Benjamin Graham fans: what did "diversification" mean to Graham?

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Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nisiprius » Fri Sep 13, 2019 10:24 am

Note: the topic is not "was Benjamin Graham right?" The topic is "what did Benjamin Graham think?"

It's my belief that before, let's say, the mid-1990s, "diversification" did not normally mean Markowitz diversification, but was a vague, qualitative term that meant not much more than "about a dozen stocks, not just one or two," and, depending on the situation, a choice between everything in one select sector (e.g. utilities) versus sector diversification--with sector diversification being a preference rather than an imperative. Furthermore, the word "diversification" very often was a reference to the business operations of an individual company, rather than to a stock portfolio.

I've been skimming The Intelligent Investor [1973 edition] (no, I've never read it through) trying to synthesize what Benjamin Graham meant by "diversification," and also as a proxy of how the word was generally understood in the 1970s and earlier.

In chapter 5 of The Intelligent Investor, he actually says
There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.
An example of a specific recommendation for portfolio diversification is:
The defensive investor who follows our suggestions will purchase only high-grade bonds plus a diversified list of leading common stocks.
I may have missed it but I didn't see any explicit guidance on how to know whether a list of stocks is "diversified."

An example of the word "diversification" to mean "within a business" rather than 'within a portfolio:"
...the acquisition of smaller firms by larger ones, usually as part of a diversification program.... the gospel of diversification of products has been adopted by more and more managements.
Although I can't find a completely explicit statement, I see a number of statements that suggest that for a "defensive investor" he supports the idea of a heavy concentration in public utilities; e.g.
Actually, there are many other companies of quality equal to excelling the average of the Dow Jones list; these would include a host of public utilities.
Finally, it seems clear to me that to Graham, diversification of any kind is purely a defensive measure, and a way of making sure your portfolio does not depart too far from the average. I see no hint at all that Graham ever saw diversification in the Markowitz sense, as a kind of active process that could boost the risk-adjusted-return of portfolios through low correlation--not even between stocks and bonds. The name "Markowitz" does not appear in the book. The word "correlation" appears only once in the portion written by Graham, and it's irrelevant:
By an unfortunate correlation, during the same time stock-buying public has been developing an ingrained preference for the major companies and a similar prejudice against the minor ones....
I did a quick skim in an effort to see whether the concept of low correlation is there implicitly under a different name, and didn't find anything obvious.
Last edited by nisiprius on Fri Sep 13, 2019 10:57 am, edited 1 time in total.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by alex_686 » Fri Sep 13, 2019 10:35 am

nisiprius wrote:
Fri Sep 13, 2019 10:24 am
Finally, it seems clear to me that to Graham, diversification of any kind is purely a defensive measure, and a way of making sure your portfolio does not depart too far from the average.

I see no hint at all that Graham ever meant diversification in the Markowitz sense, as a kind of active process that could boost the risk-adjusted-return of portfolios through low correlation--not even between stocks and bonds. The name "Markowitz" does not appear in the book. The word "correlation" appears only one in the portion written by Graham:
By an unfortunate correlation, during the same time stock-buying public has been developing an ingrained preference for the major companies and a similar prejudice against the minor ones....
I did a quick skim in an effort to see whether the concept of low correlation is there implicitly under a different name, and didn't find anything obvious.
I am confident that when when writing about diversification in the Intelligent Investor in 1949 he was not referencing Markowitz's 1952's Efficient Frontier. One of the critical reasons was that nobody used correlations back in 1949 because of the high level of computation it requires. People often criticize the simplifications that Markowitz uses. However those simplifications where a real breakthrough, allowing a IBM mainframe to actually do the calculations in a few hours.

I personally think most of your observations here are off base. It helps if you put Graham's argument in the correct place in both history and investment theory's intellectual history.

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nedsaid » Fri Sep 13, 2019 10:50 am

My take is that Graham mostly saw diversification as stocks vs. bonds, hence his advice for a portfolio not to have more that 75% stocks or less than 25% stocks with the remainder in bonds. Factors weren't talked about in his day but people were aware of certain things or at least suspected them. For as long as I can remember folks have talked about defensive stocks and this hints at Low Volatility. People have talked about Blue Chip stocks for eons and that hints of Quality. Graham talked about margin of safety below intrinsic value and that of course is Value. Also the knowledge that different sectors of the stock market acted differently from each other also hinted of factors. My guess is that Graham saw diversification not only as the number of stocks in a portfolio but also across industry sectors.

