Chapter 2 investors and inflation

Inflation and the fight against it have been on people's minds for ages. Yes, it has. The dollar's shrinking purchasing power, and in particular the fear (or speculators' expectation) of a more serious decline in the future, have strongly influenced Wall Street's thinking in the past. It is clear that when the cost of living rises, those who suffer the most are those with fixed incomes, and the same principle applies to principal. On the other hand, stock holders have the opportunity to offset the dollar's declining purchasing power with rising dividends and stock dividends.Based on these undisputed facts, many financial authorities have concluded that (1) bonds are an unprofitable investment structure, and (2) therefore ordinary shares are, by their very nature, a more profitable investment than bonds. We have heard charities advised that their portfolios should consist of 100% shares and zero interest bonds. This is a far cry from the old days when trusts were the first to hold shares.*By the late 1990s this advice, which might actually be appropriate for a foundation or financial advisor who is able to invest for a limited and long time period, had become more applicable to individual investors who have a limited life span. In the 1994 edition of his influential book Stocks Forever Run, Professor Jaresh Seyat of the Cardon School suggested that 'risk-taking' investors should buy on margin. They should borrow more than a third of their fixed assets and put 135% of their capital into stocks. Even government officials joined in. In February 1999, the Honorable Richard Dixon, Maryland's state treasurer, told an audience at an investment conference, "It makes no sense for anyone to put money in a bank fund."

Investments in the U.S. were legally restricted to high-grade bonds (and certain preferred stocks).Our readers will surely be wise enough to know that even high-quality stocks are not a better buy than bonds in all circumstances, no matter how high the stock market is and how low its current dividend yield is compared to the rates available on bonds. This statement is as absurd as the opposite, which was often heard years ago, that all bonds are safer than stocks. In this chapter we will try to apply various measures to the inflation factor in order to arrive at some conclusions as to the extent to which investors can be sensibly influenced by expectations of future rises in the level of sentiment.In this case, as in other financial situations, we must base our future policy on the wisdom of past experience. Is inflation new to this country, at least in the severe form it has endured since 1965? If we have experienced comparable (or worse) inflation, what lessons can be learned from it for dealing with today's inflation? Let us begin with Table 2-1, a brief historical table containing a wealth of information about changes in the general level of prices and the concomitant changes in the yields and market value of common stocks. Our data begin in 1915, and thus cover 55 years, at five-year intervals. (We have used 1946 instead of 1945 to avoid the last year of wartime price controls.)The first thing we'll see is that inflation has happened before, and quite substantially. The biggest five-year impact was between 1915 and 1920, when the cost of living nearly doubled. This can be compared to the period between 1965 and 1970, when it rose by 15%. In between, we saw prices fall in three periods and rise at varying rates in six, some of them quite low. After looking at this, it will be clear to investors that inflation is likely to continue or return again and again.Can we predict what the inflation rate is likely to be? The answer is not clear from our table, as it shows all kinds of variations, but it is more sensible to get an indication of this from a more systematic record of the last 20 years. The levels of consumer sentiment during this period are as follows:

"In the 19th century, average annual growth was about 2.5%, compared with 4.5% between 1965-1970 and 5.4% in 1970 alone. Government policy has always been firmly against high-level inflation, and there is some reason to believe that future federal policies will be more effective than in recent years." We believe it is best for investors to base their thinking and decisions on an expected (fluctuating) rate of inflation, say 39% per year (this is compared to an annual rate of about 2.5% over the entire period 1915-1970).What could be the implications of this increase? It will eat up half of the income currently being generated by good medium-grade tax-fee bonds (or the post-tax equivalent of our high-grade corporate bonds) to meet the rising cost of living. This is a serious contraction, but should not be exaggerated. It does not mean that the real value or purchasing power of an investor's investment will decline in the coming years. If he spends half of his post-tax interest income, his purchasing power will remain intact, even if annual inflation rises to 3%.But the obvious next question is: Would an investor be rationally more certain to buy and hold something other than high-grade bonds, even though the rate of return in 1970-1971 was unprecedented? Wouldn't an all-share plan be better than a part bond and part share plan, for example? Haven't ordinary shares developed built-in protection against inflation, and is it not almost certain that they will give better returns than bonds in the years to come? Isn't it a fact that over the 55-year period of our study, investors have had better returns on shares than on bonds?The answers to these questions are a little complicated. Certainly common stocks have outperformed bonds over long periods of time in the past. The DJIA average of 77 in 1915 rose to an average of 753 in 1970, at an annual compounded rate of just over 4%, to which we add the average dividend return of 4%. (The S&P Composite supplemental data were similar.) This compounded figure of 8% per year is certainly better than the return on bonds over the same 55-year period, but it is not much more than what is currently being offered by high-yield bonds.

This brings us to the next logical question: is there any reason to believe that in the coming years, ordinary shavers will perform better than they have in the last five and a half decades?Our answer to this difficult question is a clear no. Ordinary shares may perform better than in the past, but they are not certain to do so. We have to deal with the different temporal realities in investment results. The first concerns probabilities, or the technological future, say in the next 25 years. The second concerns what the investor is financially and mentally likely to do in the short or medium term, say five years or less. His mental state with respect to what he has done, his hopes and fears, his satisfaction or dissatisfaction, and above all what to do next, are determined not by the director's life span but by his experience year after year.We can be clear on this point. There is no close temporal relationship between inflationary (or deflationary) conditions and the movement of ordinary chevron income and prices. A clear example of this is the period between 1966-1970. There was a 22% increase in the cost of living, the most in a five-year period since 1946-1950, but both chevron income and share prices have been on the decline since 1965. There is a similar contradiction in the record in both directions over the last five-year periods.Inflation and corporate incomeAnother and very important perspective on this subject is the study of the rate of earning on capital as shown by the American business community. Of course, this too fluctuates with the general rate of economic activity, but it does not reflect the general trend of rising prices and cost of living. In fact, this rate has fallen considerably in the recent past despite the inflation of the period. (To some extent, this decline has been due to the adoption of a more liberal depreciation rate. (See Marni 2.2.) After our detailed study, we have come to the conclusion that investors cannot rely too much on the recent five-year rate of the DJIA basket. The stocks are about 10% behind the net book value. The market value of stocks in issue is much higher than the net book value. For example, a 900 stock price in mid-1921 and a 560 stock price in June 1921 - the market value of the stock is only about 6.25%. (Such a relationship is usually given in reverse, or 'time gain' style. For example, a 100 stock price in June 1921 has fallen by 18% over the 12 months since it was launched.)

