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hence the close of our second period found the public with no enthusiasm at all for common stocks. By the rule of opposites the time was ripe for the beginning of the greatest bull market in our history, presented in the last third of our chart. This phenomenon may have reached its culmination in December 1968 at 118 for Standard & Poor’s 425 industrials (and 108 for its 500-stock composite). As Table 3-1 shows, there were fairly important setbacks between 1949 and 1968 (especially in 1956–57 and 1961–62), but the recoveries therefrom were so rapid that they had to be denominated (in the long- accepted semantics) as recessions in a single bull market, rather than as separate market cycles. Between the low level of 162 for “the Dow” in mid-1949 and the high of 995 in early 1966, the advance had been more than sixfold in 17 years—which is at the average compounded rate of 11% per year, not counting dividends of, say, 31⁄2% per annum. (The advance for the Standard & Poor’s composite index was somewhat greater than that of the DJIA— actually from 14 to 96.) These 14% and better returns were documented in 1963, and later, in a much publicized study.* 2 It created a natural satisfaction * The study, in its final form, was Lawrence Fisher and James H. Lorie, “Rates of Return on Investments in Common Stock: the Year-by-Year CHART 1 125 100 90 80 70 60 50 40 30 STANDARD & POOR’S STOCK PRICE INDEXES 1941–1943 = 10 s& P 125 100 90 80 70 60 50 40 30 20 18 16 14 12 10 8 6 5 4 MONTHLY AVERAGE OF 425 STOCKS 2 20 18 16 14 12 10 8 6 5 4 RATIO SCALE 2 1900 — 04 05 — 09 10 — 14 15 — 19 20 — 24 25 — 29 30 — 34 35 — 39 40 — 44 45 — 49 50 — 54 55 — 59 60 — 64 65 — 69 70 — 74 on Wall Street with such fine achievements, and a quite illogical and dangerous conviction that equally marvelous results could be expected for common stocks in the future. Few people seem to have been bothered by the thought that the very extent of th

20 18 16 14 12 10 8 6 5 4 MONTHLY AVERAGE OF 425 STOCKS 2 20 18 16 14 12 10 8 6 5 4 RATIO SCALE 2 1900 — 04 05 — 09 10 — 14 15 — 19 20 — 24 25 — 29 30 — 34 35 — 39 40 — 44 45 — 49 50 — 54 55 — 59 60 — 64 65 — 69 70 — 74 on Wall Street with such fine achievements, and a quite illogical and dangerous conviction that equally marvelous results could be expected for common stocks in the future. Few people seem to have been bothered by the thought that the very extent of the rise might indicate that it had been overdone. The subsequent decline from the 1968 high to the 1970 low was 36% for the Standard & Poor’s com- posite (and 37% for the DJIA), the largest since the 44% suffered in 1939–1942, which had reflected the perils and uncertainties after Pearl Harbor. In the dramatic manner so characteristic of Wall Street, the low level of May 1970 was followed by a massive and speedy recovery of both averages, and the establishment of a new all-time high for the Standard & Poor’s industrials in early 1972. The annual rate of price advance between 1949 and 1970 works out at about 9% for the S & P composite (or the industrial index), using the average figures for both years. That rate of climb was, of course, much greater than for any similar period before 1950. (But in the last decade the rate of advance was much lower—51⁄4% for the S & P composite index and only the once familiar 3% for the DJIA.) The record of price movements should be supplemented by cor- responding figures for earnings and dividends, in order to provide an overall view of what has happened to our share economy over the ten decades. We present a conspectus of this kind in our Table 3-2 (p. 71). It is a good deal to expect from the reader that he study all these figures with care, but for some we hope they will be inter- esting and instructive. Let us comment on them as follows: The full decade figures smooth out the year-to-year fluctuations and leave a general pic- ture of persi

responding figures for earnings and dividends, in order to provide an overall view of what has happened to our share economy over the ten decades. We present a conspectus of this kind in our Table 3-2 (p. 71). It is a good deal to expect from the reader that he study all these figures with care, but for some we hope they will be inter- esting and instructive. Let us comment on them as follows: The full decade figures smooth out the year-to-year fluctuations and leave a general pic- ture of persistent growth. Only two of the nine decades after the first show a decrease in earnings and average prices (in 1891–1900 and 1931–1940), and no decade after 1900 shows a decrease in aver- age dividends. But the rates of growth in all three categories are quite variable. In general the performance since World War II has been superior to that of earlier decades, but the advance in the 1960s was less pronounced than that of the 1950s. Today’s investor Record, 1926–65,” The Journal of Business, vol. XLI, no. 3 (July, 1968), pp. 291–316. For a summary of the study’s wide influence, see http:// library.dfaus.com/reprints/work_of_art/. cannot tell from this record what percentage gain in earnings divi- dends and prices he may expect in the next ten years, but it does supply all the encouragement he needs for a consistent policy of common-stock investment. However, a point should be made here that is not disclosed in our table. The year 1970 was marked by a definite deterioration in the overall earnings posture of our corporations. The rate of profit on invested capital fell to the lowest percentage since the World War years. Equally striking is the fact that a considerable number of companies reported net losses for the year; many became “finan- cially troubled,” and for the first time in three decades there were quite a few important bankruptcy proceedings. These facts as much as any others have prompted the statement made above* that the great boom era may have come to an end in

all earnings posture of our corporations. The rate of profit on invested capital fell to the lowest percentage since the World War years. Equally striking is the fact that a considerable number of companies reported net losses for the year; many became “finan- cially troubled,” and for the first time in three decades there were quite a few important bankruptcy proceedings. These facts as much as any others have prompted the statement made above* that the great boom era may have come to an end in 1969–1970. A striking feature of Table 3-2 is the change in the price/earn- ings ratios since World War II.† In June 1949 the S & P composite index sold at only 6.3 times the applicable earnings of the past 12 months; in March 1961 the ratio was 22.9 times. Similarly, the divi- dend yield on the S & P index had fallen from over 7% in 1949 to only 3.0% in 1961, a contrast heightened by the fact that interest rates on high-grade bonds had meanwhile risen from 2.60% to 4.50%. This is certainly the most remarkable turnabout in the public’s attitude in all stock-market history. To people of long experience and innate caution the passage from one extreme to another carried a strong warning of trou- ble ahead. They could not help thinking apprehensively of the 1926–1929 bull market and its tragic aftermath. But these fears have not been confirmed by the event. True, the closing price of the DJIA * See pp. 50–52. † The “price/earnings ratio” of a stock, or of a market average like the S & P 500-stock index, is a simple tool for taking the market’s temperature. If, for instance, a company earned $1 per share of net income over the past year, and its stock is selling at $8.93 per share, its price/earnings ratio would be 8.93; if, however, the stock is selling at $69.70, then the price/earnings ratio would be 69.7. In general, a price/earnings ratio (or “P/E” ratio) below 10 is considered low, between 10 and 20 is considered moderate, and greater than 20 is considered expensive. (For

500-stock index, is a simple tool for taking the market’s temperature. If, for instance, a company earned $1 per share of net income over the past year, and its stock is selling at $8.93 per share, its price/earnings ratio would be 8.93; if, however, the stock is selling at $69.70, then the price/earnings ratio would be 69.7. In general, a price/earnings ratio (or “P/E” ratio) below 10 is considered low, between 10 and 20 is considered moderate, and greater than 20 is considered expensive. (For more on P/E ratios, see p. 168.) TABLE 3-2 A Picture of Stock-Market Performance, 1871–1970a Period Average Average Average Dividend Average Average Annual Growth Rateb Price Earnings P/E Ratio Average Yield Payout Earnings Dividends 1871–1880 3.58 0.32 11.3 0.21 6.0% 67% — — 1881–1890 5.00 0.32 15.6 0.24 4.7 75 – 0.64% –0.66% 1891–1900 4.65 0.30 15.5 0.19 4.0 64 – 1.04 –2.23 1901–1910 8.32 0.63 13.1 0.35 4.2 58 + 6.91 +5.33 1911–1920 8.62 0.86 10.0 0.50 5.8 58 + 3.85 +3.94 1921–1930 13.89 1.05 13.3 0.71 5.1 68 + 2.84 +2.29 1931–1940 11.55 0.68 17.0 0.78 5.1 85 – 2.15 –0.23 1941–1950 13.90 1.46 9.5 0.87 6.3 60 +10.60 +3.25 1951–1960 39.20 3.00 13.1 1.63 4.2 54 + 6.74 +5.90 1961–1970 82.50 4.83 17.1 2.68 3.2 55 + 5.80 c +5.40c 1954–1956 38.19 2.56 15.1 1.64 4.3 65 + 2.40 d +7.80d 1961–1963 66.10 3.66 18.1 2.14 3.2 58 + 5.15 d +4.42d 1968–1970 93.25 5.60 16.7 3.13 3.3 56 + 6.30 d +5.60d a The following data based largely on figures appearing in N. Molodovsky’s article, “Stock Values and Stock Prices,” Financial Analysts Journal, May 1960. These, in turn, are taken from the Cowles Commission book Common Stock Indexes for years before 1926 and from the spliced-on Standard & Poor’s 500-stock composite index for 1926 to date. b The annual growth-rate figures are Molodovsky compilations covering successive 21-year periods ending in 1890, 1900, etc. c Growth rate for 1968–1970 vs. 1958–1960. d These growth-rate figures are for 1954–1956 vs. 1947–1949, 1961–1963 vs. 1954–1956

lues and Stock Prices,” Financial Analysts Journal, May 1960. These, in turn, are taken from the Cowles Commission book Common Stock Indexes for years before 1926 and from the spliced-on Standard & Poor’s 500-stock composite index for 1926 to date. b The annual growth-rate figures are Molodovsky compilations covering successive 21-year periods ending in 1890, 1900, etc. c Growth rate for 1968–1970 vs. 1958–1960. d These growth-rate figures are for 1954–1956 vs. 1947–1949, 1961–1963 vs. 1954–1956, and for 1968–1970 vs. 1958–1960. in 1970 was the same as it was 61⁄2 years earlier, and the much her- alded “Soaring Sixties” proved to be mainly a march up a series of high hills and then down again. But nothing has happened either to business or to stock prices that can compare with the bear mar- ket and depression of 1929–1932. The Stock-Market Level in Early 1972 With a century-long conspectus of stock, prices, earnings, and dividends before our eyes, let us try to draw some conclusions about the level of 900 for the DJIA and 100 for the S & P composite index in January 1972. In each of our former editions we have discussed the level of the stock market at the time of writing, and endeavored to answer the question whether it was too high for conservative purchase. The reader may find it informing to review the conclusions we reached on these earlier occasions. This is not entirely an exercise in self- punishment. It will supply a sort of connecting tissue that links the various stages of the stock market in the past twenty years and also a taken-from-life picture of the difficulties facing anyone who tries to reach an informed and critical judgment of current market lev- els. Let us, first, reproduce the summary of the 1948, 1953, and 1959 analyses that we gave in the 1965 edition: In 1948 we applied conservative standards to the Dow Jones level of 180, and found no difficulty in reaching the conclusion that “it was not too high in relation to underlying values.” Whe

s stages of the stock market in the past twenty years and also a taken-from-life picture of the difficulties facing anyone who tries to reach an informed and critical judgment of current market lev- els. Let us, first, reproduce the summary of the 1948, 1953, and 1959 analyses that we gave in the 1965 edition: In 1948 we applied conservative standards to the Dow Jones level of 180, and found no difficulty in reaching the conclusion that “it was not too high in relation to underlying values.” When we approached this problem in 1953 the average market level for that year had reached 275, a gain of over 50% in five years. We asked ourselves the same question—namely, “whether in our opinion the level of 275 for the Dow Jones Industrials was or was not too high for sound investment.” In the light of the subsequent spectacular advance, it may seem strange to have to report that it was by no means easy for us to reach a definitive conclusion as to the attrac- tiveness of the 1953 level. We did say, positively enough, that “from the standpoint of value indications—our chief investment guide—the conclusion about 1953 stock prices must be favorable.” But we were concerned about the fact that in 1953, the averages had advanced for a longer period than in most bull markets of the past, and that its absolute level was historically high. Setting these factors against our favorable value judgment, we advised a cau- tious or compromise policy. As it turned out, this was not a partic- ularly brilliant counsel. A good prophet would have foreseen that the market level was due to advance an additional 100% in the next five years. Perhaps we should add in self-defense that few if any of those whose business was stock-market forecasting—as ours was not—had any better inkling than we did of what lay ahead. At the beginning of 1959 we found the DJIA at an all-time high of 584. Our lengthy analysis made from all points of view may be summarized in the following (from page 59 of the 1959 e

y brilliant counsel. A good prophet would have foreseen that the market level was due to advance an additional 100% in the next five years. Perhaps we should add in self-defense that few if any of those whose business was stock-market forecasting—as ours was not—had any better inkling than we did of what lay ahead. At the beginning of 1959 we found the DJIA at an all-time high of 584. Our lengthy analysis made from all points of view may be summarized in the following (from page 59 of the 1959 edition): “In sum, we feel compelled to express the conclusion that the pres- ent level of stock prices is a dangerous one. It may well be perilous because prices are already far too high. But even if this is not the case the market’s momentum is such as inevitably to carry it to unjustifiable heights. Frankly, we cannot imagine a market of the future in which there will never be any serious losses, and in which, every tyro will be guaranteed a large profit on his stock purchases.” The caution we expressed in 1959 was somewhat better justi- fied by the sequel than was our corresponding attitude in 1954. Yet it was far from fully vindicated. The DJIA advanced to 685 in 1961; then fell a little below our 584 level (to 566) later in the year; advanced again to 735 in late 1961; and then declined in near panic to 536 in May 1962, showing a loss of 27% within the brief period of six months. At the same time there was a far more serious shrinkage in the most popular “growth stocks”—as evidenced by the striking fall of the indisputable leader, International Business Machines, from a high of 607 in December 1961 to a low of 300 in June 1962. This period saw a complete debacle in a host of newly launched common stocks of small enterprises—the so-called hot issues— which had been offered to the public at ridiculously high prices and then had been further pushed up by needless speculation to levels little short of insane. Many of these lost 90% and more of the quotations in just a few mo

ed by the striking fall of the indisputable leader, International Business Machines, from a high of 607 in December 1961 to a low of 300 in June 1962. This period saw a complete debacle in a host of newly launched common stocks of small enterprises—the so-called hot issues— which had been offered to the public at ridiculously high prices and then had been further pushed up by needless speculation to levels little short of insane. Many of these lost 90% and more of the quotations in just a few months. The collapse in the first half of 1962 was disconcerting, if not disastrous, to many self-acknowledged speculators and perhaps to many more imprudent people who called themselves “in- vestors.” But the turnabout that came later that year was equally unsuspected by the financial community. The stock-market aver- ages resumed their upward course, producing the following sequence: Standard & Poor’s DJIA 500-Stock Composite December 1961 735 72.64 June 1962 536 52.32 November 1964 892 86.28 The recovery and new ascent of common-stock prices was indeed remarkable and created a corresponding revision of Wall Street sentiment. At the low level of June 1962 predictions had appeared predominantly bearish, and after the partial recovery to the end of that year they were mixed, leaning to the skeptical side. But at the outset of 1964 the natural optimism of brokerage firms was again manifest; nearly all the forecasts were on the bullish side, and they so continued through the 1964 advance. We then approached the task of appraising the November 1964 levels of the stock market (892 for the DJIA). After discussing it learnedly from numerous angles we reached three main con- clusions. The first was that “old standards (of valuation) appear inapplicable; new standards have not yet been tested by time.” The second was that the investor “must base his policy on the existence of major uncertainties. The possibilities compass the extremes, on the one hand, of a protracted and furthe

vance. We then approached the task of appraising the November 1964 levels of the stock market (892 for the DJIA). After discussing it learnedly from numerous angles we reached three main con- clusions. The first was that “old standards (of valuation) appear inapplicable; new standards have not yet been tested by time.” The second was that the investor “must base his policy on the existence of major uncertainties. The possibilities compass the extremes, on the one hand, of a protracted and further advance in the market’s level—say by 50%, or to 1350 for the DJIA; or, on the other hand, of a largely unheralded collapse of the same magni- tude, bringing the average in the neighborhood of, say, 450" (p. 63). The third was expressed in much more definite terms. We said: “Speaking bluntly, if the 1964 price level is not too high how could we say that any price level is too high?” And the chapter closed as follows: WHAT COURSE TO FOLLOW Investors should not conclude that the 1964 market level is dan- gerous merely because they read it in this book. They must weigh our reasoning against the contrary reasoning they will hear from most competent and experienced people on Wall Street. In the end each one must make his own decision and accept responsibility therefor. We suggest, however, that if the investor is in doubt as to which course to pursue he should choose the path of caution. The principles of investment, as set forth herein, would call for the fol- lowing policy under 1964 conditions, in order of urgency: 1. No borrowing to buy or hold securities. 2. No increase in the proportion of funds held in common stocks. 3. A reduction in common-stock holdings where needed to bring it down to a maximum of 50 per cent of the total portfolio. The capital-gains tax must be paid with as good grace as possible, and the proceeds invested in first-quality bonds or held as a savings deposit. Investors who for some time have been following a bona fide dollar-cost averaging plan can

conditions, in order of urgency: 1. No borrowing to buy or hold securities. 2. No increase in the proportion of funds held in common stocks. 3. A reduction in common-stock holdings where needed to bring it down to a maximum of 50 per cent of the total portfolio. The capital-gains tax must be paid with as good grace as possible, and the proceeds invested in first-quality bonds or held as a savings deposit. Investors who for some time have been following a bona fide dollar-cost averaging plan can in logic elect either to continue their periodic purchases unchanged or to suspend them until they feel the market level is no longer dangerous. We should advise rather strongly against the initiation of a new dollar-averaging plan at the late 1964 levels, since many investors would not have the stamina to pursue such a scheme if the results soon after initiation should appear highly unfavorable. This time we can say that our caution was vindicated. The DJIA advanced about 11% further, to 995, but then fell irregularly to a low of 632 in 1970, and finished that year at 839. The same kind of debacle took place in the price of “hot issues”—i.e., with declines running as much as 90%—as had happened in the 1961–62 setback. And, as pointed out in the Introduction, the whole financial picture appeared to have changed in the direction of less enthusiasm and greater doubts. A single fact may summarize the story: The DJIA closed 1970 at a level lower than six years before—the first time such a thing had happened since 1944. Such were our efforts to evaluate former stock-market levels. Is there anything we and our readers can learn from them? We con- sidered the market level favorable for investment in 1948 and 1953 (but too cautiously in the latter year), “dangerous” in 1959 (at 584 for DJIA), and “too high” (at 892) in 1964. All of these judgments could be defended even today by adroit arguments. But it is doubt- ful if they have been as useful as our more pedestrian counsels—in fa

thing had happened since 1944. Such were our efforts to evaluate former stock-market levels. Is there anything we and our readers can learn from them? We con- sidered the market level favorable for investment in 1948 and 1953 (but too cautiously in the latter year), “dangerous” in 1959 (at 584 for DJIA), and “too high” (at 892) in 1964. All of these judgments could be defended even today by adroit arguments. But it is doubt- ful if they have been as useful as our more pedestrian counsels—in favor of a consistent and controlled common-stock policy on the one hand, and discouraging endeavors to “beat the market” or to “pick the winners” on the other. Nonetheless we think our readers may derive some benefit from a renewed consideration of the level of the stock market—this time as of late 1971—even if what we have to say will prove more inter- esting than practically useful, or more indicative than conclusive. There is a fine passage near the beginning of Aristotle’s Ethics that goes: “It is the mark of an educated mind to expect that amount of exactness which the nature of the particular subject admits. It is equally unreasonable to accept merely probable conclusions from a mathematician and to demand strict demonstration from an ora- tor.” The work of a financial analyst falls somewhere in the middle between that of a mathematician and of an orator. At various times in 1971 the Dow Jones Industrial Average stood at the 892 level of November 1964 that we considered in our previ- ous edition. But in the present statistical study we have decided to use the price level and the related data for the Standard & Poor’s composite index (or S & P 500), because it is more comprehensive and representative of the general market than the 30-stock DJIA. We shall concentrate on a comparison of this material near the four dates of our former editions—namely the year-ends of 1948, 1953, 1958 and 1963—plus 1968; for the current price level we shall take the convenient figure of 100,

vi- ous edition. But in the present statistical study we have decided to use the price level and the related data for the Standard & Poor’s composite index (or S & P 500), because it is more comprehensive and representative of the general market than the 30-stock DJIA. We shall concentrate on a comparison of this material near the four dates of our former editions—namely the year-ends of 1948, 1953, 1958 and 1963—plus 1968; for the current price level we shall take the convenient figure of 100, which was registered at various times in 1971 and in early 1972. The salient data are set forth in Table 3-3. For our earnings figures we present both the last year’s showing and the average of three calendar years; for 1971 dividends we use the last twelve months’ figures; and for 1971 bond interest and wholesale prices those of August 1971. The 3-year price/earnings ratio for the market was lower in October 1971 than at year-end 1963 and 1968. It was about the same as in 1958, but much higher than in the early years of the long bull TABLE 3-3 Data Relating to Standard & Poor’s Composite Index in Various Years Year a 1948 1953 1958 1963 1968 1971 Closing price 15.20 24.81 55.21 75.02 103.9 100 d Earned in current year 2.24 2.51 2.89 4.02 5.76 5.23 Average earnings of last 3 years 1.65 2.44 2.22 3.63 5.37 5.53 Dividend in current year .93 1.48 1.75 2.28 2.99 3.10 High-grade bond interest a 2.77% 3.08% 4.12% 4.36% 6.51% 7.57% Wholesale-price index 87.9 92.7 100.4 105.0 108.7 114.3 Ratios: Price/last year’s earnings 6.3 X 9.9 X 18.4 X 18.6 X 18.0 X 19.2 X Price/3-years’ earnings 9.2 X 10.2 X 17.6 X 20.7 X 19.5 X 18.1 X 3-Years’ “earnings yield” c 10.9 % 9.8 % 5.8 % 4.8 % 5.15% 5.53% Dividend yield 5.6 % 5.5 % 3.3 % 3.04% 2.87% 3.11% Stock-earnings yield/bond yield 3.96X 3.20X 1.41X 1.10X .80X .72X Dividend yield/bond yield 2.1 X 1.8 X .80X .70X .44X .41X Earnings/book value e 11.2 % 11.8 % 12.8 % 10.5 % 11.5 % 11.5 % a Yield on S & P AAA bonds. b Calendar years i