Graham has been gone for over 40 years now, impossible to know exactly how he would feel about factors, portfolio theory, efficient frontiers and the like but Warren Buffett did say that Graham realized that markets were getting more efficient. Were Graham alive today, I suppose he would sound a lot like John Bogle. I think he would still like cheaper stocks and would take advantage of modern computers to analyze them, not too hard to see him thinking a lot along the lines of the Dimensional Funds approach but of course there is no way to know. Graham did use a bottoms up approach of analyzing company by company and buying stocks for a portfolio a company at a time. The modern approach of using stock screens and in effect creating a Value index would have been a departure from his methods but I suspect he would have come around to more modern methods of portfolio construction.

Hard to say though. Warren Buffett and Charley Munger are well known for their disdain of the Academic research, particularly Munger. No way to know if Graham would have agreed with them.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by dbr » Fri Sep 13, 2019 10:54 am

I was also going to suggest the same comment as Nedsaid that the 25%-75% standard is probably expressive of his thinking.

Past that I am not an expert on Graham or on pre-Markowitz concepts of diversification. It would seem that the science of statistics had certainly been around a long time already by 1950, but the key step would be the availability of computing power to attempt any practical analysis of financial data. One might be surprised, however, at what one might find in the classical literature in both economics and statistics.

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nisiprius » Fri Sep 13, 2019 10:56 am

alex_686 wrote:
Fri Sep 13, 2019 10:35 am
...I am confident that when when writing about diversification in the Intelligent Investor in 1949 he was not referencing Markowitz's 1952's Efficient Frontier...
I'm not being that silly, I'm using the 1973 edition. The portions that he wrote* are replete with references to events that were recent when he wrote them, e.g.
There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices. The obvious example is the recent period, 1966-1970.
...the unprecedented rate of return offered in 1970-1971...
If we examine our chart I, covering the fluctuatins of the Standard & Poor's composite index between 1900 and 1970...
*(it's actually the 2003 book with extensive commentary by Jason Zweig and an appendix by Warren Buffett)
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nedsaid » Fri Sep 13, 2019 11:05 am

What we are seeing here is that even the concept of diversification is in the eye of the beholder. Also there are different ways of looking at it. I did post an essay on this topic and reposted it in my "How Do You Like My New 'Doo" thread in hopes that the concepts would find their way into the Wiki. Not that I think I have come up with anything new exactly, I tried to provide a useful framework for better understanding the concepts regarding the topic of diversification. I discussed the elements of diversification, the methods of diversification, and the risks that we were trying to protect ourselves from with diversification.

Regardless of what Larry Swedroe says, factors are really not new. The Academics better defined what people knew or suspected for years, clarified the concepts, and provided the evidence behind them. We used to call factors investment styles. Also the concept of sector investing is sort of a prerequisite for factor investing. You just couldn't help but notice that certain kinds of stocks perform differently than other kinds of stocks. I saw this with my untrained eye for years, certain things zigged while other thinks zagged. The Academics provided the data and created a more precise language. Certain very technical terms like "thingee", "whatchamacallit", "thingamabob", "zig and zag", and "squiggly lines" got replaced with even better terms. Pretty much replaced "thingee" with a mathematical equation and called it quantitative investing.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by alex_686 » Fri Sep 13, 2019 11:21 am

nisiprius wrote:
Fri Sep 13, 2019 10:56 am
alex_686 wrote:
Fri Sep 13, 2019 10:35 am
...I am confident that when when writing about diversification in the Intelligent Investor in 1949 he was not referencing Markowitz's 1952's Efficient Frontier...
I'm not being that silly, I'm using the 1973 edition.
So lets review the facts. Graham was a successful bottom ups investor who did most of his ground breaking work in the 30s and 40s and retired in his 50s. This was a time when investment theory was in its infancy, annual reports were dressed up to make management looking good (GAP and independent auditors did not exist yet), and computer power was basically nill.

Graham retired to France about the same time that Markowitz's top down statistical method was released. It wouldn't be until the 70s with cheapish computer power when Markowitz would actually enter Wall Street.

Now, how many 79 year-olds do you know have the mental acuity and flexibility to dump large swaths of intuitive knowledge and wisdom gain over years of experience and pick up statistics and a whole new approach? Converting a bottom ups individual stock selection method to a top down risk adjustment method?

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by Forester » Fri Sep 13, 2019 11:25 am

Graham would have been an indexer I think. By the 1970s preferred checklists to exhaustive qualitative analysis.

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nisiprius » Fri Sep 13, 2019 11:27 am

Alex_686, let's take it that you don't think Benjamin Graham's opinions are relevant guidance for investors today or for the last fifty years. I said--well, quickly added--an introductory line to my initial post--saying that isn't my topic. My topic is historical: what Benjamin Graham thought "back then."

1) Relevant or not, have I sketched out the tenor of Graham's ideas accurately?