Our figures are consistent with the suggestion in the previous chapter that an investor should assume a $496 annual appreciation in book value from Shaver's average dividend return of about 3.5% on market value plus reinvestment of profits. (Note that every $1 added to book value here assumes a $1.00 increase in market value.)Readers may object that our final calculations do not take into account the increase in earnings and prices of ordinary shares in the results obtained at an assumed 3% annual inflation. We justify this on the grounds that there is no indication that comparable amounts of inflation have ever had such a significant effect on earnings per share in the past. Hard data show that all the relatively large earnings from DJIA units over the past 20 years have been due to the redirection of profits. If inflation acted as a separate profit factor, its effect would be to increase the "value" of capital already in existence. This in turn would raise the rate of earnings on such old capital, and thus on old and new capital combined. But this has never happened in the past 20 years. During this period, the level of wholesale prices rose by about 40%. (Wholesale prices affect business income more than consumer prices do.) The only way in which inflation can increase the value of ordinary shares is if the rate of earnings on capital invested increases. If we look at past records, this has never happened before.In previous economic cycles, prices in good businesses have risen and prices in bad businesses have fallen. It was generally believed that a little inflation was helpful to business profits. This view is not contradictory to the history of the 1950-1970 period, which shows a relationship between general prosperity and general price appreciation, but the data suggest that these have had little effect on any kind of earning power of equity capital, much less on the maintenance of investment income. Clearly there are some common countervailing factors that have prevented real profitability of the American corporation as a whole. Perhaps the most important of these are (1) productivity growth leads to higher wage rates and (2) the need for large amounts of new capital, which keeps the ratio of capital employed to sales tight.The figures in our Table 2-2 show that so far inflation has benefited our corporations and our stockholders, while its effects have been exactly the opposite. The most surprising of the figures in our list is the growth of corporate debt between 1950 and 1969. It is surprising how little our economists and Wall Street have commented on this development. Corporations' energy debt grew by about five times in 1950.

100% of corporate debt, while their pre-tax profits only slightly more than doubled. The rise in interest rates during this period makes it clear that corporate net indebtedness has become an adverse economic factor and a real problem for some private enterprises. (Note that in 1950, net income after interest but before tax was about 30% of corporate debt, while in 1969 it was only 13.2% of debt. The ratio in 1970 must have been even less satisfactory.) Overall, it appears that most of the 11% return on total corporate equity is being derived from the use of large amounts of new debt, which costs 417% or less after tax credits. Had our corporations maintained their 1950 debt ratio, their rate of earnings on equity would have been even lower, despite inflation.The stock market views public utility enterprises as the biggest victims of inflation. They are caught between the rising cost of borrowing money and the regulatory process of raising rates, but we would like to point out that the increase in unit costs of electricity, gas, and telephone services is so low as to be a strategic position for the future of these companies.' They are legally empowered to charge favourable rates to ensure a reasonable return on their invested capital, and hence,

These provide potential protection to their shareholders in the future, as they have had from inflation in the past.All of the above leads us back to the conclusion that an investor has no good reason to expect an average total return of more than, say, 40% from the price level at which ordinary shares in a DJIA-type portfolio were purchased in late 1971. But even if this expectation could be made for a large sum of money, all stock investment programs cannot be called perfect. If there is one thing that is certain about the future, it is that the income and average annual interest rate in stock portfolios will not grow at a steady rate of 4% or any such amount. They will be volatile, to use the memorable words of J.P. Morgan Sr. This means that, first, a buyer of ordinary shares today or tomorrow will actually be at risk of more unsatisfactory results than he is now. It took General Electric (and the DJIA itself) 25 years to recover the ground lost in the 1929-1932 crash. Moreover, if the investor limits his portfolio to ordinary shares only, he is likely to be misled by either a sharp rise or a disappointing fall. This is especially true if this factor is fueled by expectations of forthcoming inflation. Then, if the price rises again, he will not take the big rise as a sign of the danger of an inevitable fall, nor will he cash in on his handsome profits, but will take the expected inflation as tax proof and therefore buy ordinary shares, no matter how high they are above market levels or how low their dividend yield is. And this is where the misery comes from.Alternatives to ordinary shares as a hedge against inflationThe standard strategy for people around the world who don't trust their currency is to buy gold and hold it. Fortunately, this has been against the law for US citizens since 1935. Over the past 15 years, the price of gold on the open market has risen from $35 an ounce in early 1972 to $40 an ounce.

This is a mere increase of 15%, but during this entire period the owner did not get any return from the loan capital, rather he incurred an annual expense on its storage. Despite the general rise in prices, it would have been better if he had kept this loan on interest in a savings account.The almost total failure of gold to ever provide security in the purchasing power of the dollar casts serious doubts on the ability of the ordinary investor to protect himself against inflation by investing in gold. There are some expensive commodities whose market value increases considerably over a few years, such as diamonds, coins made by master craftsmen, first editions of books, rare postage stamps and coins, etc., but many, in fact most, of these have a price that is likely to be artificial or dubious or counterfeit. Of course it is hard to imagine paying $67,500 as an 'investment deal' for a 1504 Deuce Silver Heeler (not even printed that year). We admit to not having much knowledge of the subject. This area will be safe and easy for very few of our readers.Real estate ownership has long been considered a good long-term investment with a good degree of inflation protection. Unfortunately, real estate prices are also highly volatile, serious mistakes are made in location, price paid, and seller fraud is common. In conclusion, diversification is not practical for an investor with limited capital. The various types of partnerships with others involve special risks associated with new flotations. These are not much different from normal stock ownership. This is also not our area of focus. So all we can say to an investor is, make sure you understand it before you do it."conclusionNaturally, we again follow the same policy that we suggested in the previous chapter. It is only because of the uncertainties of the future that investors do not invest all their money in one place.

