These are the time-tested investment principles that guide us through financial markets.
Benjamin Graham, founder of value investing, observed that, in the short term, stock market participants frequently react irrationally to good and bad news, paying too high a price for stocks during periods of excess optimism, and then selling at a loss during periods of excess pessimism. This emotional buying and selling causes wide fluctuations in market price. It is these fluctuations that afford opportunities for the discerning, value-oriented investor to buy wisely when prices are low and to sell wisely when prices are high. Therefore, the time of maximum pessimism is the best time to buy – you get a bargain through buying quality stocks when most people are selling them. As a necessary corollary, if one must or should sell, the best time to sell is the time of maximum optimism. In the words of Charlie Munger, “All intelligent investing is value investing.”
Margin of Safety
We embrace Benjamin Graham’s central concept of a “margin of safety” to minimize stock market risk. The existence of a margin of safety is dependent on the price paid for an investment in relation to its intrinsic value. The lower the price paid in relation to intrinsic value, the greater the margin of safety. Mr. Graham’s study and experience proved that a portfolio of investments, constructed in this manner, would yield highly satisfactory long-term results.
Investments in equities should be diversified to reduce risk. In a portfolio which includes a number of good quality companies, the positive results achieved by most are likely to more than offset any disappointment in the others. However, if diversification is carried too far, it reduces or eliminates the possibility of achieving superior long-term returns in common stocks. Excessive diversification is one of the principal reasons why many typical investment portfolios fail to provide superior returns over the long term. Therefore, we diversify with the goal of protecting capital, but not so much as to make it impossible to achieve superior returns.
Cheviot’s portfolio management provides an appropriate balance between the goals of high return and safety of principal. In a balanced portfolio an investor’s assets are divided among the three principal asset classes of marketable securities: stocks, bonds, and cash equivalents. Ownership of publicly-traded securities whose values are tied to real estate and certain commodities may also be included within the balanced portfolio.
A typical balanced portfolio shares in the long-term gains of the stock market through its holdings of common stocks, while other investments, including its holdings of bonds and cash equivalents, moderate the effects of stock market volatility, produce interest income, and significantly reduce shorter-term risk.
Asset allocation is the process of deciding the percentage of an investment portfolio to be held in the aforementioned asset classes – stocks, bonds, real estate, commodities, and money market funds. We use asset allocation to emphasize the classes of investments which we believe present the best value at any given time, that is, the most reward and the least risk.
Buy and Hold
Once we have purchased at a bargain price we tend to hold our investments through subsequent fluctuations. Holding on to the shares of a high-quality company over the long term maximizes returns while reducing “friction costs” (including taxes). We sell if the share price is so high that it already anticipates and discounts the likely advances of the long-term future, if the company’s long-term prospects deteriorate significantly, or if better investment alternatives present themselves.
Minimizing taxes is an important component of successful long-term investing. What counts is the total return to the investor after deducting costs and taxes. In taxable accounts we minimize taxes in several ways. Our portfolio turnover is low. We typically realize lower-taxed long-term gains, rather than higher-taxed short-term trading profits. Tax-efficient management is something no investment fund can supply because: (1) a fund manager cannot possibly take into account the tax position of the individual shareholders; and (2) the tax laws governing mutual funds effectively preclude efficient tax management for the shareholders.
Investment vs. Speculation
It is necessary to constantly keep in mind the all-important and easily overlooked distinction between investment and speculation.
No one can predict the future movements of interest rates or short-term market fluctuations, so our investments are not based on trying to outguess the market. No one can predict the future state of the economy, so our investments are not based upon assumptions about the future of the economy.
We see the difference between investment and speculation as follows:
A share in a business vs. chips in a casino
The investor views a common stock as representing a partial ownership share in a business, while to the speculator stocks are virtual chips in the world’s largest casino.
Profiting from the operation of a business vs. the operation of the stock market
The common stock investor seeks to share in the wealth created by the operation of a successful business. The stock speculator seeks to profit from trading in the market.
Long-term vs. short-term
The common stock investor expects to make money gradually over a long time. The speculator hopes to make money in a hurry. True investors wait patiently for attractive opportunities, then buy and hold for the long term. Speculators buy and sell frequently.
Time is the friend of the investor. The longer an investor holds his stocks, the greater his profits are likely to be. But the speculator’s losses are almost certain to mount the longer he speculates. There are multitudes of investors who have enjoyed significantly profitable returns from buying and holding common stocks over the long term. There are few speculators who have both made and kept significant profits from trading in stocks.