2) Let's say they are what one aging guru wrote in 1973. Are they wildly uncharacteristic and out of step with the use of the word "diversification" in the 1970s? Or were they broadly representative of what most investors thought back then?
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by Svensk Anga » Fri Sep 13, 2019 11:49 am

nisiprius wrote:
Fri Sep 13, 2019 10:24 am


In chapter 5 of The Intelligent Investor, he actually says
There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.
I think this is just pragmatic advice, reflective of his times. Mutual funds were not popular. Circa 1973, I think they all were sold with front end loads of 8% or so, plus the ongoing expenses. Individuals directly owned a lot of the stock outstanding. If an individual is putting together a stock portfolio, he needs ten issues, maybe more, to avoid having one stinker severely impair the results of the whole. This has been common advice, maybe not original to Graham. I think the maximum of thirty comes from the impracticality of an investor keeping up with the developments in so many companies. It may also have some basis in the high fixed commissions of the day.

The multi-product companies suggested reflect the fashion of the day for corporations to become conglomerates to reduce earnings volatility and business risk associated with one dominant product.

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by rich126 » Fri Sep 13, 2019 1:39 pm

This short article (http://buffettpedia.com/2015/09/benjami ... ification/) talks about holding enough stocks to have confidence that the margin of safety will work out.
Benjamin Graham put it this way: “Even with a margin [of safety] in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.
Maybe akin to someone giving you a 25% chance of making 10X your wager, and 75% chance of losing it all. Your expected return would be 2.5X but you wouldn't want to make this wager just one time since you have a 75% of walking away with zero, instead you want to make enough wagers to have the probabilities work out.

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nedsaid » Fri Sep 13, 2019 2:01 pm

I do think there is such a thing as too much diversification, and I am probably guilty of that. Much of the diversification efforts have been in an attempt to lessen volatility in portfolios and to achieve steadier returns.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nisiprius » Fri Sep 13, 2019 2:24 pm

Forester wrote:
Fri Sep 13, 2019 11:25 am
Graham would have been an indexer I think. By the 1970s preferred checklists to exhaustive qualitative analysis.
I think so, too: A Conversation with Ben Graham (1976)
Can the average manager of institutional funds obtain better results than the Dow Jones Industrial Average or the Standard & Poor's Index over the years?

No. In effect, that would mean that the stock market experts as a whole could beat themselves--a logical contradiction.

Do you think, therefore, that the average institutional client should be content with the
DJIA results or the equivalent?


Yes. Not only that, but I think they should require approximately such results over, say, a moving five-year average period as a condition for paying standard management fees to advisors and the like.

What about the objection made against so-called index funds that different investors have different requirements?

At bottom that is only a convenient cliche or alibi to justify the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results.

...

In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?

In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by vineviz » Fri Sep 13, 2019 2:41 pm

nisiprius wrote:
Fri Sep 13, 2019 11:27 am
Alex_686, let's take it that you don't think Benjamin Graham's opinions are relevant guidance for investors today or for the last fifty years. I said--well, quickly added--an introductory line to my initial post--saying that isn't my topic. My topic is historical: what Benjamin Graham thought "back then."

1) Relevant or not, have I sketched out the tenor of Graham's ideas accurately?

2) Let's say they are what one aging guru wrote in 1973. Are they wildly uncharacteristic and out of step with the use of the word "diversification" in the 1970s? Or were they broadly representative of what most investors thought back then?
I agree with Alex_686 that Graham's views on diversification aren't relevant, but I think you're right: the classic pre-Markowitz definition of "diversified" was basically nothing more complex than "don't put all your eggs in one basket".

It's really only after the rise of capital asset pricing models and arbitrage pricing theory that this colloquial usage could be replaced with a more technical, precise, and objective usage. We often refer to this as "Markowitz diversification", but in truth this modern view depends almost as much on the work of Stephen Ross as on the work of Markowitz, Sharpe, et al.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by GRP » Fri Sep 13, 2019 2:43 pm

I've read 4 different editions of The Intelligent Investor in aggregate probably over 100 times.

OP, your take on Graham's concept of diversification is quite accurate. There's no modern portfolio theory, risk parity, or larry portfolio-esque stuff.

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by Dead Man Walking » Fri Sep 13, 2019 2:53 pm

Nisiprius,

My uncle loaned me his copy of Graham’s book in the mid 1960’s. His copy may have been the original edition. To answer your question, I interpreted his definition of diversification as diversification across sectors of the market. For example, an investor should own one automaker, one bank, one electric utility, etc. Of course, if the number of stocks in the portfolio was greater than ten, an investor might choose to own more than one stock in a particular sector.