One cannot invest in just the bond basket, no matter how strong the returns that bonds have given recently, nor in the equity basket, no matter how likely the currency rally is to continue.The more dependent the investor is on his portfolio and the income it generates, the more he needs to protect himself from this unpredictable and frustrating part of life. It is axiomatic that savvy investors want to minimize their risk. Our general feeling is that the costs involved in buying, say, telephone company bonds yielding about 7.5% are much less than those involved in buying the DJIA at 100 (or any of the other stocks listed here), but the possibility of massive inflation remains and the investor must protect himself against it. There is no way to be sure that the stock components will provide adequate protection against such inflation, but they should have more protection against a crash.This is what we said on this subject in our 1965 edition and Bhaan is saying the same thing:The film will surely tell you that there is no harm in holding ordinary shares at this level (at IA). It seems that a niche investor cannot afford to invest a reasonable amount of ordinary shares in his portfolio and hence the risk of holding a portfolio of twenty-two shares in a short period of time is low.

Important points:

1. By the late 1990s this advice, which might actually be appropriate for a foundation or financial endowment because it is able to invest unlimitedly and for a long time, had spread to individual investors, whose life spans are limited. In the 1994 edition of his influential book Stocks for the Long Run, Wharton School finance professor Jeremy Siegel suggested that 'risk-taking' investors should buy on margin. They should borrow more than one-third of their net worth and put 135% of their capital into stocks. Even government officials got in on the act. In February 1999, the Honorable Richard Dixon, Maryland's state treasurer, told an audience at an investment conference, "It makes no sense for anybody to put money in a bond fund.

2. This was one of the rare occasions when Graham predicted wrong. In 1973, two years after mercurial President Richard Nixon imposed wage and price controls, inflation hit 8.7 percent. That was the highest rate of inflation since the end of World War II. The decade from 1973 to 1982 was the most inflationary in U.S. history. The cost of living more than doubled during that period.

3.John Wearpot Morgan was the most powerful financier of the late nineteenth and early nineteenth centuries. His enormous influence often led to his being questioned as to what would happen in the stock market. Morgan had formulated a succinct and accurate forecast, "It will go up and down. See Gene Strauss, Morgan's American Financier, Redeemable Money, (12) p. 11.

4.Investment philosopher Peter L. Bernstein believes that Graham was 'blatantly wrong' about price movements, particularly gold. These metals have shown strong inflation-beating potential (at least in the years after Graham wrote this article). He points out that even if gold performs poorly, a small allocation (say 2 percent of your total assets) to a precious metals fund does little to boost your overall return. But when gold performs well, its returns are often spectacular—

5.It can sometimes return more than 100 percent in a full year and add shine to a PK portfolio on its own, but a smart investor avoids investing directly in gold because its storage and insurance costs are so high. Instead, he looks for a mutual fund that has a diversified portfolio, specializes in stocks of companies that deal in precious metals, and charges less than a percentage point in annual expenses. Limit your disbursement to 2 percent of your full financial assets (or perhaps 5 percent if you are over 65).

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market bell rings and then you can talk about how the market is doing that day. Because you trade, you make money, whether you make money or not. By speculating instead of investing, you are reducing your chances of wealth creation and increasing someone else's chances.Alm's definition of investment is clear: An investment is an activity that, through analysis, promises safety of capital and a reasonable return. Note that according to Alm, three elements are equally present in investing:You should thoroughly analyse the company and its underlying business strength before buying a stock.You will have to think carefully and protect yourself from serious losses.You should not aspire for overstatement, but rather for 'adequate performance'.

The investor calculates the creamery of the balance based on its trading price.It is this speculator who thinks the stock price will go up because someone else is willing to pay more for it. As Graham once said, the investor estimates the market price as a price standard, while the speculator takes the market price as his price standard. To the speculator, the constant flow of stock prices is like oxygen. Stop it and they will disappear, while to the investor they are of little value, which Graham called the 'quotational price'. Graham strongly urges you to invest only when you can, even if you have no way of knowing the daily price.'Like betting in a casino or gambling on horse racing, market speculation can be exciting or profitable (if you get lucky), but it is the worst way to build wealth, because Wall Street is just like Vegas or a racetrack. It creates inequalities that the market will always maintain, and in the end, it works against everyone who tries to beat the market with their betting.Investing, on the other hand, is a different kind of casino—one where you don't end up winning. As long as you play the game by the rules, the odds will be in your favor. While investors make money for themselves, speculators make money for their brokers. This is why Beale Strauss always preaches the artificial allure of speculation over the swappy virtues of investing.insecurity in high speedGraham cautions against speculation and investing, saying it is always a mistake. In the 1990s, this delusion led to a major crisis. In other words, almost everyone had lost patience, and the whole US had become Speculation Nation, a country full of traders who were calling one deal after another like the bullshit fucking August storms around hay fields.

It began to dawn on John that the easiest way to test an investing technique was to see if it worked. If they were in practice, no matter how risky or foolish the technique was, people were tempted to be 'right', but intelligent investors had no problem being temporarily right. To achieve your personal financial goals, you had to be right repeatedly and reliably. Techniques that were in vogue in the 1990s, including trend-following, ignoring diversification, buying popular mutual funds, following stock-picking 'systems', etc., seemed to work, but were unlikely to continue working in the long term because they did not meet Graham's three investing criteria.To understand why getting unjustly high returns does not mean anything, imagine two places that are 130 miles apart. If I drive at 65 mph, I can cover the distance in two hours, but if I drive at 130 mph, I can get there in one hour. If I do that, and escape punishment, was I right? Would you try it too, because you heard me boast that it works? The hype around beating the market is the same. In short, it will work as long as your luck allows. Over time, it will only hurt you.In 1973, when Shah last revised The Intelligent Investor, the annual turnover rate on the New York Stock Exchange was 20%, meaning a typical shareholder would sell a stock after holding it for five years. By 2002, the turnover rate had reached 101%, with a holding period of just 11.4 months. Back in 1971, the average mutual fund held on to a stock for about three years, but by 2002, that ownership period had shrunk to just 10.9 months. Mutual fund managers seemed to study their stocks enough to discover they shouldn't have bought them. In such a case, they would immediately sell them and start over.Even the most respected money management firms began to lose their cool. In early 1995, Nefri Vinik, the manager of Fidelity Magellan (then the world's largest mutual fund), held 12.5% of his assets in technology stocks. "The goals for which most of his shareholders have invested in the fund are years away," Vinik said. ... I think he and I have the same goals, and he feels as I do that the long-term approach is best. But just six months after writing his words on the high morals, Vinik sold nearly all of his technology holdings, selling stocks worth about $319 billion in eight 19 weeks.

