On The Origins Of Long-term Capital Losses And Gains - A Graham & Doddsville Perspective On Risk And Investing

Abstract

The year 2019 marked the 70th anniversary of The Intelligent Investor by Benjamin Graham (1949). We start this paper by reintroducing the definition of an investment operation as conceived by Graham. From this definition we deduce that in Graham’s investment philosophy investment risk equates with a permanent or long-term loss of capital – not with stock price fluctuations. According to Graham permanent or long-term losses of capital are periodically caused by the purchase of low quality securities far above their tangible value. Consequently investment risk can be avoided and a satisfactory return can be realized through the purchase of quality securities at low valuations, i.e. through the adoption of the margin-of-safety principle. In this paper we define a long-term capital loss/gain as a real capital loss/gain over a ten-year investment horizon. Applied to a dataset spanning 130 years covering four regions (US, Europe, Japan and Asia Pacific) we find that high valuation, low quality portfolios are characterized by the highest investment risk. Investors in high valuation, low quality portfolios experienced real losses of up to -75% over a ten-year investment horizon. A low valuation and a medium/high quality are on the other hand key fundamental characteristics in avoiding long-term capital losses. Concurrently low valuation, high quality stocks provided investors with a ten-year total real return of more than +100%, i.e. a doubling of purchasing power, in 10 out of the 14 decades across the four regions. Consequently, and consistent with Graham’s (1949) main conclusion, margin-of-safety investors have succeeded in combining low investment risk with high inflation-adjusted returns. Wealth managers and financial advisors can incorporate our findings and conclusions in building fundamentals-based (rather than price-fluctuation-based) risk profiles and investment programs in collaboration with their clients.