Defensive investors and stocks
Graham's four rules for a defensive stock list, why he kept out growth stocks, and dollar-cost averaging.
FinanceGraham ch. 5About 4 min: 2 reading, 2 practiceUpdated
General education, not financial advice.
- List Graham's four rules for a defensive investor's stocks
- Explain why the price rule keeps out most growth stocks
- Calculate the average cost under dollar-cost averaging
The Intelligent Investor: Benjamin Graham's ideas: lesson 5 of 24
- Graham ch. 1
- Investment versus speculation 4 min
- Graham ch. 2
- Inflation and the investor 4 min
- Graham ch. 3
- A century of market history 5 min
- Graham ch. 4
- The defensive investor's portfolio 4 min
- Graham ch. 5
- Defensive investors and stocks 4 min
- Graham ch. 6
- What the enterprising investor avoids 4 min
- Graham ch. 7
- What the enterprising investor does 5 min
- Graham ch. 8
- Mr. Market 5 min
- Living with fluctuations 5 min
- Graham ch. 9
- Investing in funds 5 min
- Graham ch. 10
- The investor and his advisers 4 min
- Graham ch. 11
- Security analysis for the lay investor 4 min
- Graham ch. 12
- Per-share earnings and their traps 4 min
- Graham ch. 13
- Comparing four companies 4 min
- Graham ch. 14
- The defensive investor's screen 4 min
- Graham ch. 15
- The enterprising investor's screen 7 min
- Graham ch. 16
- Convertibles and warrants 6 min
- Graham ch. 17
- Four extreme case histories 7 min
- Graham ch. 18
- Eight pairs of companies 7 min
- Graham ch. 19
- Shareholders, managements and dividends 5 min
- Graham ch. 20
- Margin of safety (1): the idea 5 min
- Margin of safety (2): in practice 7 min
- Graham appendix 1
- The superinvestors of Graham-and-Doddsville 6 min
- Graham postscript
- Graham today 7 min
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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 5, "The Defensive Investor and Common Stocks"
What it is
Graham's four rules for the stock part of a defensive portfolio:
- Diversify adequately but not excessively: roughly 10 to 30 different companies.
- Each company should be large, prominent and conservatively financed.
- Each should have a long record of continuous dividends (in 1972 he asked for every year since at least 1950; Zweig suggests at least 10 years today).
- Limit the price: no more than 25 times average earnings of the past seven years, and no more than 20 times the last twelve months' earnings.
Rule 4 rules out most growth stocks: companies whose earnings have grown fast and are expected to keep doing so. Graham doesn't dislike growth; he dislikes paying so much for it that a disappointment can be costly.
Dollar-cost averaging means investing the same amount at regular intervals, whatever the market does. Graham cites a study of 23 ten-year buying periods in the Dow Jones stocks (ending 1929 to 1952): every one showed a profit, by the end or within five years after.
Quick check
Tap an answer to check it.
A company earned an average of 2 per share over seven years and 3 in the last year. Its share price is 70. Does it pass Graham's rule 4?
- 70 is 35 times the seven-year average
Show answer
No: 70 is more than 25 times the seven-year average (50). Limit = 25 × 2 = 50; and 20 × 3 = 60.
Why it matters
These rules let a defensive investor own stocks without becoming a stock-picker: they exclude what is risky or expensive, then rely on diversification. (Zweig argues that a broad index fund, bought a little at a time, can now do much the same job with even less effort.)
Worked example
Dollar-cost averaging. You invest 100 each month for three months, and the price goes 10 → 5 → 10.
| Month | Price | Shares bought |
|---|---|---|
| 1 | 10 | 10 |
| 2 | 5 | 20 |
| 3 | 10 | 10 |
You spent 300 and own 40 shares: an average cost of 7.50 a share, below the average price of 8.33, because the same money bought more shares when the price was low.
Common mistake
Treating a famous, fast-growing company as safe. Growth that's already in the price leaves no room for disappointment. Graham notes that some authorities define a "true growth stock" as one expected to at least double its earnings in ten years (a compounded rate of over 7.1% a year), and that growth stocks were the favourites of speculators and big institutions alike in his day.
Key terms
- diversification
- spreading money across many holdings
- growth stock
- a company expected to grow earnings much faster than average
- dollar-cost averaging
- investing a fixed amount at regular intervals
- earnings multiplier
- another name for the P/E ratio
- conservatively financed
- not heavily in debt
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| diversification | spreading money across many holdings |
| growth stock | a company expected to grow earnings much faster than average |
| dollar-cost averaging | investing a fixed amount at regular intervals |
| earnings multiplier | another name for the P/E ratio |
| conservatively financed | not heavily in debt |
Practice
Work it through
You invest 120 a month. Prices are 12, 8 and 6 in three months.
- 10 + 15 + 20
- 360 ÷ 45
- (12 + 8 + 6) ÷ 3
Quick quiz
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How many companies does Graham suggest for adequate diversification?
- Too few to diversify
- He calls for adequate, not excessive, diversification
Show answer
About 10 to 30. Minimum ten, maximum about thirty.
Why does dollar-cost averaging give an average cost below the average price?
- No discount is involved
Show answer
The same money buys more shares when the price is low. More shares at low prices pull the average cost down.
In short
- Four rules: 10–30 companies; large, prominent, conservatively financed; long dividend record; price limits (25× seven-year average earnings, 20× last year's).
- The price rule excludes most growth stocks.
- Dollar-cost averaging: same amount, regular intervals; average cost below average price.
- Zweig: a broad index fund can now do much of this work with less effort.
Mastery check
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Check yourself
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What are Graham's two price limits in rule 4?
Show answer
At most 25 times average earnings of the past seven years, and at most 20 times the last twelve months' earnings.
Why does Graham exclude most growth stocks?
Show answer
Their prices are usually too high relative to earnings, leaving no margin for disappointment.
You invest 100 at a price of 20 and 100 at 10. What is your average cost?
Show answer
200 ÷ 15 shares ≈ 13.33.
Further reading
- Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 5.
- On this site: Owning the whole market.
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