That was a lot to take in the 'long term' and by 1999, Fidelity's discount brokerage division was offering its clients the ability to trade anywhere, anytime via Palm handheld computers, perfectly matching the firm's new slogan, 'Every second is creamy.' And the pace of turnover on the Nasdaq exchange remained extremely fast, as Figure 1-1 shows.For example, in 1999, Puma Technology shares were traded every 5.7 days on average. Despite Nasdaq's grand motto - The Stock Market for the Next Thousand Years - many of its customers held shares for less than an hour.

financial video gamesWall Street made online trading seem like a way to quickly print money: Discover Brokerage, the online arm of the venerable Price Morgan Stanley, ran a TV ad in which a shabby-dressed truck driver gives a well-heeled looking jobber a lift. "Would you like to go on vacation here?" the jobber asks, noticing a photo of a tropical beach on his dashboard. "This is my town, by the way," the driver replies. "That's an island, right?" the jobber asks, glaring. "Technically, it's a country," the driver replies, with a calm triumphant tone.The hype goes even further. Online trading involves little do and no thinking. A TV ad for Ameritrade, an online broker, showed two housewives returning from a jog. One of them logs on to her computer, makes a few mouse clicks, and exclaims, "I just made $1,700." In a TV ad for the Waterhouse brokerage firm, a man asks basketball coach Phil Jackson, "Do you know how to trade?" He replies, "I'm going to do it right now." (How many games would Jackson's NVA team have won if they had applied the same philosophy to trading—knowing nothing about the other team but saying, "I'm ready to play with them right now." This is not a formula for becoming a champion.)By 1999, about six million people were trading online, and about ten percent of them were doing 'day trading', buying and selling at a rapid pace using the Internet. From showbiz star Barva Streisand to Nicholas Biswas, a 25-year-old former waiter in Queens, New York, everyone was trading shares. "I was investing for the long term, but then I realized that there is no sense in it," said Birwas laughing. Now Birwas was trading 10 times a day and expected to earn $100,000 a year. "I don't like to see the color red in my profit and loss column." Streisand surprised everyone in her interview with Fortune by saying, "I am a Taurus Bull, so I don't like the color red. As soon as I see the color, I immediately sell my shares."Stock-related data is being continuously delivered to bars and barber shops, pubs and cafes, taxi cabs and truck stations, financial websites and even live TV.

turned the stock market into an endless national video game. The public began to think of itself as more knowledgeable about the markets than ever before. Tragically, while people were drowning in data, knowledge was nowhere to be found. Stocks were completely separate from the companies that issued them, complete figments of imagination, passing by like a blip on a TV or computer screen. If this blip went up, nothing else mattered.On December 20, 1999, Juno Online Services introduced a cutting edge business plan: purposefully lose as much money as possible. Juno announced that it would no longer charge for any of its retail services - free email, free Internet usage, and spend millions of dollars on advertising over the next year. After announcing this corporate suicide, Juno's stock price rose from $16,375 to $66.75 that same day.You didn't need to know if a business was profitable, or what products or services it made, or who was in management, or even what the company's name was. All you had to know about stocks was their ticker symbols, with those intriguing codes: CBLT, INKT, PCLN, TGLO, VRSN, WBVN. That way you could buy them much more quickly, without the annoying two-second delay you'd have when looking them up on an Internet search engine. In late 1998, the price of a small, rarely traded building-maintenance company, Temco Services, tripled in a matter of minutes to a record high. Why? In a strange fit of financial dyslexia, thousands of traders bought Temco. They mistook its TMCO ticker symbol for Ticketmaster Jounline (TMCS), an Internet darling whose shares had just begun trading for the first time that day.Oscar Wilde joked that 'a cynic knows the price of every thing but the value of none.' In this definition, stock marketers have always been The term has been deplorable, but in the late 1990s it would have stunned the Oscars themselves, as a single half-baked opinion on price could double a company's stock, while its value was completely unknown. In late 1998, Henry Blodget, an analyst at CIBC Oppenheimer, warned, "Given all the Internet's shavers, valuation is more art than science." Then, citing future growth prospects, he raised his "target price" for Amazon.com from $150 to $400 in one go. Amazon.com gained 19% that day, while Blodget protested that his target price was a forecast for the full year, surpassing $4,000 in just three weeks. A year later, PaineWebber analyst Walter Piesik predicted Qualcomm's stock would reach $1,000 in the next 12 months. The stock, which had already gained 1,842% that year, rose another 31% that day to reach $659.From formula to failureBut reckless trading is not the only form of speculation. Over the past decade or so, one speculation formula after another has been hyped, popularized, and then proven to be useless. What they all had in common was being the fastest. Being the easiest! And being loss-free. And all of them violated at least one of Graham's criteria for investing and speculation. Here are some of the popular formulas that have failed:The 'January Effect' As the calendar year changes, small stocks tend to make big gains. This was widely publicized in scholarly articles and books published in the 1980s. These studies showed that if you bought small stocks after mid-December and held them until January, you would make a profit of five to 10 percentage points on the market. This surprised many experts. After all, if it was that easy, surely everyone would have heard about it, and many people would be doing it, and the opportunity would have been lost.Firstly, we know the reason for this January shock. Many directors sell their successful car rates at the end of the year to prevent losses.

