Wednesday, June 29, 2011

Asset allocation methods from the masters part II: Benjamin Graham

In the first article of this 3 part series, I talked about an asset allocation method suggested by Peter Lynch which advocated that the investor have his portfolio consist of as high a stock component as he can tolerate. This is the case as a portfolio of stocks generally outperforms a portfolio of bonds or a portfolio of part stocks and part bonds over the long-term.

In this article, I will be talking about an asset allocation method suggested by the father of value investing, Benjamin Graham.

Benjamin Graham once suggested an asset allocation method where an investor would put 50 percent of the money in his or her portfolio in bonds while the other 50% of his or her portfolio would consist of stocks. The investor can then tweak the portfolio up to 75-25 stocks or 75-25 bond, depending on whichever asset class the investor thinks is attractive enough to commit more money to.

This asset allocation method is good for emotional investors who might panic when the price of stocks fall and might make some decisions that they could potentially regret. With at least 25% of the portfolio allocated to bonds at any one time, the investor might not get so emotionally affected even when stocks do take a tumble. This is the case as even if the value of the stock component of his portfolio falls, the investor would still receive interest income from the bond component of his portfolio which should help in keeping the investor’s emotions stable during the bear market.

Here are some other investing principles from Benjamin Graham:

Benjamin Graham came up with the margin of safety concept which advocated buying stocks at a significant discount to intrinsic value. This would give investors at least some protection against any impairment in the businesses behind the stocks that the investor bought for his portfolio. Benjamin Graham also advocated that investors do not invest in stocks trading above 1.5 times book value or stocks trading at a P/E ratio of above 15. Investors can buy stocks with a P/E ratio higher than 15 provided that the stock is trading below 1.5 times book value and vice versa. However, the sum of the P/E ratio multiplied by the price to book value ratio shouldn’t exceed 22.5.

Note: Benjamin Graham suggested calculating the earnings for the P/E ratio by averaging out earnings over 3 years. This should help in giving the investor a more accurate picture of the company’s financial performance.

I can’t remember the exact amount of EPS growth Benjamin Graham suggested that a stock should have for the long term, but investors should only invest in stocks that have grown EPS at a decent rate in the past and which they believe can keep growing EPS at decent rates in the long-term future so as to keep ahead of inflation. I personally would require a long-term growth rate of at least 6-7% (the minimum rate of growth that you should require is of course up to you).

I’m not 100% sure, but I think that the Benjamin Graham investing principles and asset allocation method I talked about in this article are meant for investors which Ben Graham called ‘defensive investors’ or investors that are not very experienced and don’t have much time to devote to investing. But even if you’re an experienced investor, there’s no harm in knowing these investing principles.

If you have any questions or have anything that you would like to share please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

This article is featured in the carnival of value investing, check it out for interesting investing articles!