4.3 Ratios: Price/last year’s earnings 6.3 X 9.9 X 18.4 X 18.6 X 18.0 X 19.2 X Price/3-years’ earnings 9.2 X 10.2 X 17.6 X 20.7 X 19.5 X 18.1 X 3-Years’ “earnings yield” c 10.9 % 9.8 % 5.8 % 4.8 % 5.15% 5.53% Dividend yield 5.6 % 5.5 % 3.3 % 3.04% 2.87% 3.11% Stock-earnings yield/bond yield 3.96X 3.20X 1.41X 1.10X .80X .72X Dividend yield/bond yield 2.1 X 1.8 X .80X .70X .44X .41X Earnings/book value e 11.2 % 11.8 % 12.8 % 10.5 % 11.5 % 11.5 % a Yield on S & P AAA bonds. b Calendar years in 1948–1968, plus year ended June 1971. c “Earnings yield” means the earnings divided by the price, in %. d Price in Oct. 1971, equivalent to 900 for the DJIA. e Three-year average figures. market. This important indicator, taken by itself, could not be con- strued to indicate that the market was especially high in January 1972. But when the interest yield on high-grade bonds is brought into the picture, the implications become much less favorable. The reader will note from our table that the ratio of stock returns (earn- ings/price) to bond returns has grown worse during the entire period, so that the January 1972 figure was less favorable to stocks, by this criterion, than in any of the previous years examined. When dividend yields are compared with bond yields we find that the relationship was completely reversed between 1948 and 1972. In the early year stocks yielded twice as much as bonds; now bonds yield twice as much, and more, than stocks. Our final judgment is that the adverse change in the bond- yield/stock-yield ratio fully offsets the better price/earnings ratio for late 1971, based on the 3-year earnings figures. Hence our view of the early 1972 market level would tend to be the same as it was some 7 years ago—i.e., that it is an unattractive one from the stand- point of conservative investment. (This would apply to most of the 1971 price range of the DJIA: between, say, 800 and 950.) In terms of historical market swings the 1971 picture would still appear to b

se change in the bond- yield/stock-yield ratio fully offsets the better price/earnings ratio for late 1971, based on the 3-year earnings figures. Hence our view of the early 1972 market level would tend to be the same as it was some 7 years ago—i.e., that it is an unattractive one from the stand- point of conservative investment. (This would apply to most of the 1971 price range of the DJIA: between, say, 800 and 950.) In terms of historical market swings the 1971 picture would still appear to be one of irregular recovery from the bad setback suf- fered in 1969–1970. In the past such recoveries have ushered in a new stage of the recurrent and persistent bull market that began in 1949. (This was the expectation of Wall Street generally during 1971.) After the terrible experience suffered by the public buyers of low-grade common-stock offerings in the 1968–1970 cycle, it is too early (in 1971) for another twirl of the new-issue merry-go-round. Hence that dependable sign of imminent danger in the market is lacking now, as it was at the 892 level of the DJIA in November 1964, considered in our previous edition. Technically, then, the out- look would appear to favor another substantial rise far beyond the 900 DJIA level before the next serious setback or collapse. But we cannot quite leave the matter there, as perhaps we should. To us, the early-1971-market’s disregard of the harrowing experiences of less than a year before is a disquieting sign. Can such heedlessness go unpunished? We think the investor must be prepared for diffi- cult times ahead—perhaps in the form of a fairly quick replay of the the 1969–1970 decline, or perhaps in the form of another bull- market fling, to be followed by a more catastrophic collapse.3 A Century of Stock-Market History 79 What Course to Follow Turn back to what we said in the last edition, reproduced on p. 75. This is our view at the same price level—say 900—for the DJIA in early 1972 as it was in late 1964. COMMENTARY ON CHAPTE

d? We think the investor must be prepared for diffi- cult times ahead—perhaps in the form of a fairly quick replay of the the 1969–1970 decline, or perhaps in the form of another bull- market fling, to be followed by a more catastrophic collapse.3 A Century of Stock-Market History 79 What Course to Follow Turn back to what we said in the last edition, reproduced on p. 75. This is our view at the same price level—say 900—for the DJIA in early 1972 as it was in late 1964. COMMENTARY ON CHAPTER 3 You’ve got to be careful if you don’t know where you’re going, ’cause you might not get there. —Yogi Berra B U LL-MAR K ET B AL ON EY In this chapter, Graham shows how prophetic he can be. He looks two years ahead, foreseeing the “catastrophic” bear market of 1973–1974, in which U.S. stocks lost 37% of their value.1 He also looks more than two decades into the future, eviscerating the logic of market gurus and best-selling books that were not even on the horizon in his lifetime. The heart of Graham’s argument is that the intelligent investor must never forecast the future exclusively by extrapolating the past. Unfortu- nately, that’s exactly the mistake that one pundit after another made in the 1990s. A stream of bullish books followed Wharton finance pro- fessor Jeremy Siegel’s Stocks for the Long Run (1994)—culminating, in a wild crescendo, with James Glassman and Kevin Hassett’s Dow 36,000, David Elias’ Dow 40,000, and Charles Kadlec’s Dow 100,000 (all published in 1999). Forecasters argued that stocks had returned an annual average of 7% after inflation ever since 1802. Therefore, they concluded, that’s what investors should expect in the future. Some bulls went further. Since stocks had “always” beaten bonds over any period of at least 30 years, stocks must be less risky than bonds or even cash in the bank. And if you can eliminate all the risk of owning stocks simply by hanging on to them long enough, then why 1 If dividends are not included, stocks fell 47.8

Forecasters argued that stocks had returned an annual average of 7% after inflation ever since 1802. Therefore, they concluded, that’s what investors should expect in the future. Some bulls went further. Since stocks had “always” beaten bonds over any period of at least 30 years, stocks must be less risky than bonds or even cash in the bank. And if you can eliminate all the risk of owning stocks simply by hanging on to them long enough, then why 1 If dividends are not included, stocks fell 47.8% in those two years. 80 quibble over how much you pay for them in the first place? (To find out why, see the sidebar on p. 82.) In 1999 and early 2000, bull-market baloney was everywhere: • On December 7, 1999, Kevin Landis, portfolio manager of the Firsthand mutual funds, appeared on CNN’s Moneyline telecast. Asked if wireless telecommunication stocks were overvalued— with many trading at infinite multiples of their earnings—Landis had a ready answer. “It’s not a mania,” he shot back. “Look at the outright growth, the absolute value of the growth. It’s big.” • On January 18, 2000, Robert Froelich, chief investment strategist at the Kemper Funds, declared in the Wall Street Journal: “It’s a new world order. We see people discard all the right companies with all the right people with the right vision because their stock price is too high—that’s the worst mistake an investor can make.” • In the April 10, 2000, issue of BusinessWeek, Jeffrey M. Apple- gate, then the chief investment strategist at Lehman Brothers, asked rhetorically: “Is the stock market riskier today than two years ago simply because prices are higher? The answer is no.” But the answer is yes. It always has been. It always will be. And when Graham asked, “Can such heedlessness go unpun- ished?” he knew that the eternal answer to that question is no. Like an enraged Greek god, the stock market crushed everyone who had come to believe that the high returns of the late 1990s were some kind of divine right. Ju

strategist at Lehman Brothers, asked rhetorically: “Is the stock market riskier today than two years ago simply because prices are higher? The answer is no.” But the answer is yes. It always has been. It always will be. And when Graham asked, “Can such heedlessness go unpun- ished?” he knew that the eternal answer to that question is no. Like an enraged Greek god, the stock market crushed everyone who had come to believe that the high returns of the late 1990s were some kind of divine right. Just look at how those forecasts by Landis, Froelich, and Applegate held up: • From 2000 through 2002, the most stable of Landis’s pet wire- less stocks, Nokia, lost “only” 67%—while the worst, Winstar Communications, lost 99.9%. • Froelich’s favorite stocks—Cisco Systems and Motorola—fell more than 70% by late 2002. Investors lost over $400 billion on Cisco alone—more than the annual economic output of Hong Kong, Israel, Kuwait, and Singapore combined. • In April 2000, when Applegate asked his rhetorical question, the Dow Jones Industrials stood at 11,187; the NASDAQ Composite Index was at 4446. By the end of 2002, the Dow was hobbling around the 8,300 level, while NASDAQ had withered to roughly 1300—eradicating all its gains over the previous six years. S U RVIV AL OF TH E F A TTE ST There was a fatal flaw in the argument that stocks have “always” beaten bonds in the long run: Reliable figures before 1871 do not exist. The indexes used to represent the U.S. stock market’s earliest returns contain as few as seven (yes, 7!) stocks.1 By 1800, however, there were some 300 companies in America (many in the Jeffersonian equivalents of the Internet: wooden turnpikes and canals). Most went bankrupt, and their investors lost their knickers. But the stock indexes ignore all the companies that went bust in those early years, a problem technically known as “sur- vivorship bias.” Thus these indexes wildly overstate the results earned by real-life investors—who lacked the 20/20 hindsig

returns contain as few as seven (yes, 7!) stocks.1 By 1800, however, there were some 300 companies in America (many in the Jeffersonian equivalents of the Internet: wooden turnpikes and canals). Most went bankrupt, and their investors lost their knickers. But the stock indexes ignore all the companies that went bust in those early years, a problem technically known as “sur- vivorship bias.” Thus these indexes wildly overstate the results earned by real-life investors—who lacked the 20/20 hindsight necessary to know exactly which seven stocks to buy. A lonely handful of companies, including Bank of New York and J. P. Mor- gan Chase, have prospered continuously since the 1790s. But for every such miraculous survivor, there were thousands of financial disasters like the Dismal Swamp Canal Co., the Penn- sylvania Cultivation of Vines Co., and the Snickers’s Gap Turn- pike Co.—all omitted from the “historical” stock indexes. Jeremy Siegel’s data show that, after inflation, from 1802 through 1870 stocks gained 7.0% per year, bonds 4.8%, and cash 5.1%. But Elroy Dimson and his colleagues at London Business School estimate that the pre-1871 stock returns are overstated by at least two percentage points per year.2 In the real world, then, stocks did no better than cash and bonds—and perhaps a bit worse. Anyone who claims that the long-term record “proves” that stocks are guaranteed to outperform bonds or cash is an ignoramus. 1 By the 1840s, these indexes had widened to include a maximum of seven finan- cial stocks and 27 railroad stocks—still an absurdly unrepresentative sample of the rambunctious young American stock market. 2 See Jason Zweig, “New Cause for Caution on Stocks,” Time, May 6, 2002, p. 71. As Graham hints on p. 65, even the stock indexes between 1871 and the 1920s suffer from survivorship bias, thanks to the hundreds of automobile, aviation, and radio companies that went bust without a trace. These returns, too, are probably overstated by one to two percent

ximum of seven finan- cial stocks and 27 railroad stocks—still an absurdly unrepresentative sample of the rambunctious young American stock market. 2 See Jason Zweig, “New Cause for Caution on Stocks,” Time, May 6, 2002, p. 71. As Graham hints on p. 65, even the stock indexes between 1871 and the 1920s suffer from survivorship bias, thanks to the hundreds of automobile, aviation, and radio companies that went bust without a trace. These returns, too, are probably overstated by one to two percentage points. T HE HI GHER T HE Y G O , TH E HAR D E R TH EY F ALL As the enduring antidote to this kind of bull-market baloney, Graham urges the intelligent investor to ask some simple, skeptical questions. Why should the future returns of stocks always be the same as their past returns? When every investor comes to believe that stocks are guaranteed to make money in the long run, won’t the market end up being wildly overpriced? And once that happens, how can future returns possibly be high? Graham’s answers, as always, are rooted in logic and common sense. The value of any investment is, and always must be, a function of the price you pay for it. By the late 1990s, inflation was withering away, corporate profits appeared to be booming, and most of the world was at peace. But that did not mean—nor could it ever mean— that stocks were worth buying at any price. Since the profits that com- panies can earn are finite, the price that investors should be willing to pay for stocks must also be finite. Think of it this way: Michael Jordan may well have been the great- est basketball player of all time, and he pulled fans into Chicago Sta- dium like a giant electromagnet. The Chicago Bulls got a bargain by paying Jordan up to $34 million a year to bounce a big leather ball around a wooden floor. But that does not mean the Bulls would have been justified paying him $340 million, or $3.4 billion, or $34 billion, per season. T HE L IMI T S O F O P T IMISM Focusing on the market’s r

so be finite. Think of it this way: Michael Jordan may well have been the great- est basketball player of all time, and he pulled fans into Chicago Sta- dium like a giant electromagnet. The Chicago Bulls got a bargain by paying Jordan up to $34 million a year to bounce a big leather ball around a wooden floor. But that does not mean the Bulls would have been justified paying him $340 million, or $3.4 billion, or $34 billion, per season. T HE L IMI T S O F O P T IMISM Focusing on the market’s recent returns when they have been rosy, warns Graham, will lead to “a quite illogical and dangerous conclusion that equally marvelous results could be expected for common stocks in the future.” From 1995 through 1999, as the market rose by at least 20% each year—a surge unprecedented in American history—stock buyers became ever more optimistic: • In mid-1998, investors surveyed by the Gallup Organization for the PaineWebber brokerage firm expected their portfolios to earn an average of roughly 13% over the year to come. By early 2000, their average expected return had jumped to more than 18%. • “Sophisticated professionals” were just as bullish, jacking up their own assumptions of future returns. In 2001, for instance, SBC Communications raised the projected return on its pension plan from 8.5% to 9.5%. By 2002, the average assumed rate of return on the pension plans of companies in the Standard & Poor’s 500- stock index had swollen to a record-high 9.2%. A quick follow-up shows the awful aftermath of excess enthusiasm: • Gallup found in 2001 and 2002 that the average expectation of one-year returns on stocks had slumped to 7%—even though investors could now buy at prices nearly 50% lower than in 2000.2 • Those gung-ho assumptions about the returns on their pension plans will cost the companies in the S & P 500 a bare minimum of $32 billion between 2002 and 2004, according to recent Wall Street estimates. Even though investors all know they’re supposed to buy low and s

he awful aftermath of excess enthusiasm: • Gallup found in 2001 and 2002 that the average expectation of one-year returns on stocks had slumped to 7%—even though investors could now buy at prices nearly 50% lower than in 2000.2 • Those gung-ho assumptions about the returns on their pension plans will cost the companies in the S & P 500 a bare minimum of $32 billion between 2002 and 2004, according to recent Wall Street estimates. Even though investors all know they’re supposed to buy low and sell high, in practice they often end up getting it backwards. Graham’s warning in this chapter is simple: “By the rule of opposites,” the more enthusiastic investors become about the stock market in the long run, the more certain they are to be proved wrong in the short run. On March 24, 2000, the total value of the U.S. stock market peaked at $14.75 trillion. By October 9, 2002, just 30 months later, the total U.S. stock market was worth $7.34 trillion, or 50.2% less—a loss of $7.41 trillion. Meanwhile, many market pundits turned sourly bear- ish, predicting flat or even negative market returns for years—even decades—to come. At this point, Graham would ask one simple question: Considering how calamitously wrong the “experts” were the last time they agreed on something, why on earth should the intelligent investor believe them now? 2 Those cheaper stock prices do not mean, of course, that investors’ expec- tation of a 7% stock return will be realized. WHA T’S N E X T? Instead, let’s tune out the noise and think about future returns as Gra- ham might. The stock market’s performance depends on three factors: • real growth (the rise of companies’ earnings and dividends) • inflationary growth (the general rise of prices throughout the economy) • speculative growth—or decline (any increase or decrease in the investing public’s appetite for stocks) In the long run, the yearly growth in corporate earnings per share has averaged 1.5% to 2% (not counting inflation).3 As of e

let’s tune out the noise and think about future returns as Gra- ham might. The stock market’s performance depends on three factors: • real growth (the rise of companies’ earnings and dividends) • inflationary growth (the general rise of prices throughout the economy) • speculative growth—or decline (any increase or decrease in the investing public’s appetite for stocks) In the long run, the yearly growth in corporate earnings per share has averaged 1.5% to 2% (not counting inflation).3 As of early 2003, inflation was running around 2.4% annually; the dividend yield on stocks was 1.9%. So, 1.5% to 2% + 2.4% + 1.9% = 5.8% to 6.3% In the long run, that means you can reasonably expect stocks to average roughly a 6% return (or 4% after inflation). If the investing public gets greedy again and sends stocks back into orbit, then that speculative fever will temporarily drive returns higher. If, instead, investors are full of fear, as they were in the 1930s and 1970s, the returns on stocks will go temporarily lower. (That’s where we are in 2003.) Robert Shiller, a finance professor at Yale University, says Graham inspired his valuation approach: Shiller compares the current price of the Standard & Poor’s 500-stock index against average corporate profits over the past 10 years (after inflation). By scanning the histori- cal record, Shiller has shown that when his ratio goes well above 20, the market usually delivers poor returns afterward; when it drops well 3 See Jeremy Siegel, Stocks for the Long Run (McGraw-Hill, 2002), p. 94, and Robert Arnott and William Bernstein, “The Two Percent Dilution,” work- ing paper, July, 2002. below 10, stocks typically produce handsome gains down the road. In early 2003, by Shiller’s math, stocks were priced at about 22.8 times the average inflation-adjusted earnings of the past decade—still in the danger zone, but way down from their demented level of 44.2 times earnings in December 1999. How has the market done in the past when it