This can reduce their tax bill. Second, professional money managers become more cautious as the end of the year approaches, and they want to preserve their good performance (or minimize bad performance). So they are reluctant to buy (or hold) falling stocks. And if the poor performing stock is very small and unknown, the money manager is even more reluctant to include it in his year-end list. All of this leads to some buying and selling of small stocks for some time. When the tax-driven selling ends in January, their prices usually rise again, which can lead to good and solid profits.The January effect has weakened, if not disappeared. According to William Schweikert, a finance professor at the University of Rochester, if you bought small stocks in late December and sold them in early January, you would have beaten the market by 8.5 percentage points between 1962 and 1979, 4.4 points between 1980 and 1989, and 5.8 points between 1990 and 2001.As many people became aware of the January effect, more traders started buying smaller stocks in December, leading to lower volumes and lower returns. Also, the January effect is most pronounced for the smallest stocks, but according to Plexus Group, a leading brokerage firm, the total cost of buying and selling such small stocks can be as high as 8% of your investment." Unfortunately, when you pay your broker, you lose all the profit from the January effect.Do what 'works' In 1996, an unknown money manager named James Oshanesi published a book titled What Works on Wall Street. In it, he argued that "investors can outperform the market." Oshanesi made a startling claim: From 1954 to 1994, you could have turned $10,000 into $8,074,504 by outperforming the market by a whopping 10 times, with an average annual return of 18.2%. How? By buying the 50 stocks that had the highest one-year returns, profits that had been growing steadily for five years, and a stock price that was 1.5 times lower than corporate revenue.

Considered the Edison of Wall Street, Oshaneghi obtained US Patent No. 5,978,778 for his 'Automated Strategies' and launched four mutual funds based on his findings. By the end of 1999, the public had invested $175 million in these funds and, in his annual letter to Sharebarco, Oshaneghi pompously stated, "As always, I am hopeful that together we will reach our long-term goals by staying on track and following our proven investment strategies."But 'What Works on Wall Street' stopped working almost as soon as Oshanesi started promoting it. As Figures 1-2 show, by 2000 Two of his funds initially failed so badly that they were shut down, and every single one of Oshanesi's funds, along with the overall stock market (as measured by the S&P 500 index), collapsed after nearly four years of consistent growth.In June 2000, Oshanesi moved closer to his long-term goals by handing over his funds to a new manager, leaving his clients alone with those 'timeless Northern investment strategies.' Oshanesi's shareholders might have been less upset if he had given his book a more appropriate title, such as What Used to Work on Wall Street ... Until I Wrote This Book.0 Follow the 'Foolish Four' In the mid-1990s, the Motley Fool website (and a few books) touted a technique known as The Foolish Four. According to the Motley Fool, "you could beat the market average over the past 25 years" and "get the most out of your mutual funds" by spending just fifteen minutes a year planning your investments. Best of all, the technique had "minimal risk." All you had to do was:1. Select the five stocks with the lowest prices and highest dividends from the Dow Jones Industrial Average.2. Leave the one with the lowest price among these.3. Place your 40% bet on the second lowest priced stock.4. Put 20% on each of the remaining three stocks.5. After one year, retest the Dow as before and reset the portfolio by 1 to 4 bars.6. Keep doing this until it is ready.

Bali Pool claimed that in the 25th century this technique would only increase the tax rate (from $20,000 in 10.3 pounds) to $1,791,000. (And Unna claimed you could do even better if you divided the square footage in terms of the five right-hand shavers of the bat, leaving out the largest one, and dividing the rest of the bill by the body.)Let us see if this policy meets the definition of monthly investment:What kind of thorough analysis could justify cracking the shaver with the most attractive price or dividend and choosing the one with a lower scoring bar with similarly desirable subs.How can the risk be minimized by investing 40% of your total capital in a single sector?And how can a portfolio of only four stocks be so toxic that it can provide enough protection to the 'mistake'In short, the Fools' Picking on the Pulse Four is one of the most ridiculous philosophies ever devised. The Fools made the same mistake as Oshanesi. If you watch enough betas over a long period of time, you'll see a number of patterns emerge by chance. Companies that generate better-than-average stock returns may have some characteristics in common, just by chance, but if these factors are not factors in the stock's outperformance, they can't be used to predict future returns.The Motley Fools' open-ended portfolios, which include any of the shares listed anonymously, cannot be compared to other stocks, and hence the future performance of the shares cannot be predicted. The study found that portfolios that did not contain any shares were also outperforming the portfolios with no names attached.

The only reason stocks will do well or bad in the future is that the business behind them is doing well or bad, no more, no less.The reality is that instead of crushing the market, the Foolish Four crushed thousands of people who were fooled into believing this was a way to invest. In 2000 alone, the four foolish stocks Caterpillar, Instman Kodak, SBC, and General Motors declined 14% while the Dow fell only 4.7%.As this example shows, there is only one thing that is never affected by a bear market on Wall Street: stale ideas. All of these so-called investment approaches have fallen victim to Graham's Law. All mechanical formulas for high-earning stock performance are "a kind of suicidal process, akin to a law of diminishing returns." There are two reasons why returns are diminishing. If the formulas are based on random strategic guesses (such as the Foolish Four), time will show them to be futile from the start. On the other hand, if the formula has worked in the past (such as the January effect), by promoting it, market pundits always blunt and often eliminate its ability to do so in the future.All of this reinforces Graham's warning that you should treat speculation the way a seasoned gambler treats his trip to the casinoWhile speculating, you should not be under the illusion that you are investing.Speculation becomes extremely dangerous the moment you start taking it seriously.Keep a strict limit on the amount you wager.Just as the smart gambler takes $100 to the casino and keeps the rest of his money locked up in a safe in his hotel room, the intelligent investor keeps a small portion of his total portfolio in a 'mad money' account. For most of us, 10% of our total assets is the maximum amount we can afford to risk on speculation. Never mix the money in your investment account with the money in a speculative account. Never let your speculative thinking dictate your investing activities. And never keep more than 10% of your earnings in your mad money account, no matter what.

For better or worse, gambling is a part of human nature and most people succumb to it, but you have to stay away from it. The best way is to make sure that you don't let yourself get fooled by confusing investing with speculation.