I didn’t understand how an investor should determine the ratio of stocks to bonds. His 75% maximum and 25% minimum for stock and bond holdings is a reasonable range for the holdings in a portfolio; however, I don’t remember how he determined when to adjust the ratio of stocks to bonds. He may have advocated some form of market timing - I can’t remember. Consequently, I am not sure if he addressed diversification in the traditional stock/bond sense.

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nedsaid » Fri Sep 13, 2019 3:51 pm

Implicit in this thread is the idea that maybe we have overdone the idea of diversification. It seems that we have thrown everything but the kitchen sink at the idea of reducing risk and sometimes I think we threw the kitchen sink at it too. Today, being properly diversified means to some people being diversified across thousands of issues, across asset classes and sub-asset classes, diversified across geography, diversified across sectors, diversified across factors, and even being diversified among trading strategies which are the liquid Alts.

You just wonder if all this has actually improved portfolio performance or reduced risk beyond Grandpa's portfolio of 20-25 stocks, a few treasury bonds, and money in the bank. If Grandpa was pretty smart and chose carefully, his investment performance was probably pretty comparable to what Bogleheads are achieving today. If he picked quality stocks, diversified across sectors, bought at reasonable prices, and had relatively long holding periods; he would have either created his own low-cost index or sampled existing indexes. Certainly an index fund reduces single stock risk and is probably a bit less volatile than Grandpa's stocks but I am not sure performance would be all that different.

We might just all be obsessing over relatively unimportant things. I am diversified up the wazoo and I wonder if all that diversification has hurt and not enhanced performance. I also wonder if I really have a less volatile portfolio after all of that. Hard to say, I have done some analysis of this but a definitive answer would take time I am not willing to spend. Not sure I even have all the tools needed for a proper analysis.

So it goes to a complexity vs. simplicity argument, or Bogle vs. Swedroe. Now that Rick Ferri has more or less taken on Bogle's mantle, it is Ferri vs. Swedroe. Rick has really de-emphasized factors over the last few years, just don't see his former enthusiasm for them anymore. Maybe Bogle was right, all we need is the S&P 500 and the Total Bond Index. Or maybe Grandpa with his 20-25 blue chip stocks, a few treasury bonds, and money in the bank was the Bogle of his time.

Not sure where I would come down on this were I starting all over again but I have chosen the "kitchen sink" approach to diversification.

If Grandpa was really smart, he might have read Benjamin Graham's books for help with stock selection. In my day, it was Peter Lynch. Alas, I was not Benjamin Graham, Warren Buffett, Peter Lynch, or even Larry Swedroe. No plans to retire to France.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by stlutz » Fri Sep 13, 2019 4:05 pm

I agree with your reading, nisi. The three phrases I would use to describe his approach are:

--pragmatic
--qualitative (which is notable given that Graham was highly quantitative overall)
--purely about risk management

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by vineviz » Fri Sep 13, 2019 4:23 pm

nedsaid wrote:
Fri Sep 13, 2019 3:51 pm
Implicit in this thread is the idea that maybe we have overdone the idea of diversification.
It's hard to see how anything but the sloppiest definition of diversification would allow for the notion of it being "overdone". Or a portfolio being "too diversified", which we sometimes see.

It'd be like something being "too balanced", "too perfect", or even "too smart". It's definitionally impossible: you can't have a surplus of diversificaiton.

I suspect what people are referring to are portfolios which are well-diversified but deficient in some other dimension (e.g. excessive costs, impractical to implement, inadequate return).
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nedsaid » Fri Sep 13, 2019 4:35 pm

vineviz wrote:
Fri Sep 13, 2019 4:23 pm
nedsaid wrote:
Fri Sep 13, 2019 3:51 pm
Implicit in this thread is the idea that maybe we have overdone the idea of diversification.
It's hard to see how anything but the sloppiest definition of diversification would allow for the notion of it being "overdone". Or a portfolio being "too diversified", which we sometimes see.

It'd be like something being "too balanced", "too perfect", or even "too smart". It's definitionally impossible: you can't have a surplus of diversificaiton.

I suspect what people are referring to are portfolios which are well-diversified but deficient in some other dimension (e.g. excessive costs, impractical to implement, inadequate return).
I have been in the camp of more diversification is always better or as Larry puts it, hyperdiversification. The problem is that you can get a cancelling out effect, simpler might be better. Perhaps all the pieces of the Rube Goldberg device won't work together or work as well as designed. Not arguing against smart but it is possible to outsmart one's self. It isn't that you can be too smart or too diversified but at some point you get diminishing returns. You won't achieve much more of a diversification benefit beyond maybe 30 stocks in a portfolio, I would rather own thousands of stocks rather than dozens, but the incremental benefit gets to be less and less as you add more and more stocks.