Stocks for the Long Run (McGraw-Hill, 2002), p. 94, and Robert Arnott and William Bernstein, “The Two Percent Dilution,” work- ing paper, July, 2002. below 10, stocks typically produce handsome gains down the road. In early 2003, by Shiller’s math, stocks were priced at about 22.8 times the average inflation-adjusted earnings of the past decade—still in the danger zone, but way down from their demented level of 44.2 times earnings in December 1999. How has the market done in the past when it was priced around today’s levels? Figure 3-1 shows the previous periods when stocks were at similar highs, and how they fared over the 10-year stretches that followed: FIGURE 3-1 Year Price/earnings ratio Total return over next 10 years 1898 21.4 9.2 1900 20.7 7.1 1901 21.7 5.9 1905 19.6 5.0 1929 22.0 -0.1 1936 21.1 4.4 1955 18.9 11.1 1959 18.6 7.8 1961 22.0 7.1 1962 18.6 9.9 1963 21.0 6.0 1964 22.8 1.2 1965 23.7 3.3 1966 19.7 6.6 1967 21.8 3.6 1968 22.3 3.2 1972 18.6 6.7 1992 20.4 9.3 Averages 20.8 6.0 Sources: http://aida.econ.yale.edu/~shiller/data/ie_data.htm; Jack Wilson and Charles Jones, “An Analysis of the S & P 500 Index and Cowles’ Extensions: Price Index and Stock Returns, 1870–1999,” The Journal of Business, vol. 75, no. 3, July, 2002, pp. 527–529; Ibbotson Associates. Notes: Price/earnings ratio is Shiller calculation (10-year average real earnings of S & P 500-stock index divided by December 31 index value). Total return is nominal annual average. So, from valuation levels similar to those of early 2003, the stock market has sometimes done very well in the ensuing 10 years, some- times poorly, and muddled along the rest of the time. I think Graham, ever the conservative, would split the difference between the lowest and highest past returns and project that over the next decade stocks will earn roughly 6% annually, or 4% after inflation. (Interestingly, that projection matches the estimate we got earlier when we added together real growth, inflationary grow

levels similar to those of early 2003, the stock market has sometimes done very well in the ensuing 10 years, some- times poorly, and muddled along the rest of the time. I think Graham, ever the conservative, would split the difference between the lowest and highest past returns and project that over the next decade stocks will earn roughly 6% annually, or 4% after inflation. (Interestingly, that projection matches the estimate we got earlier when we added together real growth, inflationary growth, and speculative growth.) Compared to the 1990s, 6% is chicken feed. But it’s a whisker better than the gains that bonds are likely to produce—and reason enough for most investors to hang on to stocks as part of a diversified portfolio. But there is a second lesson in Graham’s approach. The only thing you can be confident of while forecasting future stock returns is that you will probably turn out to be wrong. The only indisputable truth that the past teaches us is that the future will always surprise us—always! And the corollary to that law of financial history is that the markets will most brutally surprise the very people who are most certain that their views about the future are right. Staying humble about your forecast- ing powers, as Graham did, will keep you from risking too much on a view of the future that may well turn out to be wrong. So, by all means, you should lower your expectations—but take care not to depress your spirit. For the intelligent investor, hope always springs eternal, because it should. In the financial markets, the worse the future looks, the better it usually turns out to be. A cynic once told G. K. Chesterton, the British novelist and essayist, “Blessed is he who expecteth nothing, for he shall not be disappointed.” Chesterton’s rejoinder? “Blessed is he who expecteth nothing, for he shall enjoy everything.” CHAPTER 4 General Portfolio Policy: The Defensive Investor The basic characteristics of an investment portfolio are usually determ

rings eternal, because it should. In the financial markets, the worse the future looks, the better it usually turns out to be. A cynic once told G. K. Chesterton, the British novelist and essayist, “Blessed is he who expecteth nothing, for he shall not be disappointed.” Chesterton’s rejoinder? “Blessed is he who expecteth nothing, for he shall enjoy everything.” CHAPTER 4 General Portfolio Policy: The Defensive Investor The basic characteristics of an investment portfolio are usually determined by the position and characteristics of the owner or owners. At one extreme we have had savings banks, life-insurance companies, and so-called legal trust funds. A generation ago their investments were limited by law in many states to high-grade bonds and, in some cases, high-grade preferred stocks. At the other extreme we have the well-to-do and experienced businessman, who will include any kind of bond or stock in his security list pro- vided he considers it an attractive purchase. It has been an old and sound principle that those who cannot afford to take risks should be content with a relatively low return on their invested funds. From this there has developed the general notion that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be depen- dent, rather, on the amount of intelligent effort the investor is will- ing and able to bring to bear on his task. The minimum return goes to our passive investor, who wants both safety and freedom from concern. The maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill. In 1965 we added: “In many cases there may be less real risk associated with buying a ‘bargain issue’ offering the chance of a large profit than with a conventional bond purchase yielding about 41⁄2%.” This statement had more truth in it than we ourselves sus- pected, since

task. The minimum return goes to our passive investor, who wants both safety and freedom from concern. The maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill. In 1965 we added: “In many cases there may be less real risk associated with buying a ‘bargain issue’ offering the chance of a large profit than with a conventional bond purchase yielding about 41⁄2%.” This statement had more truth in it than we ourselves sus- pected, since in subsequent years even the best long-term bonds lost a substantial part of their market value because of the rise in interest rates. 88 The Basic Problem of Bond-Stock Allocation We have already outlined in briefest form the portfolio policy of the defensive investor.* He should divide his funds between high- grade bonds and high-grade common stocks. We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds. There is an implication here that the standard division should be an equal one, or 50–50, between the two major investment mediums. According to tradition the sound reason for increasing the percentage in common stocks would be the appearance of the “bargain price” levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgment of the investor the market level has become danger- ously high. These copybook maxims have always been easy to enunciate and always difficult to follow—because they go against that very human nature which produces that excesses of bull and bear mar- kets. It is almost a contradiction in terms to suggest as a feasible policy for the average stockowner that he lighten his holdings when the market advances beyond a certain point and add to them after a corresponding decline. It is because the average man op

vestor the market level has become danger- ously high. These copybook maxims have always been easy to enunciate and always difficult to follow—because they go against that very human nature which produces that excesses of bull and bear mar- kets. It is almost a contradiction in terms to suggest as a feasible policy for the average stockowner that he lighten his holdings when the market advances beyond a certain point and add to them after a corresponding decline. It is because the average man operates, and apparently must operate, in opposite fashion that we have had the great advances and collapses of the past; and—this writer believes—we are likely to have them in the future. If the division between investment and speculative operations were as clear now as once it was, we might be able to envisage investors as a shrewd, experienced group who sell out to the heed- less, hapless speculators at high prices and buy back from them at depressed levels. This picture may have had some verisimilitude in bygone days, but it is hard to identify it with financial develop- ments since 1949. There is no indication that such professional operations as those of the mutual funds have been conducted in this fashion. The percentage of the portfolio held in equities by the * See Graham’s “Conclusion” to Chapter 2, p. 56–57. two major types of funds—“balanced” and “common-stock”—has changed very little from year to year. Their selling activities have been largely related to endeavors to switch from less to more promising holdings. If, as we have long believed, the stock market has lost contact with its old bounds, and if new ones have not yet been established, then we can give the investor no reliable rules by which to reduce his common-stock holdings toward the 25% minimum and rebuild them later to the 75% maximum. We can urge that in general the investor should not have more than one-half in equities unless he has strong confidence in the soundness of his stock position and is

itch from less to more promising holdings. If, as we have long believed, the stock market has lost contact with its old bounds, and if new ones have not yet been established, then we can give the investor no reliable rules by which to reduce his common-stock holdings toward the 25% minimum and rebuild them later to the 75% maximum. We can urge that in general the investor should not have more than one-half in equities unless he has strong confidence in the soundness of his stock position and is sure that he could view a market decline of the 1969–70 type with equanimity. It is hard for us to see how such strong confidence can be justified at the levels existing in early 1972. Thus we would counsel against a greater than 50% apportionment to common stocks at this time. But, for complementary reasons, it is almost equally difficult to advise a reduction of the figure well below 50%, unless the investor is disquieted in his own mind about the current market level, and will be satisfied also to limit his participation in any further rise to, say, 25% of his total funds. We are thus led to put forward for most of our readers what may appear to be an oversimplified 50–50 formula. Under this plan the guiding rule is to maintain as nearly as practicable an equal divi- sion between bond and stock holdings. When changes in the mar- ket level have raised the common-stock component to, say, 55%, the balance would be restored by a sale of one-eleventh of the stock portfolio and the transfer of the proceeds to bonds. Conversely, a fall in the common-stock proportion to 45% would call for the use of one-eleventh of the bond fund to buy additional equities. Yale University followed a somewhat similar plan for a number of years after 1937, but it was geared around a 35% “normal hold- ing” in common stocks. In the early 1950s, however, Yale seems to have given up its once famous formula, and in 1969 held 61% of its portfolio in equities (including some convertibles). (At that time th

er of the proceeds to bonds. Conversely, a fall in the common-stock proportion to 45% would call for the use of one-eleventh of the bond fund to buy additional equities. Yale University followed a somewhat similar plan for a number of years after 1937, but it was geared around a 35% “normal hold- ing” in common stocks. In the early 1950s, however, Yale seems to have given up its once famous formula, and in 1969 held 61% of its portfolio in equities (including some convertibles). (At that time the endowment funds of 71 such institutions, totaling $7.6 billion, held 60.3% in common stocks.) The Yale example illustrates the almost lethal effect of the great market advance upon the once pop- ular formula approach to investment. Nonetheless we are convinced that our 50–50 version of this approach makes good sense for the defensive investor. It is extremely simple; it aims unquestionably in the right direction; it gives the follower the feeling that he is at least making some moves in response to market developments; most important of all, it will restrain him from being drawn more and more heavily into common stocks as the market rises to more and more dangerous heights. Furthermore, a truly conservative investor will be satisfied with the gains shown on half his portfolio in a rising market, while in a severe decline he may derive much solace from reflecting how much better off he is than many of his more venturesome friends. While our proposed 50–50 division is undoubtedly the simplest “all-purpose program” devisable, it may not turn out to be the best in terms of results achieved. (Of course, no approach, mechanical or otherwise, can be advanced with any assurance that it will work out better than another.) The much larger income return now offered by good bonds than by representative stocks is a potent argument for favoring the bond component. The investor’s choice between 50% or a lower figure in stocks may well rest mainly on his own temperament and attitude. If

simplest “all-purpose program” devisable, it may not turn out to be the best in terms of results achieved. (Of course, no approach, mechanical or otherwise, can be advanced with any assurance that it will work out better than another.) The much larger income return now offered by good bonds than by representative stocks is a potent argument for favoring the bond component. The investor’s choice between 50% or a lower figure in stocks may well rest mainly on his own temperament and attitude. If he can act as a cold-blooded weigher of the odds, he would be likely to favor the low 25% stock component at this time, with the idea of waiting until the DJIA div- idend yield was, say, two-thirds of the bond yield before he would establish his median 50–50 division between bonds and stocks. Starting from 900 for the DJIA and dividends of $36 on the unit, this would require either a fall in taxable bond yields from 71⁄2% to about 5.5% without any change in the present return on leading stocks, or a fall in the DJIA to as low as 660 if there is no reduction in bond yields and no increase in dividends. A combination of intermediate changes could produce the same “buying point.” A program of that kind is not especially complicated; the hard part is to adopt it and to stick to it not to mention the possibility that it may turn out to have been much too conservative. The Bond Component The choice of issues in the bond component of the investor’s portfolio will turn about two main questions: Should he buy tax- able or tax-free bonds, and should he buy shorter- or longer-term maturities? The tax decision should be mainly a matter of arith- metic, turning on the difference in yields as compared with the investor’s tax bracket. In January 1972 the choice in 20-year maturi- ties was between obtaining, say, 71⁄2% on “grade Aa” corporate bonds and 5.3% on prime tax-free issues. (The term “municipals” is generally applied to all species of tax-exempt bonds, including state obligations

s: Should he buy tax- able or tax-free bonds, and should he buy shorter- or longer-term maturities? The tax decision should be mainly a matter of arith- metic, turning on the difference in yields as compared with the investor’s tax bracket. In January 1972 the choice in 20-year maturi- ties was between obtaining, say, 71⁄2% on “grade Aa” corporate bonds and 5.3% on prime tax-free issues. (The term “municipals” is generally applied to all species of tax-exempt bonds, including state obligations.) There was thus for this maturity a loss in income of some 30% in passing from the corporate to the municipal field. Hence if the investor was in a maximum tax bracket higher than 30% he would have a net saving after taxes by choosing the munic- ipal bonds; the opposite, if his maximum tax was less than 30%. A single person starts paying a 30% rate when his income after deductions passes $10,000; for a married couple the rate applies when combined taxable income passes $20,000. It is evident that a large proportion of individual investors would obtain a higher return after taxes from good municipals than from good corporate bonds. The choice of longer versus shorter maturities involves quite a different question, viz.: Does the investor want to assure himself against a decline in the price of his bonds, but at the cost of (1) a lower annual yield and (2) loss of the possibility of an appreciable gain in principal value? We think it best to discuss this question in Chapter 8, The Investor and Market Fluctuations. For a period of many years in the past the only sensible bond purchases for individuals were the U.S. savings issues. Their safety was—and is—unquestioned; they gave a higher return than other bond investments of first quality; they had a money-back option and other privileges which added greatly to their attractiveness. In our earlier editions we had an entire chapter entitled “U.S. Savings Bonds: A Boon to Investors.” As we shall point out, U.S. savings bonds stil

stor and Market Fluctuations. For a period of many years in the past the only sensible bond purchases for individuals were the U.S. savings issues. Their safety was—and is—unquestioned; they gave a higher return than other bond investments of first quality; they had a money-back option and other privileges which added greatly to their attractiveness. In our earlier editions we had an entire chapter entitled “U.S. Savings Bonds: A Boon to Investors.” As we shall point out, U.S. savings bonds still possess certain unique merits that make them a suitable purchase by any individ- ual investor. For the man of modest capital—with, say, not more than $10,000 to put into bonds—we think they are still the easiest and the best choice. But those with larger funds may find other mediums more desirable. Let us list a few major types of bonds that deserve investor con- sideration, and discuss them briefly with respect to general description, safety, yield, market price, risk, income-tax status, and other features. 1. u.s. savings bonds, series e and series h. We shall first sum- marize their important provisions, and then discuss briefly the numerous advantages of these unique, attractive, and exceedingly convenient investments. The Series H bonds pay interest semi- annually, as do other bonds. The rate is 4.29% for the first year, and then a flat 5.10% for the next nine years to maturity. Interest on the Series E bonds is not paid out, but accrues to the holder through increase in redemption value. The bonds are sold at 75% of their face value, and mature at 100% in 5 years 10 months after purchase. If held to maturity the yield works out at 5%, compounded semi- annually. If redeemed earlier, the yield moves up from a minimum of 4.01% in the first year to an average of 5.20% in the next 45⁄6 years. Interest on the bonds is subject to Federal income tax, but is exempt from state income tax. However, Federal income tax on the Series E bonds may be paid at the holder’s option eit

ption value. The bonds are sold at 75% of their face value, and mature at 100% in 5 years 10 months after purchase. If held to maturity the yield works out at 5%, compounded semi- annually. If redeemed earlier, the yield moves up from a minimum of 4.01% in the first year to an average of 5.20% in the next 45⁄6 years. Interest on the bonds is subject to Federal income tax, but is exempt from state income tax. However, Federal income tax on the Series E bonds may be paid at the holder’s option either annually as the interest accrues (through higher redemption value), or not until the bond is actually disposed of. Owners of Series E bonds may cash them in at any time (shortly after purchase) at their current redemption value. Holders of Series H bonds have similar rights to cash them in at par value (cost). Series E bonds are exchangeable for Series H bonds, with certain tax advantages. Bonds lost, destroyed, or stolen may be replaced without cost. There are limitations on annual purchases, but liberal provisions for co-ownership by family members make it possible for most investors to buy as many as they can afford. Comment: There is no other investment that combines (1) absolute assurance of principal and interest payments, (2) the right to demand full “money back” at any time, and (3) guarantee of at least a 5% inter- est rate for at least ten years. Holders of the earlier issues of Series E bonds have had the right to extend their bonds at maturity, and thus to continue to accumulate annual values at successively higher rates. The deferral of income-tax payments over these long periods has been of great dollar advantage; we calculate it has increased the effective net-after-tax rate received by as much as a third in typical cases. Conversely, the right to cash in the bonds at cost price or better has given the purchasers in former years of low interest rates complete protection against the shrinkage in princi- pal value that befell many bond investors; otherwise st

ccumulate annual values at successively higher rates. The deferral of income-tax payments over these long periods has been of great dollar advantage; we calculate it has increased the effective net-after-tax rate received by as much as a third in typical cases. Conversely, the right to cash in the bonds at cost price or better has given the purchasers in former years of low interest rates complete protection against the shrinkage in princi- pal value that befell many bond investors; otherwise stated, it gave them the possibility of benefiting from the rise in interest rates by switching their low-interest holdings into very-high-coupon issues on an even-money basis. In our view the special advantages enjoyed by owners of sav- ings bonds now will more than compensate for their lower current return as compared with other direct government obligations. 2. other united states bonds. A profusion of these issues exists, covering a wide variety of coupon rates and maturity dates. All of them are completely safe with respect to payment of interest and principal. They are subject to Federal income taxes but free from state income tax. In late 1971 the long-term issues—over ten years— showed an average yield of 6.09%, intermediate issues (three to five years) returned 6.35%, and short issues returned 6.03%. In 1970 it was possible to buy a number of old issues at large dis- counts. Some of these are accepted at par in settlement of estate taxes. Example: The U.S. Treasury 31⁄2s due 1990 are in this category; they sold at 60 in 1970, but closed 1970 above 77. It is interesting to note also that in many cases the indirect obli- gations of the U.S. government yield appreciably more than its direct obligations of the same maturity. As we write, an offering appears of 7.05% of “Certificates Fully Guaranteed by the Secretary of Transportation of the Department of Transportation of the United States.” The yield was fully 1% more than that on direct obligations of the U.S., maturin

990 are in this category; they sold at 60 in 1970, but closed 1970 above 77. It is interesting to note also that in many cases the indirect obli- gations of the U.S. government yield appreciably more than its direct obligations of the same maturity. As we write, an offering appears of 7.05% of “Certificates Fully Guaranteed by the Secretary of Transportation of the Department of Transportation of the United States.” The yield was fully 1% more than that on direct obligations of the U.S., maturing the same year (1986). The certifi- cates were actually issued in the name of the Trustees of the Penn Central Transportation Co., but they were sold on the basis of a statement by the U.S. Attorney General that the guarantee “brings into being a general obligation of the United States, backed by its full faith and credit.” Quite a number of indirect obligations of this sort have been assumed by the U.S. government in the past, and all of them have been scrupulously honored. The reader may wonder why all this hocus-pocus, involving an apparently “personal guarantee” by our Secretary of Transporta- tion, and a higher cost to the taxpayer in the end. The chief reason for the indirection has been the debt limit imposed on govern- ment borrowing by the Congress. Apparently guarantees by the government are not regarded as debts—a semantic windfall for shrewder investors. Perhaps the chief impact of this situation has been the creation of tax-free Housing Authority bonds, enjoying the equivalent of a U.S. guarantee, and virtually the only tax- exempt issues that are equivalent to government bonds. Another type of government-backed issues is the recently created New Community Debentures, offered to yield 7.60% in September 1971. 3. state and municipal bonds. These enjoy exemption from Federal income tax. They are also ordinarily free of income tax in the state of issue but not elsewhere. They are either direct obliga- tions of a state or subdivision, or “revenue bonds” dependent

ivalent of a U.S. guarantee, and virtually the only tax- exempt issues that are equivalent to government bonds. Another type of government-backed issues is the recently created New Community Debentures, offered to yield 7.60% in September 1971. 3. state and municipal bonds. These enjoy exemption from Federal income tax. They are also ordinarily free of income tax in the state of issue but not elsewhere. They are either direct obliga- tions of a state or subdivision, or “revenue bonds” dependent for interest payments on receipts from a toll road, bridge, building lease, etc. Not all tax-free bonds are strongly enough protected to justify their purchase by a defensive investor. He may be guided in his selection by the rating given to each issue by Moody’s or Stan- dard & Poor’s. One of three highest ratings by both services—Aaa (AAA), Aa (AA), or A—should constitute a sufficient indication of adequate safety. The yield on these bonds will vary both with the quality and the maturity, with the shorter maturities giving the lower return. In late 1971 the issues represented in Standard & Poor’s municipal bond index averaged AA in quality rating, 20 years in maturity, and 5.78% in yield. A typical offering of Vineland, N.J., bonds, rated AA for A and gave a yield of only 3% on the one-year maturity, rising to 5.8% to the 1995 and 1996 matu- rities.1 4. corporation bonds. These bonds are subject to both Federal and state tax. In early 1972 those of highest quality yielded 7.19% for a 25-year maturity, as reflected in the published yield of Moody’s Aaa corporate bond index. The so-called lower-medium- grade issues—rated Baa—returned 8.23% for long maturities. In each class shorter-term issues would yield somewhat less than longer-term obligations. Comment. The above summaries indicate that the average investor has several choices among high-grade bonds. Those in high income-tax brackets can undoubtedly obtain a better net yield from good tax-free issues than from taxable one

