1 – Introduction

The search for millions is speculation, not investment, but there is money to be made in the stock market through discipline and patience. Unfortunately, the investing spotlight is shone on get-rich-quick schemes instead. Graham gives us an example of the exaggeration common in marketing investing: in the year 1929, an influential figure named John J. Raskob claimed that investing $15/month in common stocks,¹ and reinvesting any dividend,² would produce $80,000 in 20 years. In reality, you would only earn $8,500. But, compared to a total investment principal of $3,600 (excl. reinvested dividends), this is quite a return–especially when you need only put aside $15/month.

It is also a risk-averse strategy–the Dow Jones Industrial Average declined from 177 to 300 in the 20-year period, but you would still make large gains. This is because money was invested per-month, a strategy known as dollar-cost averaging.³ The DJIA didn’t just decline from 300-177 in a straight line, it fluctuated in between, often falling below its actual endpoint of 177.

2 – Investment vs. Speculation

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

In an investment operation, your principal must be returned, and you should also aquire an adequate amount of return. If you’ve invested $100 in an investment operation, you must have the $100 principal back and a, say, $10 return (if 10% is adequate). Anything else is speculation. Most people associate investment with speculation–especially with day-trading⁴–which is quite misleading. Investment and speculation should be thoroughly separated, and when investing you must run when you even hear of speculation.

That is not to say speculation must be avoided at all costs, because that’s not even possible. There is risk in all investments–the risk for the buyer that the stock may go down, and for the seller that the stock may go up⁵–and someone must assume that risk. Without speculators, many new companies would never get funds to innovate, as investing in these sorts of companies is a considerable risk. But speculation must, at most, be a pastime, and the bulk of your funds should be in safe investments. Note that margin accounts are also speculation because they are essentially investing beyond your means.⁶

2.1 – For the Defensive Investor

The defensive investor is one interested moreso in safety from risk than in large returns. For these people, Benjamin recommends that they:

1. Hold a significant amount of their wealth in bond-type holdings⁷ and equities. The ratio of bonds:equities should be between 25:75 and 75:25, or you could just do a simple 50:50.
2. When the market trends up, take your money from equities into bonds, and when the market trends down take your money from bonds into equities. Basically, reallocate the ratio inverse to the movement of the markets.
3. You can invest in mutual funds⁸ as a safe and simple alternative to manually managing your own portfolio.
4. You should utilize dollar-cost averaging as explained earlier.

2.2 – For the Aggressive Investor

The aggressive investor is interested in his returns moreso than his safety. For these people, it is recommended they:

1. Buy when the market is advancing, and sell when the market is declining.
2. Put more in stocks than bonds.
3. Buy short-term, sell short-term.
4. For long-term investments, buy stocks that have an excellent record of past growth, or are very likely to begin an excellent record of growth.

3 – The Investor and Inflation

Does inflation affect market movement? The record is mixed–deflation affects the stock market negatively, and regular inflation usually indicates a growing stock market. However, high-inflation’s effects are harder to pin down.

Are equities good hedges against inflation, and are they – common stocks – better than bonds for this purpose? In times of high inflation, should you reallocate to common stocks thus? As the last point indicates, the market is inherently unpredictable during times of high inflation, thus this assertion is simply false. It is also too simplistic to categorically reject all bonds in favor of stocks.

What about other hedges against inflation? Gold offers far too low returns, and is unjustifiable when we consider storage expenses. Other commodities have a similar issue, as well as the speculative nature of investing in them. Real estate is a bit more viable, but is similarly unstable and speculative. It is also considerably more complex to plan than plain commodities (you have to pick location, etc.). REITs⁹, however, do simplify the process.

With all this considered, Benjamin doubles down on his advice in the last chapter–maintain a portfolio balanced between stocks and bonds.

4 – Stock-Market History

For judging the whole stock market – the institution – as one, an understanding of stock-market history is necessary. However, one must not forecast the future through his understanding of the past alone. Never assume the market will continue to grow because it has been growing for the past few years, or vice versa.

Judge by three other factors instead: real growth–the rise in corporate earnings and average yield of dividends per share; inflationary growth–the rise of prices in the economy; and speculative growth–public opinion of the markets. A simple calculation of expected stock market growth (after inflation) is the yearly growth in corporate earnings + avg dividend yield. Speculative growth is a factor when the public’s greed drives the market up–but only temporarily, precipitating a dramatic crash.