So I am not advocating a Forrest Gump approach to investing, a guy who bought Apple because he thought it was a fruit company. Not saying we should be idiot savants here. Again, just stating that there is a concept of diminishing returns to just about anything.

The other problem of trying to be "too balanced", "too perfect", or "too smart" is that one might waste a lot of time on things that ultimately are not that important. There is a point where close enough is close enough and good enough is good enough, particularly when the future is unknown. We don't even know for certain that the Equity Risk Premium will continue, though the odds are pretty overwhelming for its continuance. So again, not arguing for stupidity here. Just saying there are limits to just about everything.

It gets down to how little is too little and how much is too much.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by patrick013 » Fri Sep 13, 2019 4:50 pm

Traditional diversification is not exactly useless. Traditional portfolio management assembles a wide variety of stocks. Emphasis on sector diversification. Portfolio selection uses standard security analysis techniques. Weighting could be equal, cap weighting, or even weighted by revenue per stock. So being flexible it has the main objective of picking excellent stocks with the number of stocks being sufficient to lower standard deviation to a stable and expected number to prevent large losses. 50 stocks has a much lower SD than a 10 stock portfolio usually. Investors "window dress" portfolios by only choosing market leaders, blue chip, well known companies but
highly diversified portfolios of micro-caps and IPO's are common.

MPT, of course, estimates the average returns, standard deviations, and correlations of investments to find an optimal portfolio and according to an investor's risk preference from the portfolio investments that exist.

So whoever is using what method I'd say most portfolios are adequately diversified per number of securities and stats provide historical metrics with norms reasonably established. Stats become extraneous when earnings change at business cycle ends. Otherwise diversification is doing it's job of holding down losses when they occur at other times. Graham appears to be more traditional and flexible than MPT.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nedsaid » Fri Sep 13, 2019 5:04 pm

What we as investors are trying to do is process improvement. It isn't that old methods are bad, it is just that new methods achieve very similar results but with much less time investment. Why go through all the trouble Grandpa went through picking 20-25 carefully analyzed stocks when you can buy the S&P 500? The results might be about the same but those results are achieved much more efficiently. Low cost passive factor investing is probably the new form of active management but with lower costs and less portfolio turnover since most active managers followed a "style" which now is defined as a "factor." So really the question is this, are tilted portfolios an improvement over the simpler portfolios built upon market cap weighted index funds? A pretty good argument is that more diversification is just simply an argument for more complexity to capture market inefficiencies. A further argument is whether those inefficiencies captured in the past can be captured in the future.

The other thing is that we study the past, observe what changes are happening now in the markets, and then come up with our best educated guess of what will work well in the future. Pretty much we are tilting the odds in our favor best we can but no guarantees of the results that we want. We always are wondering if things really are different this time.

My suspicion is that Benjamin Grahams methods of security analysis and stock picking will always "work", work in the sense that an investor will achieve acceptable investment performance. The issue is whether his methods today would result in excess portfolio performance. Graham as he was nearing death was having his doubts about that excess performance. Even if you still think Value will outperform the broad market, perhaps you could avoid all that work by just buying a good Value ETF.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nisiprius » Fri Sep 13, 2019 5:37 pm

(I assume the "maximum of about thirty" stocks was just a recognition of the practical reality of investing in individual stocks in the days of fixed commissions--anyone with more than that number was almost surely paying too much in commissions, not able to pay enough attention to every stock, and generally "going overboard.")

A side note on mutual funds. Graham (again, the 1973 edition) devotes a full chapter to them, Chapter 9, "Investing in Investment Funds."

Oddly, he does not say anything about diversification at all in the chapter--the word does not appear. But what he does have to say is interesting in its own right, though not relevant to my topic:
Investment-Fund Performance as a Whole

Before trying to answer these questions we should say something about the performance of the fund industry as a whole. Has it done a good job for its shareholders? In the most general way, how have fund investors fared as against those who made their investments directly?

We are quite certain that the funds in the aggregate have served a useful purpose. They have promoted good habits of savings and investment; they have protected countless individuals against costly mistakes in the stock market; they have brought their participants income and profits commensurate with the overall returns from common stocks. On a comparative basis we would hazard the guess that the average individual who put his money exclusively in investment-fund shares in the past ten years has fared better than the average person who made his common-stock purchases directly.