25-year maturity, as reflected in the published yield of Moody’s Aaa corporate bond index. The so-called lower-medium- grade issues—rated Baa—returned 8.23% for long maturities. In each class shorter-term issues would yield somewhat less than longer-term obligations. Comment. The above summaries indicate that the average investor has several choices among high-grade bonds. Those in high income-tax brackets can undoubtedly obtain a better net yield from good tax-free issues than from taxable ones. For others the early 1972 range of taxable yield would seem to be from 5.00% on U.S. savings bonds, with their special options, to about 71⁄2% on high-grade corporate issues. Higher-Yielding Bond Investments By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat bet- ter in terms of overall return than the first-quality issues, they expose the owner to too many individual risks of untoward devel- opments, ranging from disquieting price declines to actual default. (It is true that bargain opportunities occur fairly often in lower- grade bonds, but these require special study and skill to exploit successfully.)* Perhaps we should add here that the limits imposed by Con- gress on direct bond issues of the United States have produced at least two sorts of “bargain opportunities” for investors in the pur- chase of government-backed obligations. One is provided by the tax-exempt “New Housing” issues, and the other by the recently created (taxable) “New Community debentures.” An offering of New Housing issues in July 1971 yielded as high as 5.8%, free from both Federal and state taxes, while an issue of (taxable) New Com- munity debentures sold in September 1971 yielded 7.60%. Both obligations have the “full faith and credit” of the United States government behind them and hence are safe

the pur- chase of government-backed obligations. One is provided by the tax-exempt “New Housing” issues, and the other by the recently created (taxable) “New Community debentures.” An offering of New Housing issues in July 1971 yielded as high as 5.8%, free from both Federal and state taxes, while an issue of (taxable) New Com- munity debentures sold in September 1971 yielded 7.60%. Both obligations have the “full faith and credit” of the United States government behind them and hence are safe without question. And—on a net basis—they yield considerably more than ordinary United States bonds.† * Graham’s objection to high-yield bonds is mitigated today by the wide- spread availability of mutual funds that spread the risk and do the research of owning “junk bonds.” See the commentary on Chapter 6 for more detail. † The “New Housing” bonds and “New Community debentures” are no more. New Housing Authority bonds were backed by the U.S. Department of Housing and Urban Development (HUD) and were exempt from income tax, but they have not been issued since 1974. New Community debentures, also backed by HUD, were authorized by a Federal law passed in 1968. About $350 million of these debentures were issued through 1975, but the program was terminated in 1983. Savings Deposits in Lieu of Bonds An investor may now obtain as high an interest rate from a savings deposit in a commercial or savings bank (or from a bank certificate of deposit) as he can from a first-grade bond of short maturity. The interest rate on bank savings accounts may be low- ered in the future, but under present conditions they are a suitable substitute for short-term bond investment by the individual. Convertible Issues These are discussed in Chapter 16. The price variability of bonds in general is treated in Chapter 8, The Investor and Market Fluctu- ations. Call Provisions In previous editions we had a fairly long discussion of this aspect of bond financing, because it involved a serious but lit

t maturity. The interest rate on bank savings accounts may be low- ered in the future, but under present conditions they are a suitable substitute for short-term bond investment by the individual. Convertible Issues These are discussed in Chapter 16. The price variability of bonds in general is treated in Chapter 8, The Investor and Market Fluctu- ations. Call Provisions In previous editions we had a fairly long discussion of this aspect of bond financing, because it involved a serious but little noticed injustice to the investor. In the typical case bonds were callable fairly soon after issuance, and at modest premiums—say 5%—above the issue price. This meant that during a period of wide fluctuations in the underlying interest rates the investor had to bear the full brunt of unfavorable changes and was deprived of all but a meager participation in favorable ones. Example: Our standard example has been the issue of American Gas & Electric 100-year 5% debentures, sold to the public at 101 in 1928. Four years later, under near-panic conditions, the price of these good bonds fell to 621⁄2, yielding 8%. By 1946, in a great rever- sal, bonds of this type could be sold to yield only 3%, and the 5% issue should have been quoted at close to 160. But at that point the company took advantage of the call provision and redeemed the issue at a mere 106. The call feature in these bond contracts was a thinly disguised instance of “heads I win, tails you lose.” At long last, the bond- buying institutions refused to accept this unfair arrangement; in recent years most long-term high-coupon issues have been pro- tected against redemption for ten years or more after issuance. This still limits their possible price rise, but not inequitably. In practical terms, we advise the investor in long-term issues to sacrifice a small amount of yield to obtain the assurance of non- callability—say for 20 or 25 years. Similarly, there is an advantage in buying a low-coupon bond* at a discount

ng institutions refused to accept this unfair arrangement; in recent years most long-term high-coupon issues have been pro- tected against redemption for ten years or more after issuance. This still limits their possible price rise, but not inequitably. In practical terms, we advise the investor in long-term issues to sacrifice a small amount of yield to obtain the assurance of non- callability—say for 20 or 25 years. Similarly, there is an advantage in buying a low-coupon bond* at a discount rather than a high- coupon bond selling at about par and callable in a few years. For the discount—e.g., of a 31⁄2% bond at 631⁄2%, yielding 7.85%—carries full protection against adverse call action. Straight—i.e., Nonconvertible—Preferred Stocks Certain general observations should be made here on the subject of preferred stocks. Really good preferred stocks can and do exist, but they are good in spite of their investment form, which is an inherently bad one. The typical preferred shareholder is dependent for his safety on the ability and desire of the company to pay divi- dends on its common stock. Once the common dividends are omit- ted, or even in danger, his own position becomes precarious, for the directors are under no obligation to continue paying him unless they also pay on the common. On the other hand, the typical pre- ferred stock carries no share in the company’s profits beyond the fixed dividend rate. Thus the preferred holder lacks both the legal claim of the bondholder (or creditor) and the profit possibilities of a common shareholder (or partner). These weaknesses in the legal position of preferred stocks tend to come to the fore recurrently in periods of depression. Only a small percentage of all preferred issues are so strongly entrenched as to maintain an unquestioned investment status through all vicis- situdes. Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity. (At such times they may

(or creditor) and the profit possibilities of a common shareholder (or partner). These weaknesses in the legal position of preferred stocks tend to come to the fore recurrently in periods of depression. Only a small percentage of all preferred issues are so strongly entrenched as to maintain an unquestioned investment status through all vicis- situdes. Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity. (At such times they may be well suited to the aggressive investor but too unconventional for the defensive investor.) In other words, they should be bought on a bargain basis or not at all. We shall refer later to convertible and similarly privileged issues, which carry some special possibilities of profits. These are not ordinarily selected for a conservative portfolio. Another peculiarity in the general position of preferred stocks * A bond’s “coupon” is its interest rate; a “low-coupon” bond pays a rate of interest income below the market average. deserves mention. They have a much better tax status for corpora- tion buyers than for individual investors. Corporations pay income tax on only 15% of the income they receive in dividends, but on the full amount of their ordinary interest income. Since the 1972 corpo- rate rate is 48%, this means that $100 received as preferred-stock dividends is taxed only $7.20, whereas $100 received as bond inter- est is taxed $48. On the other hand, individual investors pay exactly the same tax on preferred-stock investments as on bond interest, except for a recent minor exemption. Thus, in strict logic, all investment-grade preferred stocks should be bought by corpo- rations, just as all tax-exempt bonds should be bought by investors who pay income tax.* Security Forms The bond form and the preferred-stock form, as hitherto dis- cussed, are well-understood and relatively simple matters. A bond- holder is entitled to receive fixed interest and payment of princ

pay exactly the same tax on preferred-stock investments as on bond interest, except for a recent minor exemption. Thus, in strict logic, all investment-grade preferred stocks should be bought by corpo- rations, just as all tax-exempt bonds should be bought by investors who pay income tax.* Security Forms The bond form and the preferred-stock form, as hitherto dis- cussed, are well-understood and relatively simple matters. A bond- holder is entitled to receive fixed interest and payment of principal on a definite date. The owner of a preferred stock is entitled to a fixed dividend, and no more, which must be paid before any com- mon dividend. His principal value does not come due on any spec- ified date. (The dividend may be cumulative or noncumulative. He may or may not have a vote.) The above describes the standard provisions and, no doubt, the majority of bond and preferred issues, but there are innumerable departures from these forms. The best-known types are convertible and similar issues, and income bonds. In the latter type, interest does not have to be paid unless it is earned by the company. (Unpaid interest may accumulate as a charge against future earn- ings, but the period is often limited to three years.) Income bonds should be used by corporations much more * While Graham’s logic remains valid, the numbers have changed. Corpora- tions can currently deduct 70% of the income they receive from dividends, and the standard corporate tax rate is 35%. Thus, a corporation would pay roughly $24.50 in tax on $100 in dividends from preferred stock versus $35 in tax on $100 in interest income. Individuals pay the same rate of income tax on dividend income that they do on interest income, so preferred stock offers them no tax advantage. extensively than they are. Their avoidance apparently arises from a mere accident of economic history—namely, that they were first employed in quantity in connection with railroad reorganizations, and hence they have been associ

ion would pay roughly $24.50 in tax on $100 in dividends from preferred stock versus $35 in tax on $100 in interest income. Individuals pay the same rate of income tax on dividend income that they do on interest income, so preferred stock offers them no tax advantage. extensively than they are. Their avoidance apparently arises from a mere accident of economic history—namely, that they were first employed in quantity in connection with railroad reorganizations, and hence they have been associated from the start with financial weakness and poor investment status. But the form itself has sev- eral practical advantages, especially in comparison with and in substitution for the numerous (convertible) preferred-stock issues of recent years. Chief of these is the deductibility of the interest paid from the company’s taxable income, which in effect cuts the cost of that form of capital in half. From the investor’s standpoint it is probably best for him in most cases that he should have (1) an unconditional right to receive interest payments when they are earned by the company, and (2) a right to other forms of protection than bankruptcy proceedings if interest is not earned and paid. The terms of income bonds can be tailored to the advantage of both the borrower and the lender in the manner best suited to both. (Conversion privileges can, of course, be included.) The acceptance by everybody of the inherently weak preferred-stock form and the rejection of the stronger income-bond form is a fascinating illustration of the way in which traditional institutions and habits often tend to persist on Wall Street despite new conditions calling for a fresh point of view. With every new wave of optimism or pessimism, we are ready to abandon history and time-tested prin- ciples, but we cling tenaciously and unquestioningly to our preju- dices. COMMENTARY ON CHAPTER 4 When you leave it to chance, then all of a sudden you don’t have any more luck. —Basketball coach Pat Riley How

form is a fascinating illustration of the way in which traditional institutions and habits often tend to persist on Wall Street despite new conditions calling for a fresh point of view. With every new wave of optimism or pessimism, we are ready to abandon history and time-tested prin- ciples, but we cling tenaciously and unquestioningly to our preju- dices. COMMENTARY ON CHAPTER 4 When you leave it to chance, then all of a sudden you don’t have any more luck. —Basketball coach Pat Riley How aggressive should your portfolio be? That, says Graham, depends less on what kinds of investments you own than on what kind of investor you are. There are two ways to be an intelligent investor: • by continually researching, selecting, and monitoring a dynamic mix of stocks, bonds, or mutual funds; • or by creating a permanent portfolio that runs on autopilot and requires no further effort (but generates very little excitement). Graham calls the first approach “active” or “enterprising”; it takes lots of time and loads of energy. The “passive” or “defensive” strategy takes little time or effort but requires an almost ascetic detachment from the alluring hullabaloo of the market. As the investment thinker Charles Ellis has explained, the enterprising approach is physically and intellectually taxing, while the defensive approach is emotionally demanding.1 If you have time to spare, are highly competitive, think like a sports fan, and relish a complicated intellectual challenge, then the active 1 For more about the distinction between physically and intellectually difficult investing on the one hand, and emotionally difficult investing on the other, see Chapter 8 and also Charles D. Ellis, “Three Ways to Succeed as an Investor,” in Charles D. Ellis and James R. Vertin, eds., The Investor’s Anthol- ogy (John Wiley & Sons, 1997), p. 72. 101 approach is up your alley. If you always feel rushed, crave simplicity, and don’t relish thinking about money, then the passive approa

he active 1 For more about the distinction between physically and intellectually difficult investing on the one hand, and emotionally difficult investing on the other, see Chapter 8 and also Charles D. Ellis, “Three Ways to Succeed as an Investor,” in Charles D. Ellis and James R. Vertin, eds., The Investor’s Anthol- ogy (John Wiley & Sons, 1997), p. 72. 101 approach is up your alley. If you always feel rushed, crave simplicity, and don’t relish thinking about money, then the passive approach is for you. (Some people will feel most comfortable combining both meth- ods—creating a portfolio that is mainly active and partly passive, or vice versa.) Both approaches are equally intelligent, and you can be successful with either—but only if you know yourself well enough to pick the right one, stick with it over the course of your investing lifetime, and keep your costs and emotions under control. Graham’s distinction between active and passive investors is another of his reminders that financial risk lies not only where most of us look for it—in the economy or in our investments—but also within ourselves. C AN Y OU B E B RA VE, OR WI LL Y OU C A VE? How, then, should a defensive investor get started? The first and most basic decision is how much to put in stocks and how much to put in bonds and cash. (Note that Graham deliberately places this discus- sion after his chapter on inflation, forearming you with the knowledge that inflation is one of your worst enemies.) The most striking thing about Graham’s discussion of how to allo- cate your assets between stocks and bonds is that he never mentions the word “age.” That sets his advice firmly against the winds of con- ventional wisdom—which holds that how much investing risk you ought to take depends mainly on how old you are.2 A traditional rule of thumb was to subtract your age from 100 and invest that percentage of your assets in stocks, with the rest in bonds or cash. (A 28-year-old would put 72% of her money in s

striking thing about Graham’s discussion of how to allo- cate your assets between stocks and bonds is that he never mentions the word “age.” That sets his advice firmly against the winds of con- ventional wisdom—which holds that how much investing risk you ought to take depends mainly on how old you are.2 A traditional rule of thumb was to subtract your age from 100 and invest that percentage of your assets in stocks, with the rest in bonds or cash. (A 28-year-old would put 72% of her money in stocks; an 81-year-old would put only 19% there.) Like everything else, these assumptions got overheated in the late 1990s. By 1999, a popular book argued that if you were younger than 30 you should put 95% of your money in stocks—even if you had only a “moderate” tolerance for risk! 3 2 A recent Google search for the phrase “age and asset allocation” turned up more than 30,000 online references. 3 James K. Glassman and Kevin A. Hassett, Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market (Times Business, 1999), p. 250. Unless you’ve allowed the proponents of this advice to subtract 100 from your IQ, you should be able to tell that something is wrong here. Why should your age determine how much risk you can take? An 89-year-old with $3 million, an ample pension, and a gaggle of grandchildren would be foolish to move most of her money into bonds. She already has plenty of income, and her grandchildren (who will eventually inherit her stocks) have decades of investing ahead of them. On the other hand, a 25-year-old who is saving for his wedding and a house down payment would be out of his mind to put all his money in stocks. If the stock market takes an Acapulco high dive, he will have no bond income to cover his downside—or his backside. What’s more, no matter how young you are, you might suddenly need to yank your money out of stocks not 40 years from now, but 40 minutes from now. Without a whiff of warning, you could lose your job, get divo

es of investing ahead of them. On the other hand, a 25-year-old who is saving for his wedding and a house down payment would be out of his mind to put all his money in stocks. If the stock market takes an Acapulco high dive, he will have no bond income to cover his downside—or his backside. What’s more, no matter how young you are, you might suddenly need to yank your money out of stocks not 40 years from now, but 40 minutes from now. Without a whiff of warning, you could lose your job, get divorced, become disabled, or suffer who knows what other kind of surprise. The unexpected can strike anyone, at any age. Everyone must keep some assets in the riskless haven of cash. Finally, many people stop investing precisely because the stock market goes down. Psychologists have shown that most of us do a very poor job of predicting today how we will feel about an emotionally charged event in the future.4 When stocks are going up 15% or 20% a year, as they did in the 1980s and 1990s, it’s easy to imagine that you and your stocks are married for life. But when you watch every dollar you invested getting bashed down to a dime, it’s hard to resist bailing out into the “safety” of bonds and cash. Instead of buying and holding their stocks, many people end up buying high, selling low, and holding nothing but their own head in their hands. Because so few investors have the guts to cling to stocks in a falling market, Graham insists that everyone should keep a minimum of 25% in bonds. That cushion, he argues, will give you the courage to keep the rest of your money in stocks even when stocks stink. To get a better feel for how much risk you can take, think about the fundamental circumstances of your life, when they will kick in, when they might change, and how they are likely to affect your need for cash: 4 For a fascinating essay on this psychological phenomenon, see Daniel Gilbert and Timothy Wilson’s “Miswanting,” at www.wjh.harvard.edu/~dtg/ Gilbert_&_Wilson(Miswanting).pdf.