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Investment vs Speculation: Who Wins in the Long Run

 

This chapter will provide an outline of the ideas we will elaborate later in the book. Our intention at the outset is to develop a portfolio policy concept that is broadly applicable to the non-professional private investor.investment vs speculationWhat is meant by 'investor'? Throughout this book this term will be used in contrast to 'speculator'. As early as 1934 in our book Security Analysis, we tried to draw a clear distinction between the two, which was this: "Investment is that which by analysis is determined as to the safety of principal and the expected return. Speculation is that which does not require this."We stuck to this definition for the next 38 years, but it is worth discussing the radical changes that took place in the use of the word 'investor' during this period. After the great market crash of 1929-1932, all common stocks came to be regarded as largely speculative in nature (one leading authority explicitly stated that only bonds should be purchased for investment). So we then had to defend our definition against the charge that it had made the scope of investment too broad.Now we have a different concern. It saves our readers from accepting the 'common jargon' that labels anyone and everyone in the stock market as an 'investor'. In our last edition we quoted the following headline from the June, 1962 cover article of our popular Finance magazine:

Small investors are bearish and are involved in excessive short sellingIn October 1970, the same magazine published an editorial critical of the 'unwary investors' who were involved in the buying spree at that time.These quotes clearly illustrate the confusion that has dominated the use of the terms investment and speculation for many years. Consider our definition of investment above and then compare it to the sale of a few shares of a stock by an inexperienced member of society who has no idea what he is selling. This member believes, on a largely emotional basis, that he will be able to buy them back at a much lower price. (It is not out of place at this point to point out that when this article appeared in 1962, the market had already fallen sharply, and was now poised for a new spectacular rally. This was as bad a time as possible for short selling.) In a more general sense, the later use of the term 'careless investor' can sometimes be taken as a humorous oxymoron, similar to 'spendthrift miser', which is not a pun, but an abuse of language.The newspapers use the word 'investor' in this way because, in plain Wall Street parlance, anyone who buys or sells a security is an investor, no matter what or for what purpose, or whether he is buying at what price, or whether he is buying for cash or on margin. Compare this with the public's attitude toward common stocks in 1948, when 90% of those questioned opposed buying common stocks. Of those questioned, the reason cited was that it was 'unsafe' and a 'gamble', and the rest cited ignorance. It is ironic, of course, (though not surprising) that common-stock purchases of all kinds were generally regarded as highly speculative or risky to a large extent,

That too at a time when they were selling it at a very attractive rate, and the biggest rally in history was about to begin. On the contrary, the fact was that they had actually moved beyond what was clearly considered a dangerous level due to past experiences, which translated into investment, and all the stock buying public became investors.The distinction between speculative and speculative investment in common stocks has always been a useful one, and its disappearance is a cause for concern. We have often advised Wall Street as an institution to reestablish the distinction and insist on it in all its dealings with the public, lest the stock exchanges themselves some day be blamed for heavy losses from speculation for failing to give adequate warning to the victims. Ironically, once again, the recent financial troubles of some stock exchange firms were caused by their inclusion of speculative common stocks in their own equity funds. We trust that readers of this book will come away with a clear understanding of the inherent risks involved in common stocks. Risks that are inherently inherent in the opportunities for profit that they provide, and which the investor must factor into his calculations.What we have just said is an indication that there is no longer such a thing as a Simon-Pure investment policy involving representative ordinary shares - such that one could wait to buy them at a price without market risk or a 'quotation loss' large enough to cause distress.The investor must often be aware of the speculative factor in his stock holdings. It is his job to keep this factor to a minimum, and be financially and mentally prepared for the worst-case scenario, which could be short- or long-term.There should be two more paragraphs on stock speculation, because as is now well known, speculative components are inherent in most representative common stocks. Explicit speculation is neither illegal nor unethical, nor difficult (for most people) to learn. Moreover, some degree of speculation is necessary and unavoidable, since many common stocks have substantial potential for both profit and loss.

There are possibilities, and one must also imagine the risks involved. There is intelligent speculation, just like there is intelligent investing, but there are many ways in which speculation is not intelligent. Some of the most important are: (1) speculating while thinking it is an investment, (2) taking speculation seriously rather than as a joke despite not having the proper knowledge and skills, and (3) investing more money in speculation than one can afford to lose.In our conservative thinking every non-professional who is merely working on margin is speculating automatically, and it is the job of his broker to give him the right advice. And anyone who is buying the so-called, 'popular' common-stocks, or something like that, is either speculating or gambling. Speculation has always been tempting, and if you are adept at the game, it is very enjoyable. But if you want to try your luck, set aside some part of your capital, the less the better, for this purpose. Do not add more money to this account just because the market is rising and profits are increasing (this is the time to withdraw money from your speculation fund). Do not do your speculative and investment operations from the same account, do not think so.Defensive Investor's Outcome ExpectationsWe have already mentioned that a defensive investor is one who is primarily interested in safety and invests hassle-free. In general terms, which route should he take in 'average normal conditions' and what returns it will give?

What can he expect-if such a Salaat really exists? Before answering these questions we need to consider first what we wrote on the subject seven years ago, second, what important changes have taken place since then in the underlying factors governing the expected return on investment, and finally what he should do and what he can expect in the present circumstances (early 1972).1. What we said six years agoWe recommended that the investor split his holdings between high-grade bonds and leading common stocks, with the proportion of bonds being no less than 25% and no more than 75%, and the opposite would essentially be true for common stocks. His simplest option would be to maintain a 50-50 ratio between the two, balancing the ratio when market activity changes it by about 5%. As an alternative policy, he could choose to reduce his holding of common stocks to 25% if he felt the market was rising dangerously. And conversely, he could increase it to a maximum of 75% if he felt a decline in the price of the balances was making them extremely attractive.In 1965, investors could buy 4.5% high-grade taxable bonds and 3.5% good tax-paying bonds. This average return on leading common stocks (with a DJIA of 892) was only about 3.2%. This and other facts call for caution. We said that, in normal markets, an investor would be able to earn an initial dividend return on his shares of between 3.5% and 4.5%, to which should be added a steady increase in the underlying value of a representative stock index of about the same amount (and in a normal market trend). This would give a 7.5% annual return, including dividends and appreciation. A fair split between bonds and stocks would yield a return of about 6% before income taxes. We added that a reasonable level of protection in the stock component would be needed against the loss of purchasing power caused by rampant inflation.It should be pointed out that the above arithmetic implies an expectation of a very low rate of stock market flow, whereas much higher growth was achieved between 1949 and 1964. For listed stocks, this rate was spectacular. Their average gain was more than 10%. This was usually seen as a guarantee that similar satisfactory growth could be relied upon in the near future. Few were prepared to consider seriously the possibility that high rates of growth in the past meant that rates were much higher. And that the outlook after 1949 was not good for the future, but rather bad.

