“In the morning, if you see me smiling in my sleep, please do not wake me up!” I advised my wife before going to sleep.
“Why?” she asked.
“Because last time you woke me up just when I was starting to learn the art of investing straight from the legends who visited me in my dreams!
“This time, if you see me smiling and talking to myself in the morning, know that I am seeing a similar dream. So don’t wake me up!”
“You sound so funny so often!” she told me as I switched off the lights.
Anyways, I saw the second part of my dream, and here’s the transcript. (Read first part here )
Me: Warren, last time we met, I asked you about the relevance of investing in stocks and especially for the long term. You tried your best to get your point through, but I was still not convinced.
Over the weekend, I thought over our discussion and then talked to some friends who are already investing in stocks. They revealed they are making 20-30% returns every month by trading in stock derivatives. Now this has gotten me really interested.
You only told me about stocks and never about derivatives the last time we talked. Why?
Warren Buffett: Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.
Charlie Munger: The world of derivatives is full of holes that very few people are really aware of. It’s like hydrogen and oxygen sitting on the corner waiting for a little flame.
Me: But haven’t the big investors made so much money from derivatives in the past?
Munger: I would economically restrain what investment banks and banks do. I would separate derivatives from the basic bridges of civilization. We don’t want civilization contaminated by extreme speculation.
Me: What if speculation can earn you so much money in quick time? Isn’t that an easy-to-win game?
Buffett: If you’re an investor, you’re looking on what the asset is going to do, if you’re a speculator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game.
Me: Investor? Speculator? What’s the difference?
Buffett: You know, speculation is like pornography…the famous quote and all that. I look at it in terms of the intent of the person engaging in the transaction.
Speculation I would define as much more focused on the price action of the stock you buy. You are not looking to the asset itself. The real test of what you’re doing is whether you care whether markets are open. When I buy a stock, I don’t care whether they close the stock market tomorrow for a couple years. I’m looking to the business, Coca-Cola or whatever, to produce returns for me in the future from the business.
Me: Okay, and what is an investment then?
Buffett: An investment operation in my view is one where you look at the asset itself to determine your decision to lay out some money now to get some more money back later on. You don’t really care whether there’s a quote on it at all.
Benjamin Graham enters the room and everyone stands as a mark of respect.
Buffett: Hey, Ben, you came in just at the right time. We were discussing what separates investing from speculation. Can you add some light to the distinction?
Benjamin Graham: One of the disastrous consequences of the New Era madness in Wall Street has been the disappearance of the former clean-cut distinctions between investment and speculation in common stocks.
Old-time investment, with its emphasis on book value and the past record, was short-sighted and naive, but it possessed the supreme virtue of moderation. Present-day “investment,” as practiced by investment trusts and everyone else, is not much more than an undisciplined wagering upon the future and as such logically indistinguishable from speculation.
Me: So you are saying that everyone is speculator and no one’s an investor these days?
Graham: In the easy language of Wall Street, everyone who buys or sells a security has become an investor, regardless of what he buys, or for what purpose, or at what price, or whether for cash or on margin.
Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble–i.e., to give way to hope, fear and greed.
Me: That’s human nature, isn’t it? But can’t such behaviour be corrected?
Graham: I arrive finally at a “law” about human nature that cannot be repealed and it is unlikely to be modified to any great extent. This law says that people without experience or superior abilities may make a lot of money fast in the stock market, but most cannot keep what they make, and most of them will end up as net losers.
Buffett: As someone said, “There is no such thing as a free lunch.”
Graham: The stock market has undoubtedly reached a stage where there are many people interested in free lunches.
Let me conclude with one of my favorite clichés – the French saying: “The more it changes the more it’s the same thing.” I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of this proverb is the phrase “the more it changes.”
The economic world has changed radically and it will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change.
But if my cliché is sound – and a cliché’s only excuse, I suppose, is that it is sound –then the stock market will continue to be essentially what it always was in the past – a place where a big bull market is inevitably followed by a big bear market.
Me: So there’s no hope, right? That’s what I have been saying all this while.
Graham: But I never said there’s no hope!
Me: So Mr. Graham, do you recommend that a man of moderate means include some stocks when he invests his savings for the long term?
Graham: My answer would be definitely “yes”, under normal conditions.
Graham: Because common stocks have the advantage, in the first instance, of representing sound, growing investments, with a higher return than you would get on bonds, and secondly, because they do carry some measure of protection against inflation.
Me: Okay, but can anyone who buys stocks succeed as an investor?
Graham: There are two requirements for success as an investor. One, you have to think correctly; and secondly, you have to think independently.
Me: Is that your only advice for investing success?
Graham: My advice would be to study the past record of the stock market, study your own capabilities, and find out whether you can identify an approach to investment you feel would be satisfactory in your own case.
And if you have done that, pursue that without any reference to what other people do or think or say. Stick to your own methods. That’s what we did with our own business. We never followed the crowd, and I think that’s favorable for you as an investor.
Buffett: You may also want to tell him your three rules for investors.
Graham: Oh yes! Let me suggest three rules for individual investor regarding investment policy:
- The individual investor should act consistently as an investor and not as a speculator. This means, in sum, that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase – in other words, that he has a margin of safety, in value terms, to protect his commitment.
- The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques.
- Finally, the investor should always have a minimum percentage of his total portfolio in common stocks and a minimum percentage in bond equivalents. I recommend at least 25 per cent of the total at all times in each category. A good case can be made for a consistent 50-50 division here, with adjustments for changes in the market level. This means the investor would switch some of his stocks into bonds on significant rises of the market level, and vice-versa when the market declines.
Me: Great! Now as far as analysing common stocks is concerned, a friend referred me to your Security Analysis , which he called the Bible of investing. Is that where I should start?
Graham: They called it the “Bible of Graham and Dodd.” Yes, well now I have lost most of the interest I had in the details of security analysis which I devoted myself to so strenuously for many years.
I feel that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession.
I think we can do it successfully with a few techniques and simple principles. The main point is to have the right general principles and the character to stick to them.
Read The Intelligent Investor – which I feel would be more useful than Security Analysis of the two books.
Me: I am very enthusiastic to try my hands at stocks now, after talking to you Mr. Graham!
Graham: While enthusiasm may be necessary for great accomplishments elsewhere, on the stock market it almost invariably leads to disaster.
“Wake up Papa! It’s already 8 O’clock!” I heard as I rubbed my eyes. This time it was my daughter who woke me up.
“Grrr…I must sleep in an isolated room the next time,” I muttered under my breath as she handed me my bicycle keys.
“All sleep and no play makes Papa a dull boy!” she told me.
I got up, determined to carry on with my dream sooner than later. This was, after all, getting very interesting.