majority of today’s mutual funds, largely because of their high costs and speculative behavior, have failed to live up to their promise. As a result, a new type of fund—the index fund—is now gradually moving toward ascendancy. Why? Both because of what it does—providing the broadest possible diversification—and because of what it doesn’t do—neither assessing high costs nor engaging in high turnover. These paraphrases of Graham’s copybook maxims are an important part of his legacy to that vast majority of shareholders who, he believed, should follow the principles he outlined for the defensive investor.

“To achieve satisfactory investment results is easier than most people realize.”

It is Benjamin Graham’s common sense, clear thinking, simplicity, and sense of financial history—along with his willingness to hold fast to the sound principles of long-term investing—that constitute his lasting legacy. He sums up his advice: “Fortunately for the typical investor, it is by no means necessary for his success that he bring the time-honored qualities . . . of courage, knowledge, judgment and experience . . . to bear upon his program—provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard, defensive investment. To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”

When it’s so easy—in fact unbelievably simple—to capture the stock market’s returns through an index fund, you don’t need to take extra risks—and wasteful costs—in striving for superior results. With Benjamin Graham’s long perspective, common sense, hard realism, and wise intellect, there is no doubt whatsoever in my mind that he would have applauded the index fund.

Don’t Take My Word for It

While Benjamin Graham’s clearly written commentary can easily be read as an endorsement of a low-cost all-stock-market index fund, don’t take my word for it. Listen instead to Warren Buffett, his protégé and collaborator whose counsel and practical aid Graham acknowledged as invaluable in the final edition of The Intelligent Investor. In 1993, Buffett, unequivocally endorsed the index fund. In 2006, he went even further, not only reaffirming this endorsement, but personally assuring me that, decades earlier, Graham himself had endorsed index funds. Hear Mr. Buffett: “A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham took this position many years ago and everything I have seen since convinces me of its truth.” I can only add, after Forrest Gump, “And that’s all I have to say about that.”