2. What has happened since 1964?The biggest change since 1964 has been the rise in interest rates on first-grade bonds to record highs, although they have recovered considerably from the 1970 lows. The yield on quality institutional stocks is now about 71226%, up from 41/2% in 1964. Meanwhile, the dividend yield on DJIA-type stocks continued to grow well during the market crash of 1969-70, but at the time of writing (when the Dow is at 900), it is less than 3.5%, compared with 3.2% at the end of 1964. The maximum market price drop for medium-term (say, 20-year) bonds during this period was about 38%, as a result of the changes in interest rates.This is the paradox of this progress. In 1964 we discussed at length the possibility that stock prices were probably too high and that this would eventually lead to a major decline, but we did not specifically consider the possibility that the same would happen to high-grade bonds. (Nor did anyone else we knew.) We warned that "long-term bond prices may vary considerably with changes in interest rates." In light of all that has happened since, this warning has been insufficiently emphasized - including the relevant examples - because the fact is that if the investor had held that amount in the DJIA at the 1964 closing price of 874, he would have had very little profit at the end of 1971. Even at the 1970 low (631), his notional loss would have been less than that of good long-term bonds. On the other hand, if he had restricted his bond-like investments to US savings bonds, short-term corporate issues, or savings accounts, he would have lost no market value of his principal during this period and would have earned a higher return than he would have received from a good shaver. Thus, he finds that in 1964 'cash equivalent' investments outperformed ordinary shares, even in the face of inflation, which in theory makes shares more liquid than cash. The fall in the quoted principal value of good long-term bonds was due to the dynamics of the money market, an obscure area which normally has no significant bearing on a person's investment policy.This is just one of an endless array of experiences over time that show that the price of securities cannot be predicted.

There is almost always much less volatility in bond prices than in stock prices. Investors can usually buy good bonds maturing in any time period without worrying much about changes in market value. There are some exceptions to this rule, as the period after 1964 proved. We will be talking more about bond price movements in the upcoming chapters.3. Expectations and policies in late 1971 and early 1972By the end of 1971 it was possible to earn 3% taxable interest on good medium-term corporate bonds, and 5.7% tax-free interest on good state and corporate securities. In the short-term sector, investors could earn about 6% on five-year US government issues. This second method did not require the buyer to worry about a possible appreciation in market value, since he was guaranteed to eventually get his money back, plus 60% interest, over a short-holding period. In 1971, the DJIA's 900 recurring price level yielded only 3.5%.Suppose we have to make a basic policy decision today, as before, about how to divide capital between high-grade chads (or other so-called liquid assets) and leading DJI A-type stocks. What course should we take in the present situation if we have no good reason to anticipate a big uptrend or a big downtrend in the near future? Suppose we estimate that, absent serious adverse changes, a defensive investor should expect a current 3.5% dividend return on his shares and an average annual growth of 3.5%. We will explain later that this growth is essentially a function of the amount of annual non-distributed profits of the various companies being redirected to their stocks. The combined return on the shares could average 7.5%, which is a function of the high-grade. On a pre-tax basis, the average return on the shares is 5.3%.

This is almost as much as one can get on a good tax-free medium-term bond.Today these expectations favour shares less than bonds than they did in the 1964 analysis. (This conclusion essentially follows from the basic fact that since 1964 the returns on bonds have been much higher than the returns on shares.) We must not forget that interest and principal payments on good bonds are more secure and therefore more certain than dividends and share price appreciation. At the same time, we are forced to conclude that today, at the end of 1971, bond investment is clearly preferable to share investment. If we are confident of this conclusion, we should advise the defensive investor to put all his money in bonds rather than ordinary shares, until there is a significant change in the current return relation in favour of shares.But of course, at today's level we cannot say with certainty that bonds will outperform stocks. Readers will immediately think of the inflation factor as a possible other factor. In the next chapter we will argue that our specific experience with US inflation does not support choosing stocks over bonds in this century, given current differences in returns, but there is always a possibility, although we consider it remote, that inflation may rise, which will in some way make stock equities better than bonds, which have fixed dollar payments. There is also the alternative possibility, which we consider highly unlikely, that US businesses will become so profitable, without inflation, as to justify a large increase in the value of ordinary stocks in the coming centuries. Finally, there are other known possibilities in which we could see excessively predictable increases in the underlying value of what is in the stock market. Investors may also be more likely to be interested in bonds for reasons not mentioned in our view.

