The Defensive Investor

"Rule No.1: Never lose money. Rule No.2: Never forget rule No.1."
                                                                                                            -Warren Buffett

Before suggesting the strategies a defensive investor must follow in the stock market, let us understand who an investor is.

An investor is someone who makes an investment with the expectation of a long term gain. On the other hand, a speculator or a trader reacts to the current market situation and tries to make quick money from fluctuations in market prices. An investor has more knowledge, than a speculator, about the enterprise in which he/she makes an investment.  

The investor can again be classified as an “aggressive/enterprising” investor and a “defensive/passive” investor. The trait of an enterprising investor will be his willingness to devote time and care to the selection of securities that are promising and which provides better than average returns. But this blog is dedicated to the defensive investor.

Who is a Defensive investor?

A defensive investor follows a conservative method of portfolio allocation and management aimed at minimizing the risk of losing principal. The defensive investor will place his emphasis mainly on the avoidance of serious mistakes or losses. His aim will be freedom from the extra effort needed for making frequent decisions. In this matter any person who can’t spare hours scanning the annual reports, financial statements and market news requires the traits of a defensive investor to become a successful investor. A defensive investor has to believe in the magic of compounding and stick to his portfolio for long term.

But the biggest challenge for a defensive investor is the ability to resist the alluring hullabaloo of the market. A defensive investor should ideally have a well-diversified portfolio covering equity, debt funds, index funds and savings or fixed deposits.

Here are a few standards that a defensive investor can apply to his purchase decisions to make sure that he obtains a sufficient quality of performance and minimization of risks:

1. Adequate size of the enterprise: Avoid small caps as the risk is higher than what a defensive investor would prefer. In short stick to large enterprises whose value does not vary greatly due to market fluctuations.
2. A sufficiently strong financial condition: For industrial companies, the current assets should be at least twice the current liabilities.

3. Earnings stability: Choose common stocks that have a history of at least a decade of earnings.
4. Dividend record: Uninterrupted dividend payment for the past one or two decades
5. Earnings growth: Look for companies that improves its financials year on year
6. Moderate P/E ratio: Current price should not be more than 15 times the average earning of the past 3 years.
7. Moderate ratio of price to assets: The current price should not be more than 1.5 times the book value for the last financial year. However as a rule of thumb, the product of P/E and price to assets should not exceed 22.5(i.e., 15*1.5). 

The parameters mentioned are specifically for the needs and temperament of the defensive investor. The investor can tweak the standards to meet the present bull market scenario and to develop a personalized set of parameters that he can then apply to all the purchases made. In this way very small companies or companies having weak financials are eliminated and hence the chances of large fluctuations are negated.

The parameters takes into account the past performance of the enterprise which may not always accurately predict its future as we can see from the explosive growth shown by the technology stocks during the dot com bubble. But as Warren Buffett puts it, "In the business world, the rearview mirror is always clearer than the windshield."

P.S: Excerpts taken from Investopedia.com and The Intelligent Investor by Benjamin Graham.
Source of images, if any: Google

Author: Praveen Cherian Jacob
Email- praveencherianjacob@gmail.com