Tuesday, May 29, 2007

Chapter 2

Have a few minutes to do some reflection on chapter 2 of intelligent investor.

Chapter 2 talks about the effects of inflation. Interestingly, last time I wasn't too concerned about inflation. I thought it was only an academic concept, as useless as newton's 1st law, so to speak. But as I grew older, the diminishing purchasing power of dollar becomes more apparent. Money is a relative concept; it's only worth as much as what you can buy.

It's hard to measure inflation, but a good and conservative 'averaged' estimate of many years would be 3%. The opposite of inflation of deflation - equally not good - where the dollar you have now can have more purchasing power.

What's the relationship between inflation and investment?

Let's examine 3 scenarios that I came up:

1. Put $1000 under your pillow

Assuming inflation of 3% per year, by the end of the year, your $1000 under your pillow will be worth $970. Not exactly a good investment choice.

2. Put $1000 in bank, say fixed deposit at 2.5% (i know it's ridiculous)

After 1 year, your money increases by 2.5%, but inflation erodes that to -0.5% (2.5% - 3%). In effect, you end up with $995. Not bad compared to scenario 1, but over longer period of time, you still lose out. Not exactly a good investment but better.

3. Put $1000 in stock market, with returns of 10% (a pretty okay returns)

After 1 year and inflation taken into account, your $1000 principal becomes $1070.

That's what inflation can do to your investment.

Between bonds and inflation, it's usually said that stocks can offset inflation because the companies can pass on the cost of inflation to consumers, thereby offsetting inflation. But Graham found that it's not necessary true. Inflation offsetting works if the inflation is not excessively high or excessively low.

In this chapter, Graham again stress the importance of this idea: You don't know for sure if anything is going to happen. Hence, he never recommends putting 100% in stocks or 100% in bonds, and one must always maintain a percentage of one's capital in different assets, just in case.

Not really agreeable to this.

But one lesson that stays after reading this chapter this is: A good investment returns is one that at least beats inflation (3%), at least beat long term treasury bills rates (around 5-6% in S'pore). Should try to beat the market average, because if we can't beat the market average, might as well invest in exchange traded funds (ETF). Less work, market averaged returns. Not too bad, I'll seriously consider ETF.

Oh, one more thing. Putting money in cash deposit is actually spending 3% on nothing. Don't do that.