ushion, he argues, will give you the courage to keep the rest of your money in stocks even when stocks stink. To get a better feel for how much risk you can take, think about the fundamental circumstances of your life, when they will kick in, when they might change, and how they are likely to affect your need for cash: 4 For a fascinating essay on this psychological phenomenon, see Daniel Gilbert and Timothy Wilson’s “Miswanting,” at www.wjh.harvard.edu/~dtg/ Gilbert_&_Wilson(Miswanting).pdf. • Are you single or married? What does your spouse or partner do for a living? • Do you or will you have children? When will the tuition bills hit home? • Will you inherit money, or will you end up financially responsible for aging, ailing parents? • What factors might hurt your career? (If you work for a bank or a homebuilder, a jump in interest rates could put you out of a job. If you work for a chemical manufacturer, soaring oil prices could be bad news.) • If you are self-employed, how long do businesses similar to yours tend to survive? • Do you need your investments to supplement your cash income? (In general, bonds will; stocks won’t.) • Given your salary and your spending needs, how much money can you afford to lose on your investments? If, after considering these factors, you feel you can take the higher risks inherent in greater ownership of stocks, you belong around Graham’s minimum of 25% in bonds or cash. If not, then steer mostly clear of stocks, edging toward Graham’s maximum of 75% in bonds or cash. (To find out whether you can go up to 100%, see the sidebar on p. 105.) Once you set these target percentages, change them only as your life circumstances change. Do not buy more stocks because the stock market has gone up; do not sell them because it has gone down. The very heart of Graham’s approach is to replace guesswork with disci- pline. Fortunately, through your 401(k), it’s easy to put your portfolio on permanent autopilot. Let’s say you are comfortable

maximum of 75% in bonds or cash. (To find out whether you can go up to 100%, see the sidebar on p. 105.) Once you set these target percentages, change them only as your life circumstances change. Do not buy more stocks because the stock market has gone up; do not sell them because it has gone down. The very heart of Graham’s approach is to replace guesswork with disci- pline. Fortunately, through your 401(k), it’s easy to put your portfolio on permanent autopilot. Let’s say you are comfortable with a fairly high level of risk—say, 70% of your assets in stocks and 30% in bonds. If the stock market rises 25% (but bonds stay steady), you will now have just under 75% in stocks and only 25% in bonds.5 Visit your 401(k)’s website (or call its toll-free number) and sell enough of your stock funds to “rebalance” back to your 70–30 target. The key is to rebal- ance on a predictable, patient schedule—not so often that you will 5 For the sake of simplicity, this example assumes that stocks rose instanta- neously. WHY NO T 100% ST OCK S? Graham advises you never to have more than 75% of your total assets in stocks. But is putting all your money into the stock market inadvisable for everyone? For a tiny minority of investors, a 100%-stock portfolio may make sense. You are one of them if you: • have set aside enough cash to support your family for at least one year • will be investing steadily for at least 20 years to come • survived the bear market that began in 2000 • did not sell stocks during the bear market that began in 2000 • bought more stocks during the bear market that began in 2000 • have read Chapter 8 in this book and implemented a formal plan to control your own investing behavior. Unless you can honestly pass all these tests, you have no business putting all your money in stocks. Anyone who panicked in the last bear market is going to panic in the next one—and will regret having no cushion of cash and bonds. drive yourself crazy, and not so seldom tha

l stocks during the bear market that began in 2000 • bought more stocks during the bear market that began in 2000 • have read Chapter 8 in this book and implemented a formal plan to control your own investing behavior. Unless you can honestly pass all these tests, you have no business putting all your money in stocks. Anyone who panicked in the last bear market is going to panic in the next one—and will regret having no cushion of cash and bonds. drive yourself crazy, and not so seldom that your targets will get out of whack. I suggest that you rebalance every six months, no more and no less, on easy-to-remember dates like New Year’s and the Fourth of July. The beauty of this periodic rebalancing is that it forces you to base your investing decisions on a simple, objective standard—Do I now own more of this asset than my plan calls for?—instead of the sheer guesswork of where interest rates are heading or whether you think the Dow is about to drop dead. Some mutual-fund companies, includ- ing T. Rowe Price, may soon introduce services that will automatically rebalance your 401(k) portfolio to your preset targets, so you will never need to make an active decision. TH E I N S AN D OUTS OF I N COM E I NVE STI N G In Graham’s day, bond investors faced two basic choices: Taxable or tax-free? Short-term or long-term? Today there is a third: Bonds or bond funds? Taxable or tax-free? Unless you’re in the lowest tax bracket,6 you should buy only tax-free (municipal) bonds outside your retirement accounts. Otherwise too much of your bond income will end up in the hands of the IRS. The only place to own taxable bonds is inside your 401(k) or another sheltered account, where you will owe no current tax on their income—and where municipal bonds have no place, since their tax advantage goes to waste.7 Short-term or long-term? Bonds and interest rates teeter on opposite ends of a seesaw: If interest rates rise, bond prices fall— although a short-term bond falls far less t

side your retirement accounts. Otherwise too much of your bond income will end up in the hands of the IRS. The only place to own taxable bonds is inside your 401(k) or another sheltered account, where you will owe no current tax on their income—and where municipal bonds have no place, since their tax advantage goes to waste.7 Short-term or long-term? Bonds and interest rates teeter on opposite ends of a seesaw: If interest rates rise, bond prices fall— although a short-term bond falls far less than a long-term bond. On the other hand, if interest rates fall, bond prices rise—and a long-term bond will outperform shorter ones.8 You can split the difference simply 6 For the 2003 tax year, the bottom Federal tax bracket is for single people earning less than $28,400 or married people (filing jointly) earning less than $47,450. 7 Two good online calculators that will help you compare the after-tax in- come of municipal and taxable bonds can be found at www.investinginbonds. com/cgi-bin/calculator.pl and www.lebenthal.com/index_infocenter.html. To decide if a “muni” is right for you, find the “taxable equivalent yield” gener- ated by these calculators, then compare that number to the yield currently available on Treasury bonds (http://money.cnn.com/markets/bondcenter/ or www.bloomberg.com/markets/C13.html). If the yield on Treasury bonds is higher than the taxable equivalent yield, munis are not for you. In any case, be warned that municipal bonds and funds produce lower income, and more price fluctuation, than most taxable bonds. Also, the alternative mini- mum tax, which now hits many middle-income Americans, can negate the advantages of municipal bonds. 8 For an excellent introduction to bond investing, see http://flagship.van guard.com/web/planret/AdvicePTIBInvestmentsInvestingInBonds.html#Inter estRates. For an even simpler explanation of bonds, see http://money.cnn. com/pf/101/lessons/7/. A “laddered” portfolio, holding bonds across a range of maturities, is anothe

nd more price fluctuation, than most taxable bonds. Also, the alternative mini- mum tax, which now hits many middle-income Americans, can negate the advantages of municipal bonds. 8 For an excellent introduction to bond investing, see http://flagship.van guard.com/web/planret/AdvicePTIBInvestmentsInvestingInBonds.html#Inter estRates. For an even simpler explanation of bonds, see http://money.cnn. com/pf/101/lessons/7/. A “laddered” portfolio, holding bonds across a range of maturities, is another way of hedging interest-rate risk. by buying intermediate-term bonds maturing in five to 10 years—which do not soar when their side of the seesaw rises, but do not slam into the ground either. For most investors, intermediate bonds are the sim- plest choice, since they enable you to get out of the game of guessing what interest rates will do. Bonds or bond funds? Since bonds are generally sold in $10,000 lots and you need a bare minimum of 10 bonds to diversify away the risk that any one of them might go bust, buying individual bonds makes no sense unless you have at least $100,000 to invest. (The only exception is bonds issued by the U.S. Treasury, since they’re pro- tected against default by the full force of the American government.) Bond funds offer cheap and easy diversification, along with the convenience of monthly income, which you can reinvest right back into the fund at current rates without paying a commission. For most investors, bond funds beat individual bonds hands down (the main exceptions are Treasury securities and some municipal bonds). Major firms like Vanguard, Fidelity, Schwab, and T. Rowe Price offer a broad menu of bond funds at low cost.9 The choices for bond investors have proliferated like rabbits, so let’s update Graham’s list of what’s available. As of 2003, interest rates have fallen so low that investors are starved for yield, but there are ways of amplifying your interest income without taking on exces- sive risk.10 Figure 4-1 summarizes t

down (the main exceptions are Treasury securities and some municipal bonds). Major firms like Vanguard, Fidelity, Schwab, and T. Rowe Price offer a broad menu of bond funds at low cost.9 The choices for bond investors have proliferated like rabbits, so let’s update Graham’s list of what’s available. As of 2003, interest rates have fallen so low that investors are starved for yield, but there are ways of amplifying your interest income without taking on exces- sive risk.10 Figure 4-1 summarizes the pros and cons. Now let’s look at a few types of bond investments that can fill spe- cial needs. C AS H I S N O T TRAS H How can you wring more income out of your cash? The intelligent investor should consider moving out of bank certificates of deposit or money-market accounts—which have offered meager returns lately— into some of these cash alternatives: Treasury securities, as obligations of the U.S. government, carry 9 For more information, see www.vanguard.com, www.fidelity.com, www. schwab.com, and www.troweprice.com. 10 For an accessible online summary of bond investing, see www.aaii.com/ promo/20021118/bonds.shtml. FIGURE 4-1 The Wide World of Bonds Treasury bills Less than one year $1,000 (D) Extremely low Treasury notes Between one and $1,000 (D) Extremely low 10 years Treasury bonds More than 10 yrs $1,000 (D) Extremely low Savings bonds Up to 30 years $25 (D) Extremely low Certificates of deposit One month to 5 yrs Usually $500 Very low; insured up to $100,000 Money-market funds 397 days or less Usually $2,500 Very low Mortgage debt One to 30 yrs $2,000–3,000 (F) Generally moderate but can be high Municipal bonds One to 30 yrs or more $5,000 (D); Generally moderate $2,000–$3,000 (F) but can be high Preferred stock Indefinite None High High-yield (“junk”) bonds Seven to 20 yrs $2,000–$3,000 (F) High Emerging-markets debt Up to 30 yrs $2,000–$3,000 (F) High Sources: Bankrate.com, Bloomberg, Lehman Brothers, Merrill Lynch, Morningstar, www.savingsbon

oney-market funds 397 days or less Usually $2,500 Very low Mortgage debt One to 30 yrs $2,000–3,000 (F) Generally moderate but can be high Municipal bonds One to 30 yrs or more $5,000 (D); Generally moderate $2,000–$3,000 (F) but can be high Preferred stock Indefinite None High High-yield (“junk”) bonds Seven to 20 yrs $2,000–$3,000 (F) High Emerging-markets debt Up to 30 yrs $2,000–$3,000 (F) High Sources: Bankrate.com, Bloomberg, Lehman Brothers, Merrill Lynch, Morningstar, www.savingsbonds.gov Notes: (D): purchased directly. (F): purchased through a mutual fund. “Ease of sale before maturity” indicates how readily you can sell at a fair price before maturity date; mutual funds typically offer better ease of sale than individual bonds. Money-market funds are Federally insured up to $100,000 if purchased at an FDIC-member bank, but otherwise carry only an implicit pledge not to lose value. Federal income tax on savings bonds is deferred until redemption or maturity. Municipal bonds are generally exempt from state income tax only in the state where they were issued. Risk if interest rates rise Ease of sale before maturity Exempt from most state income taxes? Exempt from Federal income tax? Benchmark Yield 12/31/2002 Very low High Y N 90-day 1.2 Moderate High Y N 5-year 2.7 10 year 3.8 High High Y N 30-year 4.8 Very low Low Y N EE bond Series bought after May 1995 4.2 Low Low N N 1-year nat’l. avg. 1.5 Low High N N Taxable money market avg. 0.8 Moderate to high Moderate to low N N Lehman Bros. MBS Index 4.6 Moderate to high Moderate to low N Y National Long-Term Mutual Fund avg. 4.3 High Moderate N N None Highly variable to low Moderate Low N N Merrill Lynch High Yield Index 11.9 Moderate Low N N Emerg. Mkts Bond fund avg. 8.8 virtually no credit risk—since, instead of defaulting on his debts, Uncle Sam can just jack up taxes or print more money at will. Treasury bills mature in four, 13, or 26 weeks. Because of their very short maturiti

to high Moderate to low N N Lehman Bros. MBS Index 4.6 Moderate to high Moderate to low N Y National Long-Term Mutual Fund avg. 4.3 High Moderate N N None Highly variable to low Moderate Low N N Merrill Lynch High Yield Index 11.9 Moderate Low N N Emerg. Mkts Bond fund avg. 8.8 virtually no credit risk—since, instead of defaulting on his debts, Uncle Sam can just jack up taxes or print more money at will. Treasury bills mature in four, 13, or 26 weeks. Because of their very short maturities, T-bills barely get dented when rising interest rates knock down the prices of other income investments; longer-term Treasury debt, how- ever, suffers severely when interest rates rise. The interest income on Treasury securities is generally free from state (but not Federal) income tax. And, with $3.7 trillion in public hands, the market for Trea- sury debt is immense, so you can readily find a buyer if you need your money back before maturity. You can buy Treasury bills, short-term notes, and long-term bonds directly from the government, with no bro- kerage fees, at www.publicdebt.treas.gov. (For more on inflation- protected TIPS, see the commentary on Chapter 2.) Savings bonds, unlike Treasuries, are not marketable; you cannot sell them to another investor, and you’ll forfeit three months of interest if you redeem them in less than five years. Thus they are suitable mainly as “set-aside money” to meet a future spending need—a gift for a religious ceremony that’s years away, or a jump start on putting your newborn through Harvard. They come in denominations as low as $25, making them ideal as gifts to grandchildren. For investors who can confidently leave some cash untouched for years to come, infla- tion-protected “I-bonds” recently offered an attractive yield of around 4%. To learn more, see www.savingsbonds.gov. M O VI N G B EY ON D U N CLE SAM Mortgage securities. Pooled together from thousands of mort- gages around the United States, these bonds are issued by ag

a jump start on putting your newborn through Harvard. They come in denominations as low as $25, making them ideal as gifts to grandchildren. For investors who can confidently leave some cash untouched for years to come, infla- tion-protected “I-bonds” recently offered an attractive yield of around 4%. To learn more, see www.savingsbonds.gov. M O VI N G B EY ON D U N CLE SAM Mortgage securities. Pooled together from thousands of mort- gages around the United States, these bonds are issued by agencies like the Federal National Mortgage Association (“Fannie Mae”) or the Government National Mortgage Association (“Ginnie Mae”). However, they are not backed by the U.S. Treasury, so they sell at higher yields to reflect their greater risk. Mortgage bonds generally underperform when interest rates fall and bomb when rates rise. (Over the long run, those swings tend to even out and the higher average yields pay off.) Good mortgage-bond funds are available from Vanguard, Fidelity, and Pimco. But if a broker ever tries to sell you an individual mortgage bond or “CMO,” tell him you are late for an appointment with your proctologist. Annuities. These insurance-like investments enable you to defer cur- rent taxes and capture a stream of income after you retire. Fixed annuities offer a set rate of return; variable ones provide a fluctuating return. But what the defensive investor really needs to defend against here are the hard-selling insurance agents, stockbrokers, and financial planners who peddle annuities at rapaciously high costs. In most cases, the high expenses of owning an annuity—including “surrender charges” that gnaw away at your early withdrawals—will overwhelm its advantages. The few good annuities are bought, not sold; if an annuity produces fat commis- sions for the seller, chances are it will produce meager results for the buyer. Consider only those you can buy directly from providers with rock- bottom costs like Ameritas, TIAA-CREF, and Vanguard.11 11 In gener

s who peddle annuities at rapaciously high costs. In most cases, the high expenses of owning an annuity—including “surrender charges” that gnaw away at your early withdrawals—will overwhelm its advantages. The few good annuities are bought, not sold; if an annuity produces fat commis- sions for the seller, chances are it will produce meager results for the buyer. Consider only those you can buy directly from providers with rock- bottom costs like Ameritas, TIAA-CREF, and Vanguard.11 11 In general, variable annuities are not attractive for investors under the age of 50 who expect to be in a high tax bracket during retirement or who have Preferred stock. Preferred shares are a worst-of-both-worlds investment. They are less secure than bonds, since they have only a secondary claim on a company’s assets if it goes bankrupt. And they offer less profit potential than common stocks do, since companies typically “call” (or forcibly buy back) their preferred shares when inter- est rates drop or their credit rating improves. Unlike the interest pay- ments on most of its bonds, an issuing company cannot deduct preferred dividend payments from its corporate tax bill. Ask yourself: If this company is healthy enough to deserve my investment, why is it paying a fat dividend on its preferred stock instead of issuing bonds and getting a tax break? The likely answer is that the company is not healthy, the market for its bonds is glutted, and you should approach its preferred shares as you would approach an unrefrigerated dead fish. Common stock. A visit to the stock screener at http://screen. yahoo.com/stocks.html in early 2003 showed that 115 of the stocks in the Standard & Poor’s 500 index had dividend yields of 3.0% or greater. No intelligent investor, no matter how starved for yield, would ever buy a stock for its dividend income alone; the company and its businesses must be solid, and its stock price must be reasonable. But, thanks to the bear market that began in 2000, some

would approach an unrefrigerated dead fish. Common stock. A visit to the stock screener at http://screen. yahoo.com/stocks.html in early 2003 showed that 115 of the stocks in the Standard & Poor’s 500 index had dividend yields of 3.0% or greater. No intelligent investor, no matter how starved for yield, would ever buy a stock for its dividend income alone; the company and its businesses must be solid, and its stock price must be reasonable. But, thanks to the bear market that began in 2000, some leading stocks are now outyielding Treasury bonds. So even the most defen- sive investor should realize that selectively adding stocks to an all- bond or mostly-bond portfolio can increase its income yield—and raise its potential return.12 not already contributed the maximum to their existing 401(k) or IRA accounts. Fixed annuities (with the notable exception of those from TIAA- CREF) can change their “guaranteed” rates and smack you with nasty sur- render fees. For thorough and objective analysis of annuities, see two superb articles by Walter Updegrave: “Income for Life,” Money, July, 2002, pp. 89–96, and “Annuity Buyer’s Guide,” Money, November, 2002, pp. 104–110. 12 For more on the role of dividends in a portfolio, see Chapter 19. CHAPTER 5 The Defensive Investor and Common Stocks Investment Merits of Common Stocks In our first edition (1949) we found it necessary at this point to insert a long exposition of the case for including a substantial common-stock component in all investment portfolios.* Common stocks were generally viewed as highly speculative and therefore unsafe; they had declined fairly substantially from the high levels of 1946, but instead of attracting investors to them because of their reasonable prices, this fall had had the opposite effect of undermin- ing confidence in equity securities. We have commented on the converse situation that has developed in the ensuing 20 years, whereby the big advance in stock prices made them appear safe and

all investment portfolios.* Common stocks were generally viewed as highly speculative and therefore unsafe; they had declined fairly substantially from the high levels of 1946, but instead of attracting investors to them because of their reasonable prices, this fall had had the opposite effect of undermin- ing confidence in equity securities. We have commented on the converse situation that has developed in the ensuing 20 years, whereby the big advance in stock prices made them appear safe and profitable investments at record high levels which might actu- ally carry with them a considerable degree of risk.† The argument we made for common stocks in 1949 turned on * At the beginning of 1949, the average annual return produced by stocks over the previous 20 years was 3.1%, versus 3.9% for long-term Treasury bonds—meaning that $10,000 invested in stocks would have grown to $18,415 over that period, while the same amount in bonds would have turned into $21,494. Naturally enough, 1949 turned out to be a fabulous time to buy stocks: Over the next decade, the Standard & Poor’s 500-stock index gained an average of 20.1% per year, one of the best long-term returns in the history of the U.S. stock market. † Graham’s earlier comments on this subject appear on pp. 19–20. Just imagine what he would have thought about the stock market of the late 1990s, in which each new record-setting high was considered further “proof” that stocks were the riskless way to wealth! 112 two main points. The first was that they had offered a considerable degree of protection against the erosion of the investor’s dollar caused by inflation, whereas bonds offered no protection at all. The second advantage of common stocks lay in their higher average return to investors over the years. This was produced both by an average dividend income exceeding the yield on good bonds and by an underlying tendency for market value to increase over the years in consequence of the reinvestment of undistributed p