5 – For the Defensive Investor: Expanded

5.1 – On Stocks

Graham argues that passive investors get low-returns–those intelligent investors willing to get their hands dirty will ensure a maximum return, regardless of aggressive or defensive portfolios.

It all begins with determining your bond-stock ratio. The most plain configuration would be 50:50 (bonds:stock), with 25:75 or 75:25 if the market is down and the market is up, respectively.

This is because you want to buy the lows, sell the highs. But this is an obvious principle–putting it to practice is considerably tougher. Most of the issue is psychological, really, with average investors buying high expecting to cash in on the ride, only realizing afterwards that they were at the peak… what you want to do is be the one selling to them at the peak, and buying it back for cheap once the ride is over.

If you don’t have confidence in your decision-making and discipline regarding this, just keep your stock allocation below 50%. If you want to be safer (more defensive, if you will), you can increase in lesser proportions–for example, increasing to 55% stocks when you think the market is down, and 55% bonds when you think it’s up. This buffets your losses somewhat if you make a mistaken judgment.

5.2 – On Bonds

There are really two factors in this: do you want tax-free or taxable bonds, and shorter or longer term maturities? The first is usually an arithmetic issue. Comparing two bonds, say, deduct your taxes from the taxable bond and see the actual returns on the two, then pick. Simple maths.

The second is a bit different. In picking bonds, do you want a bond that yields lower annually and does not promise returns on gains that occur but is safer (short-term), or the opposite (long-term)? If interest rates rise, for instance, short-term bonds fall less, but if interest rates fall, they also rise less. Medium-term bonds are usually the best choice, if you don’t want to put too much thought into it.

Another factor might be: do you need investments to supplement your actual income/month? In that case, invest more on short-term bonds.

6 – On Common Stonks

Common stocks offer greater returns (incl. dividends) than bonds, usually, and thus function as somewhat better hedges against inflation. Even in the worst of conditions, a common-stock portfolio alongside your bonds would be better than an all-bond holding.

On picking your portfolio, Graham offers the following advice:

1. Ensure you are diversified–in between a minimum of 10 stocks and a maximum of 30
2. Practice due dilligence on these company picks–ensure they are large and conservatively/prudently financed
3. Ensure a long dividend payments history–most DJIA companies abide by this, generally, but 10 years should be the minimum
4. The price you’re willing to pay for a stock should be decided by the average earnings of said stock over the past 10-years–namely, you should not be paying more than 25x these average earnings. Basically, if the P/E ratio of a company–where the E is its earnings averaged over the last 10 years–is >25, do not buy!

Practice dollar-cost averaging!

7 – What You Shouldn’t Do: For the Aggressive Investor: Expanded

The aggressive investor must be willing to leave the safety of high-grade bonds and common stocks. This does not mean investing in inferior types of bonds or preferred stocks, however. The same goes for foreign government bonds, new bonds, and new stocks, or, stocks with good finances but limited only to the near past.

With such high yields on even first-rate non-convertible corporate bonds, it makes very little sense to buy junk bonds. There is no need to take the risk, even for the aggressive investor. If high-grade bonds do not yield high enough interest rates, then it may be worth buying heavily discounted junk bonds. These bonds (and preferred stocks) also have the tendency to sink severely during tough markets, only to recover rapidly after everything ‘goes back to normal’–so use that to your advantage, and diversify your risk by buying mutual funds.

Foreign government bonds are best avoided. They are not only inherently unstable, but they also require you to be somewhat familiar with the finances and even politics of the foreign government whose bonds you are purchasing.

Be cautious with new issues. IPOs are usually offered at discounted rates to attract investors, which adds to the scent of allure–but is all the more reason to be cautious about them. IPOs are also undertaken usually when the market is at a peak–meaning, they’re selling you the stock while it’s going to be valued highest, at least for the near future. And, always remember Graham’s principle that you should only buy a stock if you think it is a cheap way to own a desirable business.

8 – What You Should Do: For the Aggressive Investor: Expanded

Graham gives us some simple principles for the dos of aggressive investing.