The last point is probably true even though the actual performance of the funds seems to have been no better than that of common stocks as a whole, and even though the cost of investing in mutual funds may have been greater than that of direct purchases. The real choice of the average individual has not been between constructing and acquiring a well-balanced common-stock portfolio or doing the same thing, a bit more expensively, by buying into the funds. More likely his choice has been between succumbing to the wiles of the doorbell-ringing mutual-fund salesman on the one hand, as against succumbing to the even wilier and much more dangerous peddlers of second- and third-rate new offerings. We cannot help thinking, too, that the average individual who opens a brokerage account with the idea of making conservative common-stock investments is likely to find himself beset by untoward influences in the direction of speculation and speculative losses; these temptations should be much less for the mutual-fund buyer.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nedsaid » Fri Sep 13, 2019 5:52 pm

From what you are saying Nisiprius, it sounds like that you have to read between the lines a bit with Graham. Certainly he believed in diversification even if he didn't explicitly say it.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nisiprius » Fri Sep 13, 2019 6:44 pm

nedsaid wrote:
Fri Sep 13, 2019 5:52 pm
From what you are saying Nisiprius, it sounds like that you have to read between the lines a bit with Graham. Certainly he believed in diversification even if he didn't explicitly say it.
Oh, certainly he did. My opening post quoted him as saying "The defensive investor who follows our suggestions will purchase only high-grade bonds plus a diversified list of leading common stocks." The question is more what did he understand by the term? He doesn't appear to define it, or devote much attention to the question of how you decide whether or not a "list of leading common stocks" is "diversified." It seems to be casual, not quantitative. He says that the defensive investor has
a choice of two approaches, the DJIA type of portfolio and the quantitatively-tested portfolio. In the first he acquires a true cross-section of the leading issues... This could be done, most simply perhaps, by buying the same amounts of all thirty of the issues in the Dow Jones Industrial Average. Ten shares of each, at the 900 level for the average, would cost an aggregate of about $16,000.
He's darned close to indexing there. If he isn't actually there--suggesting an equal-weighted DJIA portfolio.

The "quantitative" approach means stock-picking according to earnings, dividends, etc.--with a side detour on the possible benefits of an all-utilities portfolio. At the end, though,
Our advice to the defensive investor is that he let it alone. Let him emphasis diversification more than individual selection. Incidentally, the universally accepted idea of diversification is, in part at least, the negation of the ambitious pretensions of selectivity.
What's curious is that after saying defensive investors should "purchase ... a diversified list of leading common stocks," you might have expected him to say some kind things about mutual funds as being a good way to purchase such a list... and he doesn't.

At any rate, what's seems clear to me is that to him, "diversification" means "non-selective," approximating an index instead of trying to beat it. The idea of diversification as a way to beat an index through synergistic activity of uncorrelated assets isn't there at all.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by nedsaid » Fri Sep 13, 2019 7:10 pm

nisiprius wrote:
Fri Sep 13, 2019 6:44 pm
nedsaid wrote:
Fri Sep 13, 2019 5:52 pm
From what you are saying Nisiprius, it sounds like that you have to read between the lines a bit with Graham. Certainly he believed in diversification even if he didn't explicitly say it.
Oh, certainly he did. My opening post quoted him as saying "The defensive investor who follows our suggestions will purchase only high-grade bonds plus a diversified list of leading common stocks." The question is more what did he understand by the term? He doesn't appear to define it, or devote much attention to the question of how you decide whether or not a "list of leading common stocks" is "diversified." It seems to be casual, not quantitative. He says that the defensive investor has
a choice of two approaches, the DJIA type of portfolio and the quantitatively-tested portfolio. In the first he acquires a true cross-section of the leading issues... This could be done, most simply perhaps, by buying the same amounts of all thirty of the issues in the Dow Jones Industrial Average. Ten shares of each, at the 900 level for the average, would cost an aggregate of about $16,000.
He's darned close to indexing there. If he isn't actually there--suggesting an equal-weighted DJIA portfolio.

The "quantitative" approach means stock-picking according to earnings, dividends, etc.--with a side detour on the possible benefits of an all-utilities portfolio. At the end, though,
Our advice to the defensive investor is that he let it alone. Let him emphasis diversification more than individual selection. Incidentally, the universally accepted idea of diversification is, in part at least, the negation of the ambitious pretensions of selectivity.
What's curious is that after saying defensive investors should "purchase ... a diversified list of leading common stocks," you might have expected him to say some kind things about mutual funds as being a good way to purchase such a list... and he doesn't.

At any rate, what's seems clear to me is that to him, "diversification" means "non-selective," approximating an index instead of trying to beat it. The idea of diversification as a way to beat an index through synergistic activity of uncorrelated assets isn't there at all.
Equal weighted portfolio? Sounds familiar, doesn't it? Graham was ahead of his time thinking about equal weighted portfolios, except of course he was thinking of the DOW 30, a narrow index rather than a broad index like the S&P 500.