. The first was that they had offered a considerable degree of protection against the erosion of the investor’s dollar caused by inflation, whereas bonds offered no protection at all. The second advantage of common stocks lay in their higher average return to investors over the years. This was produced both by an average dividend income exceeding the yield on good bonds and by an underlying tendency for market value to increase over the years in consequence of the reinvestment of undistributed profits. While these two advantages have been of major importance— and have given common stocks a far better record than bonds over the long-term past—we have consistently warned that these benefits could be lost by the stock buyer if he pays too high a price for his shares. This was clearly the case in 1929, and it took 25 years for the market level to climb back to the ledge from which it had abysmally fallen in 1929–1932.* Since 1957 common stocks have once again, through their high prices, lost their traditional advantage in dividend yield over bond interest rates.† It remains to * The Dow Jones Industrial Average closed at a then-record high of 381.17 on September 3, 1929. It did not close above that level until November 23, 1954—more than a quarter of a century later—when it hit 382.74. (When you say you intend to own stocks “for the long run,” do you realize just how long the long run can be—or that many investors who bought in 1929 were no longer even alive by 1954?) However, for patient investors who reinvested their income, stock returns were positive over this otherwise dismal period, simply because dividend yields averaged more than 5.6% per year. Accord- ing to professors Elroy Dimson, Paul Marsh, and Mike Staunton of London Business School, if you had invested $1 in U.S. stocks in 1900 and spent all your dividends, your stock portfolio would have grown to $198 by 2000. But if you had reinvested all your dividends, your stock portfolio would have been worth $16,7

or patient investors who reinvested their income, stock returns were positive over this otherwise dismal period, simply because dividend yields averaged more than 5.6% per year. Accord- ing to professors Elroy Dimson, Paul Marsh, and Mike Staunton of London Business School, if you had invested $1 in U.S. stocks in 1900 and spent all your dividends, your stock portfolio would have grown to $198 by 2000. But if you had reinvested all your dividends, your stock portfolio would have been worth $16,797! Far from being an afterthought, dividends are the greatest force in stock investing. † Why do the “high prices” of stocks affect their dividend yields? A stock’s yield is the ratio of its cash dividend to the price of one share of common stock. If a company pays a $2 annual dividend when its stock price is $100 per share, its yield is 2%. But if the stock price doubles while the dividend stays constant, the dividend yield will drop to 1%. In 1959, when the trend Graham spotted in 1957 became noticeable to everyone, most Wall Street be seen whether the inflation factor and the economic-growth fac- tor will make up in the future for this significantly adverse devel- opment. It should be evident to the reader that we have no enthusiasm for common stocks in general at the 900 DJIA level of late 1971. For reasons already given* we feel that the defensive investor cannot afford to be without an appreciable proportion of common stocks in his portfolio, even if he must regard them as the lesser of two evils—the greater being the risks attached to an all-bond holding. Rules for the Common-Stock Component The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter. Here we would sug- gest four rules to be followed: 1. There should be adequate though not excessive diversifica- tion. This might mean a minimum of ten different issues and a maximum of about thirty.† 2. Each company selected should be large, prominent, and con- ser

e lesser of two evils—the greater being the risks attached to an all-bond holding. Rules for the Common-Stock Component The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter. Here we would sug- gest four rules to be followed: 1. There should be adequate though not excessive diversifica- tion. This might mean a minimum of ten different issues and a maximum of about thirty.† 2. Each company selected should be large, prominent, and con- servatively financed. Indefinite as these adjectives must be, their general sense is clear. Observations on this point are added at the end of the chapter. 3. Each company should have a long record of continuous divi- dend payments. (All the issues in the Dow Jones Industrial Aver- pundits declared that it could not possibly last. Never before had stocks yielded less than bonds; after all, since stocks are riskier than bonds, why would anyone buy them at all unless they pay extra dividend income to com- pensate for their greater risk? The experts argued that bonds would outyield stocks for a few months at most, and then things would revert to “normal.” More than four decades later, the relationship has never been normal again; the yield on stocks has (so far) continuously stayed below the yield on bonds. * See pp. 56–57 and 88–89. † For another view of diversification, see the sidebar in the commentary on Chapter 14 (p. 368). age met this dividend requirement in 1971.) To be specific on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950.* 4. The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve-month period. But such a restriction would eliminate nearly all the strongest and most popular companies from the port- fol

on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950.* 4. The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve-month period. But such a restriction would eliminate nearly all the strongest and most popular companies from the port- folio. In particular, it would ban virtually the entire category of “growth stocks,” which have for some years past been the favorites of both speculators and institutional investors. We must give our reasons for proposing so drastic an exclusion. Growth Stocks and the Defensive Investor The term “growth stock” is applied to one which has increased its per-share earnings in the past at well above the rate for common stocks generally and is expected to continue to do so in the future. (Some authorities would say that a true growth stock should be expected at least to double its per-share earnings in ten years—i.e., to increase them at a compounded annual rate of over 7.1%.)† Obviously stocks of this kind are attractive to buy and to own, pro- vided the price paid is not excessive. The problem lies there, of * Today’s defensive investor should probably insist on at least 10 years of continuous dividend payments (which would eliminate from consideration only one member of the Dow Jones Industrial Average—Microsoft—and would still leave at least 317 stocks to choose from among the S & P 500 index). Even insisting on 20 years of uninterrupted dividend payments would not be overly restrictive; according to Morgan Stanley, 255 companies in the S & P 500 met that standard as of year-end 2002. † The “Rule of 72” is a handy mental tool. To estimate the length of time an amount of money takes to double, simply divide its assumed growth rate into 72. At 6%, for instance, money will double

ustrial Average—Microsoft—and would still leave at least 317 stocks to choose from among the S & P 500 index). Even insisting on 20 years of uninterrupted dividend payments would not be overly restrictive; according to Morgan Stanley, 255 companies in the S & P 500 met that standard as of year-end 2002. † The “Rule of 72” is a handy mental tool. To estimate the length of time an amount of money takes to double, simply divide its assumed growth rate into 72. At 6%, for instance, money will double in 12 years (72 divided by 6 = 12). At the 7.1% rate cited by Graham, a growth stock will double its earnings in just over 10 years (72/7.1 = 10.1 years). course, since growth stocks have long sold at high prices in relation to current earnings and at much higher multiples of their average profits over a past period. This has introduced a speculative ele- ment of considerable weight in the growth-stock picture and has made successful operations in this field a far from simple matter. The leading growth issue has long been International Business Machines, and it has brought phenomenal rewards to those who bought it years ago and held on to it tenaciously. But we have already pointed out* that this “best of common stocks” actually lost 50% of its market price in a six-months’ decline during 1961–62 and nearly the same percentage in 1969–70. Other growth stocks have been even more vulnerable to adverse developments; in some cases not only has the price fallen back but the earnings as well, thus causing a double discomfiture to those who owned them. A good second example for our purpose is Texas Instruments, which in six years rose from 5 to 256, without paying a dividend, while its earnings increased from 40 cents to $3.91 per share. (Note that the price advanced five times as fast as the profits; this is characteristic of popular common stocks.) But two years later the earnings had dropped off by nearly 50% and the price by four-fifths, to 49.† The reader will understand fr

well, thus causing a double discomfiture to those who owned them. A good second example for our purpose is Texas Instruments, which in six years rose from 5 to 256, without paying a dividend, while its earnings increased from 40 cents to $3.91 per share. (Note that the price advanced five times as fast as the profits; this is characteristic of popular common stocks.) But two years later the earnings had dropped off by nearly 50% and the price by four-fifths, to 49.† The reader will understand from these instances why we regard growth stocks as a whole as too uncertain and risky a vehicle for the defensive investor. Of course, wonders can be accomplished with the right individual selections, bought at the right levels, and later sold after a huge rise and before the probable decline. But the average investor can no more expect to accomplish this than to find money growing on trees. In contrast we think that the group of * Graham makes this point on p. 73. † To show that Graham’s observations are perennially true, we can substi- tute Microsoft for IBM and Cisco for Texas Instruments. Thirty years apart, the results are uncannily similar: Microsoft’s stock dropped 55.7% from 2000 through 2002, while Cisco’s stock—which had risen roughly 50-fold over the previous six years—lost 76% of its value from 2000 through 2002. As with Texas Instruments, the drop in Cisco’s stock price was sharper than the fall in its earnings, which dropped just 39.2% (comparing the three-year average for 1997–1999 against 2000–2002). As always, the hotter they are, the harder they fall. large companies that are relatively unpopular, and therefore obtainable at reasonable earnings multipliers,* offers a sound if unspectacular area of choice by the general public. We shall illus- trate this idea in our chapter on portfolio selection. Portfolio Changes It is now standard practice to submit all security lists for peri- odic inspection in order to see whether their quality can be improved. This

r 1997–1999 against 2000–2002). As always, the hotter they are, the harder they fall. large companies that are relatively unpopular, and therefore obtainable at reasonable earnings multipliers,* offers a sound if unspectacular area of choice by the general public. We shall illus- trate this idea in our chapter on portfolio selection. Portfolio Changes It is now standard practice to submit all security lists for peri- odic inspection in order to see whether their quality can be improved. This, of course, is a major part of the service provided for clients by investment counselors. Nearly all brokerage houses are ready to make corresponding suggestions, without special fee, in return for the commission business involved. Some brokerage houses maintain investment services on a fee basis. Presumably our defensive investor should obtain—at least once a year—the same kind of advice regarding changes in his portfolio as he sought when his funds were first committed. Since he will have little expertness of his own on which to rely, it is essential that he entrust himself only to firms of the highest reputation; other- wise he may easily fall into incompetent or unscrupulous hands. It is important, in any case, that at every such consultation he make clear to his adviser that he wishes to adhere closely to the four rules of common-stock selection given earlier in this chapter. Inci- dentally, if his list has been competently selected in the first instance, there should be no need for frequent or numerous changes.† * “Earnings multiplier” is a synonym for P/E or price/earnings ratios, which measure how much investors are willing to pay for a stock compared to the profitability of the underlying business. (See footnote † on p. 70 in Chapter 3.) † Investors can now set up their own automated system to monitor the quality of their holdings by using interactive “portfolio trackers” at such web- sites as www.quicken.com, moneycentral.msn.com, finance.yahoo.com, and www.morn

for frequent or numerous changes.† * “Earnings multiplier” is a synonym for P/E or price/earnings ratios, which measure how much investors are willing to pay for a stock compared to the profitability of the underlying business. (See footnote † on p. 70 in Chapter 3.) † Investors can now set up their own automated system to monitor the quality of their holdings by using interactive “portfolio trackers” at such web- sites as www.quicken.com, moneycentral.msn.com, finance.yahoo.com, and www.morningstar.com. Graham would, however, warn against relying exclu- sively on such a system; you must use your own judgment to supplement the software. Dollar-Cost Averaging The New York Stock Exchange has put considerable effort into popularizing its “monthly purchase plan,” under which an investor devotes the same dollar amount each month to buying one or more common stocks. This is an application of a special type of “formula investment” known as dollar-cost averaging. During the predominantly rising-market experience since 1949 the results from such a procedure were certain to be highly satisfactory, espe- cially since they prevented the practitioner from concentrating his buying at the wrong times. In Lucile Tomlinson’s comprehensive study of formula invest- ment plans,1 the author presented a calculation of the results of dollar-cost averaging in the group of stocks making up the Dow Jones industrial index. Tests were made covering 23 ten-year pur- chase periods, the first ending in 1929, the last in 1952. Every test showed a profit either at the close of the purchase period or within five years thereafter. The average indicated profit at the end of the 23 buying periods was 21.5%, exclusive of dividends received. Needless to say, in some instances there was a substantial tempo- rary depreciation at market value. Miss Tomlinson ends her discus- sion of this ultrasimple investment formula with the striking sentence: “No one has yet discovered any other formula for invest-

in 1929, the last in 1952. Every test showed a profit either at the close of the purchase period or within five years thereafter. The average indicated profit at the end of the 23 buying periods was 21.5%, exclusive of dividends received. Needless to say, in some instances there was a substantial tempo- rary depreciation at market value. Miss Tomlinson ends her discus- sion of this ultrasimple investment formula with the striking sentence: “No one has yet discovered any other formula for invest- ing which can be used with so much confidence of ultimate suc- cess, regardless of what may happen to security prices, as Dollar Cost Averaging.” It may be objected that dollar-cost averaging, while sound in principle, is rather unrealistic in practice, because few people are so situated that they can have available for common-stock investment the same amount of money each year for, say, 20 years. It seems to me that this apparent objection has lost much of its force in recent years. Common stocks are becoming generally accepted as a neces- sary component of a sound savings-investment program. Thus, systematic and uniform purchases of common stocks may present no more psychological and financial difficulties than similar con- tinuous payments for United States savings bonds and for life insurance—to which they should be complementary. The monthly amount may be small, but the results after 20 or more years can be impressive and important to the saver. The Investor’s Personal Situation At the beginning of this chapter we referred briefly to the posi- tion of the individual portfolio owner. Let us return to this matter, in the light of our subsequent discussion of general policy. To what extent should the type of securities selected by the investor vary with his circumstances? As concrete examples representing widely different conditions, we shall take: (1) a widow left $200,000 with which to support herself and her children; (2) a successful doctor in mid-career, with savin

on At the beginning of this chapter we referred briefly to the posi- tion of the individual portfolio owner. Let us return to this matter, in the light of our subsequent discussion of general policy. To what extent should the type of securities selected by the investor vary with his circumstances? As concrete examples representing widely different conditions, we shall take: (1) a widow left $200,000 with which to support herself and her children; (2) a successful doctor in mid-career, with savings of $100,000 and yearly accretions of $10,000; and (3) a young man earning $200 per week and saving $1,000 a year.* For the widow, the problem of living on her income is a very dif- ficult one. On the other hand the need for conservatism in her investments is paramount. A division of her fund about equally between United States bonds and first-grade common stocks is a compromise between these objectives and corresponds to our gen- eral prescription for the defensive investor. (The stock component may be placed as high as 75% if the investor is psychologically pre- pared for this decision, and if she can be almost certain she is not buying at too high a level. Assuredly this is not the case in early 1972.) We do not preclude the possibility that the widow may qualify as an enterprising investor, in which case her objectives and meth- ods will be quite different. The one thing the widow must not do is to take speculative chances in order to “make some extra income.” By this we mean trying for profits or high income without the nec- essary equipment to warrant full confidence in overall success. It would be far better for her to draw $2,000 per year out of her prin- cipal, in order to make both ends meet, than to risk half of it in poorly grounded, and therefore speculative, ventures. The prosperous doctor has none of the widow’s pressures and compulsions, yet we believe that his choices are pretty much the same. Is he willing to take a serious interest in the business of inve

ing for profits or high income without the nec- essary equipment to warrant full confidence in overall success. It would be far better for her to draw $2,000 per year out of her prin- cipal, in order to make both ends meet, than to risk half of it in poorly grounded, and therefore speculative, ventures. The prosperous doctor has none of the widow’s pressures and compulsions, yet we believe that his choices are pretty much the same. Is he willing to take a serious interest in the business of investment? If he lacks the impulse or the flair, he will do best to * To update Graham’s figures, take each dollar amount in this section and multiply it by five. accept the easy role of the defensive investor. The division of his portfolio should then be no different from that of the “typical” widow, and there would be the same area of personal choice in fix- ing the size of the stock component. The annual savings should be invested in about the same proportions as the total fund. The average doctor may be more likely than the average widow to elect to become an enterprising investor, and he is perhaps more likely to succeed in the undertaking. He has one important handi- cap, however—the fact that he has less time available to give to his investment education and to the administration of his funds. In fact, medical men have been notoriously unsuccessful in their secu- rity dealings. The reason for this is that they usually have an ample confidence in their own intelligence and a strong desire to make a good return on their money, without the realization that to do so successfully requires both considerable attention to the matter and something of a professional approach to security values. Finally, the young man who saves $1,000 a year—and expects to do better gradually—finds himself with the same choices, though for still different reasons. Some of his savings should go automati- cally into Series E bonds. The balance is so modest that it seems hardly worthwhile for him t

ong desire to make a good return on their money, without the realization that to do so successfully requires both considerable attention to the matter and something of a professional approach to security values. Finally, the young man who saves $1,000 a year—and expects to do better gradually—finds himself with the same choices, though for still different reasons. Some of his savings should go automati- cally into Series E bonds. The balance is so modest that it seems hardly worthwhile for him to undergo a tough educational and temperamental discipline in order to qualify as an aggressive investor. Thus a simple resort to our standard program for the defensive investor would be at once the easiest and the most logi- cal policy. Let us not ignore human nature at this point. Finance has a fasci- nation for many bright young people with limited means. They would like to be both intelligent and enterprising in the placement of their savings, even though investment income is much less important to them than their salaries. This attitude is all to the good. There is a great advantage for the young capitalist to begin his financial education and experience early. If he is going to oper- ate as an aggressive investor he is certain to make some mistakes and to take some losses. Youth can stand these disappointments and profit by them. We urge the beginner in security buying not to waste his efforts and his money in trying to beat the market. Let him study security values and initially test out his judgment on price versus value with the smallest possible sums. Thus we return to the statement, made at the outset, that the kind of securities to be purchased and the rate of return to be sought depend not on the investor’s financial resources but on his financial equipment in terms of knowledge, experience, and tem- perament. Note on the Concept of “Risk” It is conventional to speak of good bonds as less risky than good preferred stocks and of the latter as less risky than go

test out his judgment on price versus value with the smallest possible sums. Thus we return to the statement, made at the outset, that the kind of securities to be purchased and the rate of return to be sought depend not on the investor’s financial resources but on his financial equipment in terms of knowledge, experience, and tem- perament. Note on the Concept of “Risk” It is conventional to speak of good bonds as less risky than good preferred stocks and of the latter as less risky than good common stocks. From this was derived the popular prejudice against com- mon stocks because they are not “safe,” which was demonstrated in the Federal Reserve Board’s survey of 1948. We should like to point out that the words “risk” and “safety” are applied to securi- ties in two different senses, with a resultant confusion in thought. A bond is clearly proved unsafe when it defaults its interest or principal payments. Similarly, if a preferred stock or even a com- mon stock is bought with the expectation that a given rate of divi- dend will be continued, then a reduction or passing of the dividend means that it has proved unsafe. It is also true that an investment contains a risk if there is a fair possibility that the holder may have to sell at a time when the price is well below cost. Nevertheless, the idea of risk is often extended to apply to a pos- sible decline in the price of a security, even though the decline may be of a cyclical and temporary nature and even though the holder is unlikely to be forced to sell at such times. These chances are pres- ent in all securities, other than United States savings bonds, and to a greater extent in the general run of common stocks than in senior issues as a class. But we believe that what is here involved is not a true risk in the useful sense of the term. The man who holds a mortgage on a building might have to take a substantial loss if he were forced to sell it at an unfavorable time. That element is not taken into account

der is unlikely to be forced to sell at such times. These chances are pres- ent in all securities, other than United States savings bonds, and to a greater extent in the general run of common stocks than in senior issues as a class. But we believe that what is here involved is not a true risk in the useful sense of the term. The man who holds a mortgage on a building might have to take a substantial loss if he were forced to sell it at an unfavorable time. That element is not taken into account in judging the safety or risk of ordinary real- estate mortgages, the only criterion being the certainty of punctual payments. In the same way the risk attached to an ordinary com- mercial business is measured by the chance of its losing money, not by what would happen if the owner were forced to sell. In Chapter 8 we shall set forth our conviction that the bona fide investor does not lose money merely because the market price of his holdings declines; hence the fact that a decline may occur does not mean that he is running a true risk of loss. If a group of well- selected common-stock investments shows a satisfactory overall return, as measured through a fair number of years, then this group investment has proved to be “safe.” During that period its market value is bound to fluctuate, and as likely as not it will sell for a while under the buyer’s cost. If that fact makes the investment “risky,” it would then have to be called both risky and safe at the same time. This confusion may be avoided if we apply the concept of risk solely to a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position—or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.2 Many common stocks do involve risks of such deterioration. But it is our thesis that a properly executed group investment in com- mon stocks does not carry any substantial risk of t

be avoided if we apply the concept of risk solely to a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position—or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.2 Many common stocks do involve risks of such deterioration. But it is our thesis that a properly executed group investment in com- mon stocks does not carry any substantial risk of this sort and that therefore it should not be termed “risky” merely because of the ele- ment of price fluctuation. But such risk is present if there is danger that the price may prove to have been clearly too high by intrinsic- value standards—even if any subsequent severe market decline may be recouped many years later. Note on the Category of “Large, Prominent, and Conservatively Financed Corporations” The quoted phrase in our caption was used earlier in the chapter to describe the kind of common stocks to which defensive investors should limit their purchases—provided also that they had paid continuous dividends for a considerable number of years. A criterion based on adjectives is always ambiguous. Where is the dividing line for size, for prominence, and for conservatism of financial structure? On the last point we can suggest a specific stan- dard that, though arbitrary, is in line with accepted thinking. An industrial company’s finances are not conservative unless the com- mon stock (at book value) represents at least half of the total capi- talization, including all bank debt.3 For a railroad or public utility the figure should be at least 30%. The words “large” and “prominent” carry the notion of substan- tial size combined with a leading position in the industry. Such companies are often referred to as “primary”; all other common stocks are then called “secondary,” except that growth stocks are ordinarily placed in a separate class by those who buy them as such. To