1. Buy when cheap, and sell when expensive
2. Buy growth stocks
3. After careful evaluation, buy bargain issues
4. Keep diversified–concentration may make wealth, but it can also kill it

Graham makes some careful changes to the definition of ‘growth stocks’.¹⁰ He argues that growth stocks are not companies positioned to do better in the near future–a growth stock must already have a record of high growth and realistic, founded expectations that it will do as well, or better, in the future.

There are some problems with growth stocks. For instance, such stocks are expensive. You wouldn’t be the only one with the idea of purchasing them, after all. Often, these factors are already recognized into the price of the stock–especially when you’re late to the party (look for a PE ratio <25, with earnings being averaged over the past seven years). And, of course, you may turn out to be wrong about company prospects. No one can see into the future, after all. Finally, the more a growth stock has grown, the less room for growth it has left. Thus, it grows more slowly.

Growth stocks fluctuate heavily. In fact, they fluctuate so much, based on even small happenings, that they may as well be speculative. Their volatility is almost entirely correlated with their actual growth compared to one wildcard factor: public enthusiasm. If public enthusiasm outgrows actual stock growth, the stock becomes a risky hold. It’s hard to index ‘public enthusiasm’, and thus these stocks become speculative.

If there are overvalued growth stocks, then there will also be undervalued growth stocks. Graham calls these the ‘relatively unpopular large company’. These are a large companies going through temporary unpopularity. They must be large, because large companies are more quicker and more likely to respond correctly to the issues that caused their temporary unpopularity.

Be careful in picking bargain issues and only purchase them ‘on the basis of facts established by analysis’. Mathematically, Graham defines bargains as having a price worth less than 50% their actual value.

9 – Investing in Investment Funds

Investment companies that allow you to redeem your shares at any time are called mutual funds, or open-end funds. Funds that don’t allow you to withdraw at any time are closed-end funds.

Funds that hold all-stock portfolios are stock-funds, funds that hold all-bond portfolios are bond funds, and balanced funds usually have 1/3rd or more bonds.

Investing in funds offers greater returns and security than common stocks or bonds purchased directly. This is true even if (as they mostly do) funds directly follow the market or the S&P 500.

Some general points about funds:

1. Invest in funds that spend less on operating costs. The > the fund expenses, the < its returns.
2. The > the frequency a fund trades its stocks, the < it earns.
3. Funds with high past returns aren’t likely to remain winners.
4. Investing in popular funds–popular because they ensured high returns in the near past–is very risky. The companies invested in by that fund get even more overvalued as more and more people put their money into the fund, and run a greater chance of crashing.
5. Invest in funds with managers who are their own biggest shareholders. This ensures they manage your money like it’s their own (because it is).
6. Invest in cheaper funds.
7. Invest in funds that offer something unique.
8. Invest in funds that close their doors to new investors when they feel their investments are getting too popular–saving them from the consequences of overvaluation and having more money than they know what to do with.
9. Sell when the fund goes through an unexpected change in strategy, increase in expenses, or ensures a suddenly erratic return (good or bad).

10 – The Investor and His Advisers

When basing your investments on advice from anyone – be it relatives or your broker – ensure that the advice is realistic, unimaginative, and conservative. If not, don’t practice it, unless you trust the advisor extremely well.

Investment advisors who charge for services are almost always practical and realistic, and don’t promise anything big. Keep this standard for everyone Again, louder for the people in the back, THERE IS NO EASY PATH TO WEALTH! Anyone selling you this is a fraud, otherwise he would be profiting from it alone.

Brokerage reputation varies depending on the place where you’re investing, but they are a good choice to go to for advice. You probably need advice, investing or general financial, if you have:

1. Horrible budgeting skills – you’re living paycheck-to-paycheck, or even worse, you fail to pay your bills on time regularly
2. Big losses on your investments–but only if they’re worse than the stock markets returns over the same (large) period of time
3. If your life is changing dramatically, and you need to reorient your finances, help is always nice.

11 – Security Analysis for the Lay Investor

Security analysis is the examination and evaluation of individual stocks and bonds. Financial analysis is security analysis, general portfolio policy, and general economic analysis, all combined.

When dealing with bonds or preferred stocks, check that the ratio of earnings (averaged over the last 7yrs) to total fixed charges is >=5, but this varies sector-to-sector. Ensure that the operation is large, also.

Individual forecasts are usually off-the-mark, more often than not, so focus on group forecasts instead.