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Double Your Income series: Learn from the father of value investing

You see when markets are cheap, you should maximise your stock exposure and when they turn expensive, you should maximise your bond exposure.

November 28, 2019 / 03:27 PM IST

In an earlier piece, I wrote about my investing system – Double Income – I mentioned the three pillars it rests upon.

Specifically, it is built upon the principles of three legends of investing – Benjamin Graham, Warren Buffett and John Bogle.

Let's look at these three components of Double Income one at a time.

In this piece, I focus of Benjamin Graham…

The father of value investing gave a great speech in 1963 that left a deep impression on me. I am not going to bore you with the details of the speech. You can read it in its entirety here.

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Here's an excerpt I found to be the most important.

The investor must recognize that there are uncertain and hence speculative elements in any policy he follows — even an all-Government-bond program. He must deal with these uncertainties by a policy of continuous compromise between bonds and common stocks, and by adequate diversification.

He must make a strong effort to have more money invested in common stocks at lower market levels (at least on the basis of cost) than at what he recognizes to be potentially high levels.

Graham's point is simple. No one can predict the future. No one has a crystal ball.

Thus, the best way to prevent your capital from getting totally wiped out is to have only some of it in stocks and the rest of it in bonds.

I know this approach will do a world of good to our principle of safety first. After all, the capital invested in bonds will be safe even if there is a huge stock market meltdown.

But what about maximising returns? Will this approach ensure we not just minimise downside but also maximise upside?

Well, this is where Graham's genius comes into play.

You see when markets are cheap, you should maximise your stock exposure and when they turn expensive, you should maximise your bond exposure.

In other words, when there is a high chance that stocks would do well over the next 1-2 years, stock allocation can be high. In fact, it can go to as high as 70 percent to 75 percent with the remaining in bonds.

And when there is a high chance that stocks may not do well because the markets are expensive, stock allocation can be scaled down. It can be taken to as low as 25 percent to 30 percent.

This rule kills two birds in one stone. It tries to maximise upside and at the same time, doesn't throw caution to the winds.

It ensures at least 25 percent of the capital is invested in bonds at all times.

Graham didn't pluck this rule out of thin air. He very well knew there is a vicious correction in the market every few years. This tendency may not change because human nature is what it is.

Thus, minimising allocation to stocks when the chance of a correction is high and maximising it when the chance of a bull market is high, is a great strategy.

It is one of the best ways to outperform the market in the long run.

My Double Income Map has thus taken inspiration from this Graham strategy. When markets are cheap, it can have as much as 75 percent to 80 percent in stocks.

And when they are expensive, as much as 40 percent of the corpus will be recommended to be invested in bonds.

Please note that the allocation will be reviewed every year. Fresh allocations will be recommended based on the broader market valuations prevailing at the time.

I believe this one rule will go a long way towards achieving our long-term goals. With the broader allocation out of the way, we can turn our attention to individual stocks.

What are the kind of stocks that will make up the stock portion of the corpus and how much to be invested in each stock?

Well, here's where the great Warren Buffett comes in. I’ll explain the Warren Buffett component of my Double Income strategy in my next article.

Stay tuned.

 

(This post is a joint initiative between Moneycontrol and Equity Master. Rahul Shah is Equitymaster’s Co-head of Research. He has more than 16 years’ experience in equity research and building investing systems.)

Disclaimer: Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. This Article is for information purposes and is not providing any professional/investment advice through it and Equitymaster disclaims warranty of any kind, whether express or implied, as to any matter/content contained in this Article, including without limitation the implied warranties of merchantability and fitness for a particular purpose. Information contained in this Article is believed to be reliable but Equitymaster does not warrant its completeness or accuracy. Equitymaster will not be responsible for any loss or liability incurred by the reader as a consequence of his taking any investment decisions based on the contents of this Article. The reader must make his own investment decisions based on his specific investment objective and financial position and using such independent advisors as he believes necessary.
Rahul Shah
first published: Nov 26, 2019 06:00 pm

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