ock (at book value) represents at least half of the total capi- talization, including all bank debt.3 For a railroad or public utility the figure should be at least 30%. The words “large” and “prominent” carry the notion of substan- tial size combined with a leading position in the industry. Such companies are often referred to as “primary”; all other common stocks are then called “secondary,” except that growth stocks are ordinarily placed in a separate class by those who buy them as such. To supply an element of concreteness here, let us suggest that to be “large” in present-day terms a company should have $50 mil- lion of assets or do $50 million of business.* Again to be “promi- nent” a company should rank among the first quarter or first third in size within its industry group. It would be foolish, however, to insist upon such arbitrary crite- ria. They are offered merely as guides to those who may ask for guidance. But any rule which the investor may set for himself and which does no violence to the common-sense meanings of “large” and “prominent” should be acceptable. By the very nature of the case there must be a large group of companies that some will and others will not include among those suitable for defensive invest- ment. There is no harm in such diversity of opinion and action. In fact, it has a salutary effect upon stock-market conditions, because it permits a gradual differentiation or transition between the cate- gories of primary and secondary stock issues. * In today’s markets, to be considered large, a company should have a total stock value (or “market capitalization”) of at least $10 billion. According to the online stock screener at http://screen.yahoo.com/stocks.html, that gave you roughly 300 stocks to choose from as of early 2003. COMMENTARY ON CHAPTER 5 Human felicity is produc’d not so much by great Pieces of good Fortune that seldom happen, as by little Advantages that occur every day. —Benjamin Franklin TH E B E ST

s. * In today’s markets, to be considered large, a company should have a total stock value (or “market capitalization”) of at least $10 billion. According to the online stock screener at http://screen.yahoo.com/stocks.html, that gave you roughly 300 stocks to choose from as of early 2003. COMMENTARY ON CHAPTER 5 Human felicity is produc’d not so much by great Pieces of good Fortune that seldom happen, as by little Advantages that occur every day. —Benjamin Franklin TH E B E ST D E FE N S E I S A G OOD OFFE N S E After the stock-market bloodbath of the past few years, why would any defensive investor put a dime into stocks? First, remember Graham’s insistence that how defensive you should be depends less on your tolerance for risk than on your willingness to put time and energy into your portfolio. And if you go about it the right way, investing in stocks is just as easy as parking your money in bonds and cash. (As we’ll see in Chapter 9, you can buy a stock-market index fund with no more effort than it takes to get dressed in the morning.) Amidst the bear market that began in 2000, it’s understandable if you feel burned—and if, in turn, that feeling makes you determined never to buy another stock again. As an old Turkish proverb says, “After you burn your mouth on hot milk, you blow on your yogurt.” Because the crash of 2000–2002 was so terrible, many investors now view stocks as scaldingly risky; but, paradoxically, the very act of crashing has taken much of the risk out of the stock market. It was hot milk before, but it is room-temperature yogurt now. Viewed logically, the decision of whether to own stocks today has nothing to do with how much money you might have lost by owning them a few years ago. When stocks are priced reasonably enough to give you future growth, then you should own them, regardless of the losses they may have cost you in the recent past. That’s all the more true when bond yields are low, reducing the future returns on inco

of the risk out of the stock market. It was hot milk before, but it is room-temperature yogurt now. Viewed logically, the decision of whether to own stocks today has nothing to do with how much money you might have lost by owning them a few years ago. When stocks are priced reasonably enough to give you future growth, then you should own them, regardless of the losses they may have cost you in the recent past. That’s all the more true when bond yields are low, reducing the future returns on income- producing investments. 124 As we have seen in Chapter 3, stocks are (as of early 2003) only mildly overpriced by historical standards. Meanwhile, at recent prices, bonds offer such low yields that an investor who buys them for their supposed safety is like a smoker who thinks he can protect himself against lung cancer by smoking low-tar cigarettes. No matter how defensive an investor you are—in Graham’s sense of low maintenance, or in the contemporary sense of low risk—today’s values mean that you must keep at least some of your money in stocks. Fortunately, it’s never been easier for a defensive investor to buy stocks. And a permanent autopilot portfolio, which effortlessly puts a little bit of your money to work every month in predetermined invest- ments, can defend you against the need to dedicate a large part of your life to stock picking. S H OU LD Y OU “B UY WHA T Y OU K N O W”? But first, let’s look at something the defensive investor must always defend against: the belief that you can pick stocks without doing any homework. In the 1980s and early 1990s, one of the most popular investing slogans was “buy what you know.” Peter Lynch—who from 1977 through 1990 piloted Fidelity Magellan to the best track record ever compiled by a mutual fund—was the most charismatic preacher of this gospel. Lynch argued that amateur investors have an advantage that professional investors have forgotten how to use: “the power of common knowledge.” If you discover a great new rest

lief that you can pick stocks without doing any homework. In the 1980s and early 1990s, one of the most popular investing slogans was “buy what you know.” Peter Lynch—who from 1977 through 1990 piloted Fidelity Magellan to the best track record ever compiled by a mutual fund—was the most charismatic preacher of this gospel. Lynch argued that amateur investors have an advantage that professional investors have forgotten how to use: “the power of common knowledge.” If you discover a great new restaurant, car, toothpaste, or jeans—or if you notice that the parking lot at a nearby business is always full or that people are still working at a company’s headquarters long after Jay Leno goes off the air—then you have a per- sonal insight into a stock that a professional analyst or portfolio man- ager might never pick up on. As Lynch put it, “During a lifetime of buying cars or cameras, you develop a sense of what’s good and what’s bad, what sells and what doesn’t . . . and the most important part is, you know it before Wall Street knows it.” 1 Lynch’s rule—“You can outperform the experts if you use your edge by investing in companies or industries you already understand”—isn’t 1 Peter Lynch with John Rothchild, One Up on Wall Street (Penguin, 1989), p. 23. totally implausible, and thousands of investors have profited from it over the years. But Lynch’s rule can work only if you follow its corollary as well: “Finding the promising company is only the first step. The next step is doing the research.” To his credit, Lynch insists that no one should ever invest in a company, no matter how great its products or how crowded its parking lot, without studying its financial statements and estimating its business value. Unfortunately, most stock buyers have ignored that part. Barbra Streisand, the day-trading diva, personified the way people abuse Lynch’s teachings. In 1999 she burbled, “We go to Starbucks every day, so I buy Starbucks stock.” But the Funny Girl forgot that no m

doing the research.” To his credit, Lynch insists that no one should ever invest in a company, no matter how great its products or how crowded its parking lot, without studying its financial statements and estimating its business value. Unfortunately, most stock buyers have ignored that part. Barbra Streisand, the day-trading diva, personified the way people abuse Lynch’s teachings. In 1999 she burbled, “We go to Starbucks every day, so I buy Starbucks stock.” But the Funny Girl forgot that no matter how much you love those tall skinny lattes, you still have to ana- lyze Starbucks’s financial statements and make sure the stock isn’t even more overpriced than the coffee. Countless stock buyers made the same mistake by loading up on shares of Amazon.com because they loved the website or buying e*Trade stock because it was their own online broker. “Experts” gave the idea credence too. In an interview televised on CNN in late 1999, portfolio manager Kevin Landis of the Firsthand Funds was asked plaintively, “How do you do it? Why can’t I do it, Kevin?” (From 1995 through the end of 1999, the Firsthand Technol- ogy Value fund produced an astounding 58.2% average annualized gain.) “Well, you can do it,” Landis chirped. “All you really need to do is focus on the things that you know, and stay close to an industry, and talk to people who work in it every day.” 2 The most painful perversion of Lynch’s rule occurred in corporate retirement plans. If you’re supposed to “buy what you know,” then what could possibly be a better investment for your 401(k) than your own company’s stock? After all, you work there; don’t you know more about the company than an outsider ever could? Sadly, the employees 2 Kevin Landis interview on CNN In the Money, November 5, 1999, 11 A.M. eastern standard time. If Landis’s own record is any indication, focusing on “the things that you know” is not “all you really need to do” to pick stocks successfully. From the end of 1999 through the end of 2002,

w,” then what could possibly be a better investment for your 401(k) than your own company’s stock? After all, you work there; don’t you know more about the company than an outsider ever could? Sadly, the employees 2 Kevin Landis interview on CNN In the Money, November 5, 1999, 11 A.M. eastern standard time. If Landis’s own record is any indication, focusing on “the things that you know” is not “all you really need to do” to pick stocks successfully. From the end of 1999 through the end of 2002, Landis’s fund (full of technology companies that he claimed to know “firsthand” from his base in Silicon Valley) lost 73.2% of its value, an even worse pounding than the average technology fund suffered over that period. of Enron, Global Crossing, and WorldCom—many of whom put nearly all their retirement assets in their own company’s stock, only to be wiped out—learned that insiders often possess only the illusion of knowledge, not the real thing. Psychologists led by Baruch Fischhoff of Carnegie Mellon Univer- sity have documented a disturbing fact: becoming more familiar with a subject does not significantly reduce people’s tendency to exaggerate how much they actually know about it.3 That’s why “investing in what you know” can be so dangerous; the more you know going in, the less likely you are to probe a stock for weaknesses. This pernicious form of overconfidence is called “home bias,” or the habit of sticking to what is already familiar: • Individual investors own three times more shares in their local phone company than in all other phone companies combined. • The typical mutual fund owns stocks whose headquarters are 115 miles closer to the fund’s main office than the average U.S. com- pany is. • 401(k) investors keep between 25% and 30% of their retirement assets in the stock of their own company.4 In short, familiarity breeds complacency. On the TV news, isn’t it always the neighbor or the best friend or the parent of the criminal who says in a shocked voice,

s more shares in their local phone company than in all other phone companies combined. • The typical mutual fund owns stocks whose headquarters are 115 miles closer to the fund’s main office than the average U.S. com- pany is. • 401(k) investors keep between 25% and 30% of their retirement assets in the stock of their own company.4 In short, familiarity breeds complacency. On the TV news, isn’t it always the neighbor or the best friend or the parent of the criminal who says in a shocked voice, “He was such a nice guy”? That’s because whenever we are too close to someone or something, we take our beliefs for granted, instead of questioning them as we do when we con- front something more remote. The more familiar a stock is, the more likely it is to turn a defensive investor into a lazy one who thinks there’s no need to do any homework. Don’t let that happen to you. 3 Sarah Lichtenstein and Baruch Fischhoff, “Do Those Who Know More Also Know More about How Much They Know?” Organizational Behavior and Human Performance, vol. 20, no. 2, December, 1977, pp. 159–183. 4 See Gur Huberman, “Familiarity Breeds Investment”; Joshua D. Coval and Tobias J. Moskowitz, “The Geography of Investment”; and Gur Huberman and Paul Sengmuller, “Company Stock in 401(k) Plans,” all available at http://papers.ssrn.com. C AN Y OU R OLL Y OU R O WN? Fortunately, for a defensive investor who is willing to do the required homework for assembling a stock portfolio, this is the Golden Age: Never before in financial history has owning stocks been so cheap and convenient.5 Do it yourself. Through specialized online brokerages like www. sharebuilder.com, www.foliofn.com, and www.buyandhold.com, you can buy stocks automatically even if you have very little cash to spare. These websites charge as little as $4 for each periodic purchase of any of the thousands of U.S. stocks they make available. You can invest every week or every month, reinvest the dividends, and even trickle your money into sto

re in financial history has owning stocks been so cheap and convenient.5 Do it yourself. Through specialized online brokerages like www. sharebuilder.com, www.foliofn.com, and www.buyandhold.com, you can buy stocks automatically even if you have very little cash to spare. These websites charge as little as $4 for each periodic purchase of any of the thousands of U.S. stocks they make available. You can invest every week or every month, reinvest the dividends, and even trickle your money into stocks through electronic withdrawals from your bank account or direct deposit from your paycheck. Sharebuilder charges more to sell than to buy—reminding you, like a little whack across the nose with a rolled-up newspaper, that rapid selling is an investing no-no—while FolioFN offers an excellent tax-tracking tool. Unlike traditional brokers or mutual funds that won’t let you in the door for less than $2,000 or $3,000, these online firms have no minimum account balances and are tailor-made for beginning investors who want to put fledgling portfolios on autopilot. To be sure, a transaction fee of $4 takes a monstrous 8% bite out of a $50 monthly investment—but if that’s all the money you can spare, then these microinvesting sites are the only game in town for building a diversified portfolio. You can also buy individual stocks straight from the issuing compa- nies. In 1994, the U.S. Securities and Exchange Commission loos- ened the handcuffs it had long ago clamped onto the direct sale of stocks to the public. Hundreds of companies responded by creating Internet-based programs allowing investors to buy shares without going through a broker. Some helpful online sources of information on buying stocks directly include www.dripcentral.com, www.netstock direct.com (an affiliate of Sharebuilder), and www.stockpower.com. 5 According to finance professor Charles Jones of Columbia Business School, the cost of a small, one-way trade (either a buy or a sell) in a New York Stock Exchange–

stocks to the public. Hundreds of companies responded by creating Internet-based programs allowing investors to buy shares without going through a broker. Some helpful online sources of information on buying stocks directly include www.dripcentral.com, www.netstock direct.com (an affiliate of Sharebuilder), and www.stockpower.com. 5 According to finance professor Charles Jones of Columbia Business School, the cost of a small, one-way trade (either a buy or a sell) in a New York Stock Exchange–listed stock dropped from about 1.25% in Graham’s day to about 0.25% in 2000. For institutions like mutual funds, those costs are actually higher. (See Charles M. Jones, “A Century of Stock Market Li- quidity and Trading Costs,” at http://papers.ssrn.com.) You may often incur a variety of nuisance fees that can exceed $25 per year. Even so, direct-stock purchase programs are usually cheaper than stockbrokers. Be warned, however, that buying stocks in tiny increments for years on end can set off big tax headaches. If you are not prepared to keep a permanent and exhaustively detailed record of your purchases, do not buy in the first place. Finally, don’t invest in only one stock—or even just a handful of different stocks. Unless you are not willing to spread your bets, you shouldn’t bet at all. Graham’s guideline of owning between 10 and 30 stocks remains a good starting point for investors who want to pick their own stocks, but you must make sure that you are not overexposed to one industry.6 (For more on how to pick the individual stocks that will make up your portfolio, see pp. 114–115 and Chapters 11, 14, and 15.) If, after you set up such an online autopilot portfolio, you find your- self trading more than twice a year—or spending more than an hour or two per month, total, on your investments—then something has gone badly wrong. Do not let the ease and up-to-the-minute feel of the Inter- net seduce you into becoming a speculator. A defensive investor runs—and wins—the r

ndustry.6 (For more on how to pick the individual stocks that will make up your portfolio, see pp. 114–115 and Chapters 11, 14, and 15.) If, after you set up such an online autopilot portfolio, you find your- self trading more than twice a year—or spending more than an hour or two per month, total, on your investments—then something has gone badly wrong. Do not let the ease and up-to-the-minute feel of the Inter- net seduce you into becoming a speculator. A defensive investor runs—and wins—the race by sitting still. Get some help. A defensive investor can also own stocks through a discount broker, a financial planner, or a full-service stockbroker. At a discount brokerage, you’ll need to do most of the stock-picking work yourself; Graham’s guidelines will help you create a core portfolio requiring minimal maintenance and offering maximal odds of a steady return. On the other hand, if you cannot spare the time or summon the interest to do it yourself, there’s no reason to feel any shame in hiring someone to pick stocks or mutual funds for you. But there’s one responsibility that you must never delegate. You, and no one but you, must investigate (before you hand over your money) whether an adviser is trustworthy and charges reasonable fees. (For more point- ers, see Chapter 10.) Farm it out. Mutual funds are the ultimate way for a defensive investor to capture the upside of stock ownership without the down- 6 To help determine whether the stocks you own are sufficiently diversified across different industrial sectors, you can use the free “Instant X-Ray” func- tion at www.morningstar.com or consult the sector information (Global Industry Classification Standard) at www.standardandpoors.com. side of having to police your own portfolio. At relatively low cost, you can buy a high degree of diversification and convenience—letting a professional pick and watch the stocks for you. In their finest form— index portfolios—mutual funds can require virtually no monitoring or

ified across different industrial sectors, you can use the free “Instant X-Ray” func- tion at www.morningstar.com or consult the sector information (Global Industry Classification Standard) at www.standardandpoors.com. side of having to police your own portfolio. At relatively low cost, you can buy a high degree of diversification and convenience—letting a professional pick and watch the stocks for you. In their finest form— index portfolios—mutual funds can require virtually no monitoring or maintenance whatsoever. Index funds are a kind of Rip Van Winkle investment that is highly unlikely to cause any suffering or surprises even if, like Washington Irving’s lazy farmer, you fall asleep for 20 years. They are a defensive investor’s dream come true. For more detail, see Chapter 9. FI LLI N G I N TH E P O TH OLE S As the financial markets heave and crash their way up and down day after day, the defensive investor can take control of the chaos. Your very refusal to be active, your renunciation of any pretended ability to predict the future, can become your most powerful weapons. By put- ting every investment decision on autopilot, you drop any self-delusion that you know where stocks are headed, and you take away the market’s power to upset you no matter how bizarrely it bounces. As Graham notes, “dollar-cost averaging” enables you to put a fixed amount of money into an investment at regular intervals. Every week, month, or calendar quarter, you buy more—whether the markets have gone (or are about to go) up, down, or sideways. Any major mutual fund company or brokerage firm can automatically and safely transfer the money electronically for you, so you never have to write a check or feel the conscious pang of payment. It’s all out of sight, out of mind. The ideal way to dollar-cost average is into a portfolio of index funds, which own every stock or bond worth having. That way, you renounce not only the guessing game of where the market is going but which sectors o

have gone (or are about to go) up, down, or sideways. Any major mutual fund company or brokerage firm can automatically and safely transfer the money electronically for you, so you never have to write a check or feel the conscious pang of payment. It’s all out of sight, out of mind. The ideal way to dollar-cost average is into a portfolio of index funds, which own every stock or bond worth having. That way, you renounce not only the guessing game of where the market is going but which sectors of the market—and which particular stocks or bonds within them—will do the best. Let’s say you can spare $500 a month. By owning and dollar-cost averaging into just three index funds—$300 into one that holds the total U.S. stock market, $100 into one that holds foreign stocks, and $100 into one that holds U.S. bonds—you can ensure that you own almost every investment on the planet that’s worth owning.7 Every 7 For more on the rationale for keeping a portion of your portfolio in foreign stocks, see pp. 186–187. month, like clockwork, you buy more. If the market has dropped, your preset amount goes further, buying you more shares than the month before. If the market has gone up, then your money buys you fewer shares. By putting your portfolio on permanent autopilot this way, you prevent yourself from either flinging money at the market just when it is seems most alluring (and is actually most dangerous) or refusing to buy more after a market crash has made investments truly cheaper (but seemingly more “risky”). According to Ibbotson Associates, the leading financial research firm, if you had invested $12,000 in the Standard & Poor’s 500-stock index at the beginning of September 1929, 10 years later you would have had only $7,223 left. But if you had started with a paltry $100 and simply invested another $100 every single month, then by August 1939, your money would have grown to $15,571! That’s the power of disciplined buying—even in the face of the Great Depression and the