Also ahead of his time a bit, it sounds like Graham believed that in many cases that mutual funds weren't worth the 8 1/2 % upfront load and the annual expense ratio. He must have believed that an investor picking blue chip stocks across industry groups would do just as well. Investors probably could have paid a 2% to 3% commission to get into the stocks, if holding periods were long enough, the costs would actually be lower than the mutual funds of the time. Holding the DOW 30 in equal weights would give you a pretty darned good sample of the entire market.

I guess what I did with my individual stocks was pretty close to what Graham suggested though I have attempted to create a Value oriented portfolio. Last I checked, I almost tracked the Vanguard Value Index over the last 15 years but still trailed Total Stock Market Index. So not bad. But so far, no offers to appear on any TV shows to tell my secrets. Pretty much, I picked good stuff at reasonable prices but didn't try to get too cute with the analysis. Thing is, I could have just bought the Vanguard Value Index or even the Vanguard High Dividend Index, both of which are chock full of the kind of stocks I like. This is what I mean by efficiency.

It sounds like Graham towards the end of his life realized that the markets were getting more efficient and that the rewards from bottoms up company by company analysis were shrinking. Buffett took Charley Munger's advice and mostly abandoned Graham's strategy. He focused on great businesses rather than good businesses. The problem is that great businesses are never cheap because everyone else realizes that those businesses are great. The advantage is that the great companies have better competitive advantages, a wider moat, than the good companies. Half the battle is minimizing your losses in bear markets, great companies hold up better in bad markets than good companies. Buffett still used Graham's methods of analysis but changed his criteria for analyzing companies, he was looking for greatness and not cheapness. My suspicion is that as the field of security analysis improved, the margins of safety that Buffett used to get were just not available anymore. Graham made the mistake of writing his book on how to do it. As far as I know, Buffett has never written a book explaining how he succeeded. His annual reports reveal a lot but Buffett won't give away the secret sauce, that is why he makes things sound easier than they really are.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by alex_686 » Fri Sep 13, 2019 7:18 pm

nisiprius wrote:
Fri Sep 13, 2019 11:27 am
Alex_686, let's take it that you don't think Benjamin Graham's opinions are relevant guidance for investors today or for the last fifty years. I said--well, quickly added--an introductory line to my initial post--saying that isn't my topic. My topic is historical: what Benjamin Graham thought "back then."
This is misrepresentive of what I believe. We could get into a fairly lengthily debate of my opinions of Graham and if they hold but that would be another topic. The primary thrust of my argument is that Graham's work came before Markowitz, so of course he was using it in a non-Markowitz meaning.
nisiprius wrote:
Fri Sep 13, 2019 11:27 am
1) Relevant or not, have I sketched out the tenor of Graham's ideas accurately?

2) Let's say they are what one aging guru wrote in 1973. Are they wildly uncharacteristic and out of step with the use of the word "diversification" in the 1970s? Or were they broadly representative of what most investors thought back then?
It is also important put Graham's work in context.

Graham never actually defines diversification or risk in a rigorous sense, just in a general hand waving sense. In part this is because he lacked statistical tools and computer power. In part because he was working with a deterministic model. Lastly, and most importantly I think, is that the academic text book he wrote was called "Security Analysis", not Portfolio Analysis. (Note The Intelligent Investor is the lay version of the text book.) He was concerned about pricing and selecting individual stocks, not portfolio construction. Bottom up, not top down. Deterministic, not statistical. In short, the complete opposite of Markowitz. You can bridge this divide, but you need to overhaul Graham and put it on a more vigorous mathematical footing.

But yeah, my reading of history was that diversification was defined mostly by hand waving in the 70s, at least by practitioners. It would not be until the 90s(?) until Markowitz would take center stage. This was before my time so I am resting this on a fair amount of historical reading. I would not even say this was a bad approach. After all, the main tool back then would have been Lotus 123 and lots of hand punching into computers.

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by Ferdinand2014 » Fri Sep 13, 2019 7:36 pm

“Stockholders as a whole must prosper or suffer with the rise and fall of corporations as a whole....An unabashed cross-section approach appears too simple to be sound, and it reduces the role of security analysis to a minimum. We suggest that the student should not dismiss it too contemptuously. It is by no means certain that the analyst will get better results from the type of selectivity most favored in Wall Street— viz., picking out the industries or individual companies that are likely to make the best comparative showing in the near future.... If we could assume that price of each of the leading issues already reflects the expectable developments of the next year or two, then a random selection should work out as well as one confined to those with the best near-term outlook.”

“More and more institutions are likely to realize that they cannot expect better than market-average results from their equity portfolios unless they have the advantage of better-than-average financial and security analysis. Logically this should move some of the institutions toward accepting the S&P 500 results as the norm for expectable performance. In turn this might lead to using the S&P 500 or 425 lists as actual portfolios. If this proves true, clients may then find themselves questioning the standard fees most of them are paying financial institutions to handle these investments.”


