Essential Takeaways From Chapter 6 of The Intelligent Investor: Portfolio Policy for the Enterprising Investor: Negative Approach

Chapter 6 of "The Intelligent Investor" by Benjamin Graham is dedicated to outlining what an enterprising investor should not invest in. An enterprising investor is an individual who has more time, knowledge, and expertise to invest in the stock market compared to a defensive investor. This chapter aims to guide enterprising investors on the wrong choices they might make and prevent them from making hasty decisions.

The Defensive Investor vs. The Enterprising Investor

Graham starts by emphasizing that the primary difference between a defensive investor and an enterprising investor is the amount of time and energy they can devote to their investment portfolio. The defensive investor is content with a passive and protected portfolio style, while the enterprising investor wants to take a more active role in managing their investments. Graham explains that an enterprising investor should start by building a foundation of a defensive investor, which is a portfolio that is divided between high-grade bonds and high-grade common stocks.

Avoid Second-Grade Bonds and Preferred Stocks

Graham cautions against investing in second-grade bonds or preferred stocks because these securities have two contradictory attributes. These securities tend to perform well in good markets but suffer severe losses in bad markets. Therefore, investing in these securities can lead to a significant loss of principal, which goes against the primary tenets of value investing. Moreover, the investor is unlikely to acquire and hold enough of these issues long enough for a bounce-back to be a realistic strategy.

Overseas and IPOs

Graham advises against investing in overseas securities, mainly because the investor has no legal recourse to enforce their claims if things go awry in other nations. Furthermore, the individual investor and their country are usually better suited when the investor keeps their money at home. However, if an investor chooses to invest overseas, a good rule of thumb would be to stick with low-load mutual funds specializing in bond issues in emerging-market nations, which should account for a maximum of 10% of the investor's bond holdings.

Initial public offerings (IPOs) are also regarded as money traps in the eyes of Graham. He considers IPOs as overpriced, imaginary profits only, insider's private opportunity, or idiotic, preposterous, and outrageous. Therefore, it's best to leave IPOs out of an investment portfolio. However, if the investor is willing to assume the risk of an IPO, then the due diligence they do must show that there are more reasons than sheer speculation for the acquisition of those issues. Graham also recognizes that some investors may want to buy into a company they truly believe will succeed. In such cases, the investor must exercise caution and conduct thorough research before investing.

Junk Bonds

Graham advises investors to approach junk bonds with caution. Although they may offer high yields, investing in these securities can lead to a significant loss of principal, which goes against the primary tenets of value investing. However, if an investor wants to invest in junk bonds, they should do so through a low-load junk bond fund. Junk bonds may act as a sensible counterweight in an investor's 401(k) if interest rates rise, as they tend to outperform standard bonds when interest rates rise.

Conclusion

In conclusion, chapter 6 of "The Intelligent Investor" is an essential guide for enterprising investors, outlining what they should avoid when investing in the stock market. Graham emphasizes that investors should focus on building a foundation of a defensive investor by investing in high-grade bonds and high-grade common stocks.

Investors should avoid second-grade bonds, preferred stocks, IPOs, and overseas securities. If an investor wants to invest in junk bonds, they should do so through a low-load junk bond fund. By following these guidelines, investors can make more informed investment decisions and minimize the risk of losing their principal.