ut seemingly more “risky”). According to Ibbotson Associates, the leading financial research firm, if you had invested $12,000 in the Standard & Poor’s 500-stock index at the beginning of September 1929, 10 years later you would have had only $7,223 left. But if you had started with a paltry $100 and simply invested another $100 every single month, then by August 1939, your money would have grown to $15,571! That’s the power of disciplined buying—even in the face of the Great Depression and the worst bear market of all time.8 Figure 5-1 shows the magic of dollar-cost averaging in a more re- cent bear market. Best of all, once you build a permanent autopilot portfolio with index funds as its heart and core, you’ll be able to answer every mar- ket question with the most powerful response a defensive investor could ever have: “I don’t know and I don’t care.” If someone asks whether bonds will outperform stocks, just answer, “I don’t know and I don’t care”—after all, you’re automatically buying both. Will health-care stocks make high-tech stocks look sick? “I don’t know and I don’t care”—you’re a permanent owner of both. What’s the next Microsoft? “I don’t know and I don’t care”—as soon as it’s big enough to own, your index fund will have it, and you’ll go along for the ride. Will foreign stocks beat U.S. stocks next year? “I don’t know and I don’t care”—if they do, you’ll capture that gain; if they don’t, you’ll get to buy more at lower prices. By enabling you to say “I don’t know and I don’t care,” a permanent autopilot portfolio liberates you from the feeling that you need to fore- cast what the financial markets are about to do—and the illusion that 8 Source: spreadsheet data provided courtesy of Ibbotson Associates. Although it was not possible for retail investors to buy the entire S & P 500 index until 1976, the example nevertheless proves the power of buying more when stock prices go down. FIGURE 5-1 Every Little Bit Helps 6,000 5,000 4,000 3,000 2,

ow and I don’t care,” a permanent autopilot portfolio liberates you from the feeling that you need to fore- cast what the financial markets are about to do—and the illusion that 8 Source: spreadsheet data provided courtesy of Ibbotson Associates. Although it was not possible for retail investors to buy the entire S & P 500 index until 1976, the example nevertheless proves the power of buying more when stock prices go down. FIGURE 5-1 Every Little Bit Helps 6,000 5,000 4,000 3,000 2,000 1,000 0 From the end of 1999 through the end of 2002, the S & P 500-stock average fell relentlessly. But if you had opened an index-fund account with a $3,000 mini- mum investment and added $100 every month, your total outlay of $6,600 would have lost 30.2%—considerably less than the 41.3% plunge in the market. Better yet, your steady buying at lower prices would build the base for an explo- sive recovery when the market rebounds. Source: The Vanguard Group anyone else can. The knowledge of how little you can know about the future, coupled with the acceptance of your ignorance, is a defensive investor’s most powerful weapon. CHAPTER 6 Portfolio Policy for the Enterprising Investor: Negative Approach The “aggressive” investor should start from the same base as the defensive investor, namely, a division of his funds between high- grade bonds and high-grade common stocks bought at reasonable prices.* He will be prepared to branch out into other kinds of secu- rity commitments, but in each case he will want a well-reasoned justification for the departure. There is a difficulty in discussing this topic in orderly fashion, because there is no single or ideal pat- tern for aggressive operations. The field of choice is wide; the selec- tion should depend not only on the individual’s competence and equipment but perhaps equally well upon his interests and prefer- ences. The most useful generalizations for the enterprising investor are of a negative sort. Let him leave

ents, but in each case he will want a well-reasoned justification for the departure. There is a difficulty in discussing this topic in orderly fashion, because there is no single or ideal pat- tern for aggressive operations. The field of choice is wide; the selec- tion should depend not only on the individual’s competence and equipment but perhaps equally well upon his interests and prefer- ences. The most useful generalizations for the enterprising investor are of a negative sort. Let him leave high-grade preferred stocks to cor- porate buyers. Let him also avoid inferior types of bonds and pre- ferred stocks unless they can be bought at bargain levels—which means ordinarily at prices at least 30% under par for high-coupon * Here Graham has made a slip of the tongue. After insisting in Chapter 1 that the definition of an “enterprising” investor depends not on the amount of risk you seek, but the amount of work you are willing to put in, Graham falls back on the conventional notion that enterprising investors are more “aggressive.” The rest of the chapter, however, makes clear that Graham stands by his original definition. (The great British economist John Maynard Keynes appears to have been the first to use the term “enterprise” as a syn- onym for analytical investment.) 133 issues, and much less for the lower coupons.* He will let someone else buy foreign-government bond issues, even though the yield may be attractive. He will also be wary of all kinds of new issues, including convertible bonds and preferreds that seem quite tempt- ing and common stocks with excellent earnings confined to the recent past. For standard bond investments the aggressive investor would do well to follow the pattern suggested to his defensive confrere, and make his choice between high-grade taxable issues, which can now be selected to yield about 71⁄4%, and good-quality tax-free bonds, which yield up to 5.30% on longer maturities.† Second-Grade Bonds and Preferred Stocks Since in l

cluding convertible bonds and preferreds that seem quite tempt- ing and common stocks with excellent earnings confined to the recent past. For standard bond investments the aggressive investor would do well to follow the pattern suggested to his defensive confrere, and make his choice between high-grade taxable issues, which can now be selected to yield about 71⁄4%, and good-quality tax-free bonds, which yield up to 5.30% on longer maturities.† Second-Grade Bonds and Preferred Stocks Since in late-1971 it is possible to find first-rate corporate bonds to yield 71⁄4%, and even more, it would not make much sense to buy second-grade issues merely for the higher return they offer. In fact corporations with relatively poor credit standing have found it vir- tually impossible to sell “straight bonds”—i.e., nonconvertibles— to the public in the past two years. Hence their debt financing has been done by the sale of convertible bonds (or bonds with warrants attached), which place them in a separate category. It follows that virtually all the nonconvertible bonds of inferior rating represent older issues which are selling at a large discount. Thus they offer the possibility of a substantial gain in principal value under favor- able future conditions—which would mean here a combination of an improved credit rating for the company and lower general interest rates. * “High-coupon issues” are corporate bonds paying above-average interest rates (in today’s markets, at least 8%) or preferred stocks paying large divi- dend yields (10% or more). If a company must pay high rates of interest in order to borrow money, that is a fundamental signal that it is risky. For more on high-yield or “junk” bonds, see pp. 145–147. † As of early 2003, the equivalent yields are roughly 5.1% on high-grade corporate bonds and 4.7% on 20-year tax-free municipal bonds. To up- date these yields, see www.bondsonline.com/asp/news/composites/html or www.bloomberg.com/markets/rates.html and www.bloomberg.

red stocks paying large divi- dend yields (10% or more). If a company must pay high rates of interest in order to borrow money, that is a fundamental signal that it is risky. For more on high-yield or “junk” bonds, see pp. 145–147. † As of early 2003, the equivalent yields are roughly 5.1% on high-grade corporate bonds and 4.7% on 20-year tax-free municipal bonds. To up- date these yields, see www.bondsonline.com/asp/news/composites/html or www.bloomberg.com/markets/rates.html and www.bloomberg.com/markets/ psamuni.html. But even in the matter of price discounts and resultant chance of principal gain, the second-grade bonds are in competition with bet- ter issues. Some of the well-entrenched obligations with “old- style” coupon rates (21⁄2% to 4%) sold at about 50 cents on the dollar in 1970. Examples: American Telephone & Telegraph 25⁄8s, due 1986 sold at 51; Atchison Topeka & Santa Fe RR 4s, due 1995, sold at 51; McGraw-Hill 37⁄8s, due 1992, sold at 501⁄2. Hence under conditions of late-1971 the enterprising investors can probably get from good-grade bonds selling at a large discount all that he should reasonably desire in the form of both income and chance of appreciation. Throughout this book we refer to the possibility that any well- defined and protracted market situation of the past may return in the future. Hence we should consider what policy the aggressive investor might have to choose in the bond field if prices and yields of high-grade issues should return to former normals. For this rea- son we shall reprint here our observations on that point made in the 1965 edition, when high-grade bonds yielded only 41⁄2%. Something should be said now about investing in second-grade issues, which can readily be found to yield any specified return up to 8% or more. The main difference between first- and second- grade bonds is usually found in the number of times the interest charges have been covered by earnings. Example: In early 1964 Chicago, Milwaukee, St. Paul

ormer normals. For this rea- son we shall reprint here our observations on that point made in the 1965 edition, when high-grade bonds yielded only 41⁄2%. Something should be said now about investing in second-grade issues, which can readily be found to yield any specified return up to 8% or more. The main difference between first- and second- grade bonds is usually found in the number of times the interest charges have been covered by earnings. Example: In early 1964 Chicago, Milwaukee, St. Paul and Pacific 5% income debenture bonds, at 68, yielded 7.35%. But the total interest charges of the road, before income taxes, were earned only 1.5 times in 1963, against our requirement of 5 times for a well-protected railroad issue.1 Many investors buy securities of this kind because they “need income” and cannot get along with the meager return offered by top-grade issues. Experience clearly shows that it is unwise to buy a bond or a preferred which lacks adequate safety merely because the yield is attractive.* (Here the word “merely” implies that the issue is not selling at a large discount and thus does not offer an opportunity for a substantial gain in principal value.) Where such securities are bought at full prices—that is, not many points under * For a recent example that painfully reinforces Graham’s point, see p. 146 below. 100 *—the chances are very great that at some future time the holder will see much lower quotations. For when bad business comes, or just a bad market, issues of this kind prove highly sus- ceptible to severe sinking spells; often interest or dividends are suspended or at least endangered, and frequently there is a pro- nounced price weakness even though the operating results are not at all bad. As a specific illustration of this characteristic of second-quality senior issues, let us summarize the price behavior of a group of ten railroad income bonds in 1946–47. These comprise all of those which sold at 96 or more in 1946, their high prices

t, issues of this kind prove highly sus- ceptible to severe sinking spells; often interest or dividends are suspended or at least endangered, and frequently there is a pro- nounced price weakness even though the operating results are not at all bad. As a specific illustration of this characteristic of second-quality senior issues, let us summarize the price behavior of a group of ten railroad income bonds in 1946–47. These comprise all of those which sold at 96 or more in 1946, their high prices averaging 1021⁄2. By the following year the group had registered low prices averaging only 68, a loss of one-third of the market value in a very short time. Peculiarly enough, the railroads of the country were showing much better earnings in 1947 than in 1946; hence the drastic price decline ran counter to the business picture and was a reflection of the selloff in the general market. But it should be pointed out that the shrinkage in these income bonds was proportionately larger than that in the common stocks in the Dow Jones industrial list (about 23%). Obviously the purchaser of these bonds at a cost above 100 could not have expected to participate to any extent in a further rise in the securities market. The only attractive feature was the income yield, averaging about 4.25% (against 2.50% for first- grade bonds, an advantage of 1.75% in annual income). Yet the sequel showed all too soon and too plainly that for the minor advantage in annual income the buyer of these second-grade bonds was risking the loss of a substantial part of his principal. The above example permits us to pay our respects to the popu- lar fallacy that goes under the sobriquet of a “businessman’s investment.” That involves the purchase of a security showing a larger yield than is obtainable on a high-grade issue and carrying a correspondingly greater risk. It is bad business to accept an * Bond prices are quoted in percentages of “par value,” or 100. A bond priced at “85” is selling at 85% of its pr

bonds was risking the loss of a substantial part of his principal. The above example permits us to pay our respects to the popu- lar fallacy that goes under the sobriquet of a “businessman’s investment.” That involves the purchase of a security showing a larger yield than is obtainable on a high-grade issue and carrying a correspondingly greater risk. It is bad business to accept an * Bond prices are quoted in percentages of “par value,” or 100. A bond priced at “85” is selling at 85% of its principal value; a bond originally offered for $10,000, but now selling at 85, will cost $8,500. When bonds sell below 100, they are called “discount” bonds; above 100, they become “premium” bonds. acknowledged possibility of a loss of principal in exchange for a mere 1 or 2% of additional yearly income. If you are willing to assume some risk you should be certain that you can realize a really substantial gain in principal value if things go well. Hence a second-grade 5.5 or 6% bond selling at par is almost always a bad purchase. The same issue at 70 might make more sense—and if you are patient you will probably be able to buy it at that level. Second-grade bonds and preferred stocks possess two contra- dictory attributes which the intelligent investor must bear clearly in mind. Nearly all suffer severe sinking spells in bad markets. On the other hand, a large proportion recover their position when favorable conditions return, and these ultimately “work out all right.” This is true even of (cumulative) preferred stocks that fail to pay dividends for many years. There were a number of such issues in the early 1940s, as a consequence of the long depression of the 1930s. During the postwar boom period of 1945–1947 many of these large accumulations were paid off either in cash or in new securities, and the principal was often discharged as well. As a result, large profits were made by people who, a few years previ- ously, had bought these issues when they were friendless and sol

en of (cumulative) preferred stocks that fail to pay dividends for many years. There were a number of such issues in the early 1940s, as a consequence of the long depression of the 1930s. During the postwar boom period of 1945–1947 many of these large accumulations were paid off either in cash or in new securities, and the principal was often discharged as well. As a result, large profits were made by people who, a few years previ- ously, had bought these issues when they were friendless and sold at low prices.2 It may well be true that, in an overall accounting, the higher yields obtainable on second-grade senior issues will prove to have offset those principal losses that were irrecoverable. In other words, an investor who bought all such issues at their offering prices might conceivably fare as well, in the long run, as one who limited himself to first-quality securities; or even somewhat better.3 But for practical purposes the question is largely irrelevant. Regardless of the outcome, the buyer of second-grade issues at full prices will be worried and discommoded when their price declines precipitately. Furthermore, he cannot buy enough issues to assure an “average” result, nor is he in a position to set aside a portion of his larger income to offset or “amortize” those principal losses which prove to be permanent. Finally, it is mere common sense to abstain from buying securities at around 100 if long experience indicates that they can probably be bought at 70 or less in the next weak market. Foreign Government Bonds All investors with even small experience know that foreign bonds, as a whole, have had a bad investment history since 1914. This was inevitable in the light of two world wars and an interven- ing world depression of unexampled depth. Yet every few years market conditions are sufficiently favorable to permit the sale of some new foreign issues at a price of about par. This phenomenon tells us a good deal about the working of the average investor’

the next weak market. Foreign Government Bonds All investors with even small experience know that foreign bonds, as a whole, have had a bad investment history since 1914. This was inevitable in the light of two world wars and an interven- ing world depression of unexampled depth. Yet every few years market conditions are sufficiently favorable to permit the sale of some new foreign issues at a price of about par. This phenomenon tells us a good deal about the working of the average investor’s mind—and not only in the field of bonds. We have no concrete reason to be concerned about the future his- tory of well-regarded foreign bonds such as those of Australia or Norway. But we do know that, if and when trouble should come, the owner of foreign obligations has no legal or other means of enforcing his claim. Those who bought Republic of Cuba 41⁄2s as high as 117 in 1953 saw them default their interest and then sell as low as 20 cents on the dollar in 1963. The New York Stock Exchange bond list in that year also included Belgian Congo 51⁄4s at 36, Greek 7s at 30, and various issues of Poland as low as 7. How many readers have any idea of the repeated vicissitudes of the 8% bonds of Czechoslovakia, since they were first offered in this coun- try in 1922 at 961⁄2? They advanced to 112 in 1928, declined to 673⁄4 in 1932, recovered to 106 in 1936, collapsed to 6 in 1939, recovered (unbelievably) to 117 in 1946, fell promptly to 35 in 1948, and sold as low as 8 in 1970! Years ago an argument of sorts was made for the purchase of foreign bonds here on the grounds that a rich creditor nation such as ours was under moral obligation to lend abroad. Time, which brings so many revenges, now finds us dealing with an intractable balance-of-payments problem of our own, part of which is ascrib- able to the large-scale purchase of foreign bonds by American investors seeking a small advantage in yield. For many years past we have questioned the inherent attractiveness of such invest

an argument of sorts was made for the purchase of foreign bonds here on the grounds that a rich creditor nation such as ours was under moral obligation to lend abroad. Time, which brings so many revenges, now finds us dealing with an intractable balance-of-payments problem of our own, part of which is ascrib- able to the large-scale purchase of foreign bonds by American investors seeking a small advantage in yield. For many years past we have questioned the inherent attractiveness of such invest- ments from the standpoint of the buyer; perhaps we should add now that the latter would benefit both his country and himself if he declined these opportunities. New Issues Generally It might seem ill-advised to attempt any broad statements about new issues as a class, since they cover the widest possible range of quality and attractiveness. Certainly there will be exceptions to any suggested rule. Our one recommendation is that all investors should be wary of new issues—which means, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance.* The second is that most new issues are sold under “favorable market conditions”— which means favorable for the seller and consequently less favor- able for the buyer.† The effect of these considerations becomes steadily more impor- tant as we go down the scale from the highest-quality bonds through second-grade senior issues to common-stock flotations at the bottom. A tremendous amount of financing, consisting of the repayment of existing bonds at call price and their replacement by new issues with lower coupons, was done in the past. Most of this was in the category of high-grade bonds and preferred stocks. The buyers were largely financial institutions, amply qualified to pro- tect their interests. He

teadily more impor- tant as we go down the scale from the highest-quality bonds through second-grade senior issues to common-stock flotations at the bottom. A tremendous amount of financing, consisting of the repayment of existing bonds at call price and their replacement by new issues with lower coupons, was done in the past. Most of this was in the category of high-grade bonds and preferred stocks. The buyers were largely financial institutions, amply qualified to pro- tect their interests. Hence these offerings were carefully priced to * New issues of common stock—initial public offerings or IPOs—normally are sold with an “underwriting discount” (a built-in commission) of 7%. By con- trast, the buyer’s commission on older shares of common stock typically ranges below 4%. Whenever Wall Street makes roughly twice as much for selling something new as it does for selling something old, the new will get the harder sell. † Recently, finance professors Owen Lamont of the University of Chicago and Paul Schultz of the University of Notre Dame have shown that corpora- tions choose to offer new shares to the public when the stock market is near a peak. For technical discussion of these issues, see Lamont’s “Evaluating Value Weighting: Corporate Events and Market Timing” and Schultz’s “Pseudo Market Timing and the Long-Run Performance of IPOs” at http:// papers.ssrn.com. meet the going rate for comparable issues, and high-powered salesmanship had little effect on the outcome. As interest rates fell lower and lower the buyers finally came to pay too high a price for these issues, and many of them later declined appreciably in the market. This is one aspect of the general tendency to sell new secu- rities of all types when conditions are most favorable to the issuer; but in the case of first-quality issues the ill effects to the purchaser are likely to be unpleasant rather than serious. The situation proves somewhat different when we study the lower-grade bonds and preferr

nterest rates fell lower and lower the buyers finally came to pay too high a price for these issues, and many of them later declined appreciably in the market. This is one aspect of the general tendency to sell new secu- rities of all types when conditions are most favorable to the issuer; but in the case of first-quality issues the ill effects to the purchaser are likely to be unpleasant rather than serious. The situation proves somewhat different when we study the lower-grade bonds and preferred stocks sold during the 1945–46 and 1960–61 periods. Here the effect of the selling effort is more apparent, because most of these issues were probably placed with individual and inexpert investors. It was characteristic of these offerings that they did not make an adequate showing when judged by the performance of the companies over a sufficient num- ber of years. They did look safe enough, for the most part, if it could be assumed that the recent earnings would continue without a serious setback. The investment bankers who brought out these issues presumably accepted this assumption, and their salesmen had little difficulty in persuading themselves and their customers to a like effect. Nevertheless it was an unsound approach to invest- ment, and one likely to prove costly. Bull-market periods are usually characterized by the transfor- mation of a large number of privately owned businesses into com- panies with quoted shares. This was the case in 1945–46 and again beginning in 1960. The process then reached extraordinary propor- tions until brought to a catastrophic close in May 1962. After the usual “swearing-off” period of several years the whole tragicom- edy was repeated, step by step, in 1967–1969.* * In the two years from June 1960, through May 1962, more than 850 com- panies sold their stock to the public for the first time—an average of more than one per day. In late 1967 the IPO market heated up again; in 1969 an aston- ishing 781 new stocks were born. That overs