- Passive - Buy and Hold strategy, buys mutual funds, has others manage investments, does not have time to devote significant time to research and trading.
- Active - Buy and Monitor strategy, buys individual stocks and bonds, manages own investments, devotes a significant amount of time and resources to research and trading.
Most people fall somewhere between these two types but will tend toward one or the other. This is probably one of the most important distinctions that a person can make when understanding what type of investor he or she is. For example, a passive investor who attempts to pick his own stocks without devoting enough time to research and monitoring will likely fail in his strategy. Also a word of caution to the active investor; an active investor who attempts to build a portfolio without sufficient funds (at least more than $100,000) will likely spend an inordinate amount of money on transaction fees and commissions thus reducing the total rate of return. Ideally, an active investor, in addition to having an aptitude for research and analysis, should have more than $300,000 to build an appropriately diverse portfolio.
Assuming all of the above is taken into account, the following guidelines would apply to an active value investor. I will discuss solutions for a passive investor next week in Part 3. The following guidelines are a synopsis of Benjamin Graham's investing guidelines from his book: The Intelligent Investor. These guidelines are extremely generalized and form a basis for evaluation but not all encompassing. Please augment this knowledge with your own readings.
- Look at the average current yield on top-quality (triple-A) corporate bonds. Say 4.5%
- Multiply that by 2. =9%
- Divide 100 by the number found in (2). =11.11
- The number in (3) gives you the highest acceptable P/E ratio of the stocks that you can choose from. P/E = 11.11
- Note: Generally, don't go for stocks with P/E ratios greater than 10. P/E ratios of 7 or lower should preferrably be chosen.
- The ratio of stockholders’ equity to total assets should be at least 50%. For example, if a company has stockholders’ equity of $30 million and total assets of $50 million, the ratio is 60%. Since that is over 50%, the company passes the test.
- Form a portfolio of at least 30 stocks: this is the ideal minimum.
- Hold onto the stocks until you make a 50% profit. As soon as the stock goes up that much, sell it.
- If a stock has not met your objective profit of 50% by the end of the second calendar year from the time of purchase, sell it regardless of price. For example, if you bought a stock in September 2002, you would sell it no later than the end of 2004.
- When times are bad for the stock market, i.e., when stocks are selling at low P/E levels, take advantage of the situation and put 75% of your investment capital into common stocks. In good times, when the market is overpriced, when you have trouble finding stocks with low P/E ratios, you should have no more than 25% of your funds in stocks and the rest in other less risky assets.
I would also say that an active investor should devote a significant amount of time to developing his or her analysis skills and into researching potential investments and monitoring his or her current investments. 15 to 20 hours per week for a portfolio over $300,000.
I'll have some more to say about value investing next week for the passive investor or investors who have less than the funds required to build an adequately diverse portfolio.
What do you think? Is Value Investing the way to go? Are you a passive or active investor?