What Mistakes Should an Active Investor Avoid?

An active investor is not simply someone who takes more risk. In Benjamin Graham’s sense, an active investor is someone willing to spend more time and effort analyzing investments and, because of that, can look beyond the standard choices available to a defensive investor.

But that creates its own risk: having more options can easily turn into an excuse for taking unnecessary risk.

So before asking “What should I buy?”, it is worth asking a different question:

“What mistakes should I avoid?”

Bonds

One of the easiest mistakes is sacrificing quality just to get a higher yield.

Suppose a high-quality bond yields 5%, while a weaker one offers 7%. The extra 2% may look attractive, but the trade-off is not always favorable. If that additional income comes with a meaningful risk of losing a large part of the principal, the extra yield may not compensate you nearly enough.

Graham gives an example where a group of second-grade bonds fell from roughly 102 to 68, while their yield advantage over high-grade bonds was only about 1.75 percentage points. In other words, investors were taking substantial downside risk for a relatively small increase in annual income.

For me, the key point is simple:

A higher yield is not, by itself, a good reason to take more risk.

At the same time, a lower-quality bond is not automatically a bad investment. The same bond that looks unattractive at 100 may become interesting at 70. At that price, the investor is no longer relying only on the higher yield — there may also be meaningful capital appreciation if conditions improve.

So the quality of the security and the quality of the investment are not the same thing. Price changes the equation.

Graham applies similar caution to foreign government bonds. The yield may be attractive, but if things go wrong, the investor may have far fewer ways to enforce a claim. Extra income does not necessarily compensate for that kind of risk.

New Issues

The second major mistake is becoming too enthusiastic about new issues.

Graham gives two simple reasons for caution.

First, new issues come with strong selling pressure behind them. The company, the investment bank, and everyone involved in the deal want the offering to succeed.

Second, and more importantly, companies usually issue new securities when market conditions are favorable for them.

That means conditions may be excellent for the seller without being equally attractive for the buyer.

Graham also describes a pattern that tends to repeat during bull markets.

Early in the cycle, decent companies may come to market at reasonable prices, and early buyers may make good returns. That attracts more interest.

As enthusiasm builds:

• the number of new issues increases;
• the quality of the businesses declines;
• the prices being asked get higher;
• and eventually the market starts paying excessive prices even for weak companies.

The danger is even greater when a company’s strong performance is concentrated in only the last few years. Temporary growth or unusually high margins can easily be mistaken for normal economics, and investors may end up paying a high multiple on already inflated earnings.

An active investor needs more discipline precisely because there are more opportunities available.

The advantage is not that you can buy more kinds of securities. The advantage is that you can judge more carefully when it makes sense to move beyond the standard choices — and when it does not.

Sometimes the right investment decision is not to buy anything at all.

Source

Benjamin Graham, The Intelligent Investor.