Intelligent Investor Chapter 4 Summary: General Portfolio Policy : The Defensive Investor

General Portfolio Policy : The Defensive Investor

• Portfolio depends on position and characteristics of owner.
• Rate of return sought should be dependent on the amount of intelligent effort the investor can spend.
• Divide portfolio between high grade bonds and high grade common stocks.
• Stock percentage in portfolio should be increased only when there are bargain issues because of a protracted bear market.
• Investors supposedly should sell to speculators at high prices and buy back from them at depressed levels. But mutual funds managed by professionals seem to have been just switching from less to more promising issues instead.
• If common stock increases to 55% because of market high, sale of 1/11 stocks and investing the proceeds in bonds will restore the 50-50 balance.
• In 1970, it was advised to hold only 25% shares and buy more only when DJIA dividend yield hits at least 2/3rds of bond yield.

Bonds:

• People in high tax brackets will benefit from tax exempted municipal bonds than the bonds that incur tax.
• US savings bonds provide protection, high return than other first quality bonds and money back options. But people with large funds might find better returns elsewhere. Exchangeable Series E and H bondse(exempt from state tax).
• Indirect obligations(guaranteed) of US Govt give better yields than direct(sold in the name of Govt) ones and they are safe just like savings bonds.
• State and Municipal bonds are exempt from state tax in the state of issue. Moody/S&P ratings help.
• Short term bonds fetch low returns compared to longer term bonds.
• Corporation bonds incur both Federal and State tax.
• High yield/Junk bonds - risky and not suggested for conventional investor.
• Savings deposits produce similar interest rates as first quality bonds.
• Make sure the bonds are non-callable for at least 20-25 years.

Preferred Stocks:

• Depends on company's ability and willingness to pay dividends on common stock - if common stock holders aren't paid, then company isn't obliged to pay preferred stock holders. Also they have no share in company's profits beyond the promised fixed dividend.
• Better to buy only when the prices are too low because of a temporary adversity. Buy only on bargain.
• Suited only for aggressive investor.
• More beneficial for corporate to buy than for individuals as they enjoy less tax compared to bonds. But for individuals, tax is same for PS or bonds.

Income bonds - interest is paid only when companies earn any. Corporations can benefit from them as they get paid interest when company earns and they are protrected in case of bankruptcy.

Commentary:

When you leave it to chance, then all of a sudden you don't have any more luck.

• Aggressive investor's portfolio will be a dynamic mix of stocks, bonds, mutual funds which he keeps researching, selecting and monitoring.  Defensive investor creates a permanent portfolio that runs on autopilot and requires no further effort.
• The old thumb rule about investing (100-age) percentage in stocks is like subtracting 100 from your IQ. Everyone will have some or the other unexpected situations that demand risk-less cash. Also, young people may need money in short term for their wedding/house and rich old person with ample monthly income can take risks instead of going for an all-bond portfolio. Depending on your position - single/married, children, ailing parents, career threats, business safety, how much money you can afford to lose, how much income is supplemented by your investments, your risk level varies - so does your portfolio. It is suggested to go for 100% stock portfolio only if you have saved cash to support your family for one year, can steadily invest for next 20 years, survived 2000 bear market - bought more stocks and didn't sell, have a formal plan to control your investment behavior. 
• Re-balance your portfolio for every six months.
• Unless you are in lowest tax bracket, own only tax free municipal bonds. Own taxable bonds only in tax deferred accounts.
• As Interest rates rise, bond prices fall- short term bonds fall less. Buy intermediate term bonds 5-10 years which remain quite stable.
• Bonds are sold in $10K dollars lot, so it's difficult to diversify and buy some 10 bonds as the cost would be $100K. Bond funds are better in such case as they are cheap and provide more diversification with monthly income that can be reinvested without any commission.
• Certificate of deposits, money markets were providing meager returns(2000).
• T-bills, notes and debts(all bonds with short, medium, long terms) can be bought without any brokerage fee and have huge market in case if you want to sell.
• Savings bonds aren't that sellable and incur penalty on early withdrawal. Good for future as a set-aside money. I-bonds provide protection against inflation.
• Mortgage securities are pooled from many mortgages and give high yield with high risk. Good for long term.
• Annuities provide steady stream of income after retirement. But the expenses may be high. Buy only from providers with rock bottom costs.
• Preferred stocks are less secure than bonds and have less profit potential than common stocks. Companies get tax benefit from issuing bonds than preferred stocks, if they are selling preferred stocks with high dividend, chances are the company isn't in healthy condition.
• Don't buy stock just for high dividends, always look at the company business.

See Intelligent Investor Summary for other chapters summary.