1.) 25-75% common stocks and high grade bond ratio
2.) Minimum of 10 and up to 30 stocks. (According to Burton Malkiel at about 60 stocks, your un systemic risk is diversified away)
3.) avoid purchasing above a P/E of 25
4.) History of consistent dividend payments
5.) company should be large, prominent and conservatively managed
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by Workable Goblin » Fri Sep 13, 2019 8:45 pm

alex_686 wrote:
Fri Sep 13, 2019 7:18 pm
After all, the main tool back then would have been Lotus 123 and lots of hand punching into computers.
Not even that; Lotus 123 wasn't released until a decade after the last edition of The Intelligent Investor came out. At the time, doing a real statistical analysis of stock movements would have required a high priest of computing to write a bespoke program on a mainframe or, at best, a minicomputer, not to mention, yes, the hand punching in (possibly literally, with punch cards full of data). So it wasn't so practical then. I'm tempted to make an analogy to a number of scientific fields where, although in principle there were known methods to computationally model or analyze certain phenomena, it wasn't actually practical at the time because of limitations in available computational power.

To get back to the OP, I have read The Intelligent Investor several times over the past decade or two (I was precocious!), and I would say that Graham's definition of diversification was, as alex says, rather casual and intuitive. It always seemed to mean, as far as I could tell, that you oughtn't put all your money into one or a few stocks or bonds, but buy enough that the failure of one or two wouldn't sink your portfolio; and to buy bonds and stocks so that stocks having a bad time or bonds having a bad time also wouldn't sink your portfolio. As others in the thread have noted, at the time that was probably about as well as you could do given the fees on mutual funds and brokerage commissions, but nowadays I think a TSM + TBM portfolio (+ International) would be a good approximation of what he was aiming for.

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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by JoMoney » Fri Sep 13, 2019 10:31 pm

FWIW, Edgar Lawrence Smith in his 1924 book "Common Stocks As Long Term Investments" (a book Graham was certainly familiar with) ... he makes repeated reference to the term "diversification" for investment and using "diversified lists" of stocks in his study. As far as I can tell, the term is used simply with the understanding that a list or sample size should be large enough to represent the group (i.e. an industry sector, capitalization size, or stocks in general) and thereby capture the underlying properties of the group and avoid idiosyncrasies of a specific issue.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by RadAudit » Sat Sep 14, 2019 8:25 am

OP, thanks for starting this thread. It is interesting to me to see how and why the concept of diversification came to be. (Or as one movie character was observed to say - I don't think that word means what you think it means.) The prior poster notes the idea that the growth in the number and size of the industrial corporations (since 1900) allowed / required broad public participation to raise the capital necessary for the continued growth of the company. He indicates that in the 10 years prior to 1900 essentially only railroads had achieved the size necessary for broad public participation.

In the "The Great Depression - A Diary" by Roth - a lawyer not an economist, the writer notes on 10/16/31 that "Money should be invested not locally but on a national scale if possible, including stocks and bonds in companies located in other communities and operating nationally. Many wealthy families in Youngstown grew rich on only local industries and banks but were pretty well cleaned out..." Apparently the idea of geographical diversification hadn't made sufficient inroads into the thoughts of the common investor of the day. And probably the idea of the possible impact on other local corporations (banks) of the collapse of a single large local industry (steel) hadn't got much traction by then, either. Such an idea may have required an investor, well versed in accounting, to examine public financial records in order to make that deduction prior to 1929.

So whatever Graham was thinking by the 1940s about diversification was probably not as far along as what we think it means now - but it was definitely ahead of the broad opinions of the day.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by JoMoney » Sat Sep 14, 2019 8:59 am

The idea of "diversification" as risk mitigation is ancient. The idea of "diversification" as being something that has to provide some price-movement correlation benefit is a newfangled concept.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by vineviz » Sat Sep 14, 2019 9:06 am

JoMoney wrote:
Sat Sep 14, 2019 8:59 am
The idea of "diversification" as risk mitigation is ancient. The idea of "diversification" as being something that has to provide some price-movement correlation benefit is a newfangled concept.
They are the same idea, just specified with differing degrees of specificity.
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Re: Benjamin Graham fans: what did "diversification" mean to Graham?

Post by soter » Sat Sep 14, 2019 11:09 am

Graham's thoughts on diversification can be fund in his lectures dated 1947https://www.wiley.com/legacy/products/s ... lec10.html:
You would not really be diversifying, because that is practically the same thing as buying ten shares of Electric Bond and Share instead of buying one share of each; since the same factors would apply to all of them. That point is well taken. For real diversification; you must be sure that the factors that make for success or failure differ in one case from another.

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