Investing 100% may lead to regrets, even if the return level is favorable.So after this foregoing discussion of the more important considerations, we will return to the basic trade-off strategy that is in place for defensive investors—especially those who have put a large amount into one bond-type holding and a small amount into equities. It is still true that they can have a simple 30-50 split between the two components, or a ratio that suits them, with a minimum of 25% to a maximum of 75% difference between them. We will present our detailed views on these alternative strategies in the following chapters.Since the total return assumed by the principal investor from ordinary stakes is approximately the same as that from wands, the expected return (including the appreciation in the share price) for the principal investor is not much different regardless of how he divides his money between the two components. As per the above calculation, the average return from the two components could be 7.8% on a pre-tax basis or 5.5% on a tax-free basis (or after paying estimated taxes). The return from this arrangement would be higher than what a traditional conservative investor would have realized over the long term. This may seem unattractive compared to the approximately 14% return generated by the predominantly bull market over the 20 years since 1949, but it is important to remember that between 1949 and 1969 the DJIA more than quintupled in value while its earnings and dividends doubled. Thus the impressive market record during that period was due primarily to a change in the mindset of investors and speculators, not to their own growth. Fundamental corporate values. It could also be described as a 'bootstrap operation' to some extent.In looking at the strategic investor's common stock portfolio, we have looked only at the key issues that are among the 30 components of the Dow Jones Industrial Average. We have done so only as a point of view, and this is not to say that Devan Che is capable of buying any of the 30 issues. In fact, there are many other companies whose quality is equal to or better than the average of the companies listed in the Dow Jones. This includes public utility companies (which are considered to be the Dow Jones average components). But the main point here is that The defensive investor's overall results should not differ significantly from those of any other representative or specialized list, or it would be more accurate to say that neither he nor his advisers can predict with certainty how much they will ultimately differ. While it is true that the art of smart investing lies in the selection of particular issues that produce returns that are superior to those of the general market, we remain skeptical of the defensive investor's ability to achieve above-average results that would, in effect, undermine his overall performance. (Our skepticism also extends to the management of book funds by specialists.)We illustrate our point by giving an example that at first glance seems to be the opposite. Between December 1960 and December 1970 the DJIA rose from 616 to 839, or 36%, but during the same period the much larger Standard & Poor's 500-stock index rose from 58.11 to 92.15, or 58%. Clearly the second group was a better buy than the first, but who in 1960 would have been so audacious as to predict that what appeared to be a variety of classifications of all types of ordinary stocks would accurately outperform the Dow's "grand thirty dictators"? We assert that this proves that few people can reliably forecast price changes, either absolute or relative.We repeat without hesitation that the warning cannot be overemphasized that investors should not expect better than average results when buying new, or however "hot," issues, i.e., those that are recommended for immediate profits. In the long run, the opposite is almost certain to happen. The defensive investor should limit himself to stocks of important companies with a long track record of profitable operations on solid financials. (Any securities analyst who is adept at his job can make such a list.)

Aggressive investors can also buy other types of ordinary shares, but they too must have attractive fundamentals based on intelligent analysis.In closing this section, we would like to briefly mention three helpful concepts or practices of the defensive investor. First, buying shares of well-organized investment funds as an alternative to building his common-stock portfolio. He can also use a common trust fund or a group of cormised funds, which are operated by trust companies and banks in many states, or, if he has the means, use the services of an accredited investment advisory firm. This will give him professional management with a standard line on his investment program. Third, the tool is dollar-cost averaging, which simply means that one invests the same number of dollars each month or each quarter in common stocks. In this way, he will buy more stocks when the market is down than when it is up, and in the end he will get a satisfactory total return on all his holdings. In fact, this is the basis for a broader approach called formula investing. We have already mentioned this in our recommendation that investors diversify their common shares to a minimum of 25% to a maximum of 75%, in order to maintain an inverse relationship with market movements. These considerations are important for defensive investors, and will be discussed in detail in the following chapters."How does an aggressive investor expect results?Of course, our enterprising securities buyer may hope to get better results than his more cautious or quieter counterparts, but he must first make sure that he does not get worse results. It is not uncommon on Wall Street to end up with losses instead of profits, despite all the energy, study, and efficiency one can muster. These qualities, if channeled in the wrong direction, are indistinguishable from inefficiencies. It is therefore essential that the enterprising investor begin with a clear idea of which system is more likely to succeed in a logical manner, and which is not.

First, we need to consider some of the ways that investors and speculators commonly attempt to achieve better-than-average results. These include:1. Trading in the market generally means buying shares in the market when it is rising and selling them when it is falling. The balances chosen have a better 'stance' than the market average. A small number of investors are constantly engaged in short selling. Here they sell issues which they do not currently own but have borrowed through the established mechanism of the stock exchanges. Their aim is to profit from a fall in the price of these issues. They do this by buying them at a price lower than the price at which they sold them. (As our quote in the Wall Street Journal on p. 19 indicates, 'small investors' sometimes try their unskilled hand at short selling without giving too much meaning to the term).2. Short-term selectivity This means buying shares of companies that are reporting or expected to report rising earnings, or that are expected to have some favorable conditions.3. Long-term selectivity This usually emphasizes an impressive record of growth in the past, which is likely to continue in the future. In some cases the 'investor' himself selects companies that may not have shown impressive results yet, but are likely to establish high earnings power later. (Such companies are often found in a technical field, e.g. computers, medicine, electronics, and are often developing new processes or products that are considered particularly promising.)We have already expressed our negative view towards the investor's chances of complete success in these areas of activity. First of all, we reject these investment areas on both theoretical and practical grounds. "Share trading is not an operation which provides safety of principal and satisfactory returns on the basis of analysis. More about share trading is explained in the upcoming chapters."In trying to find the most promising short or long term stocks, an investor faces two kinds of obstacles. First, the human resource Fallibility and the nature of the self. He may be wrong in predicting the future, and even if he is right, current market prices will already reflect what he predicted. In the area of short-term criticality, a company's current year results are usually known to everyone on Wall Street. Next year's results are, to a large extent, predictable, and are already being given a lot of thought. So an investor who is picking an issue based on this year's best results, or what he has been led to expect for next year, is likely to be doing the same for the same reasons as everyone else.The dilemmas facing investors when selecting stocks for their long-term prospects are basically the same. The obvious possibility of forecast error-as we have shown in our airline example-is certainly greater when trying to make short-term gains, because experts tend to be misled in making such predictions. It would theoretically be possible for an investor to profit by making a correct forecast when the rest of Wall Street is guessing wrong, but that would only be theoretical. How many enterprising investors can rely on the wit or have the gift of prediction to beat professional analysts at their favorite game of guessing long-term futures?Thus, we can come to the logical and counterintuitive conclusion that to enjoy a reasonable chance of consistently delivering above-average results, an investor must adhere to two strategies: (1) be fundamentally strong and promising and (2) not be popular on Wall Street.Are there any such policies for the enterprising investor? Again, theoretically, the answer is yes, and there is good reason to believe that if it were actually done, the answer would be positive. Everyone knows that in the ordinary market speculative stock prices frequently move far in either direction. This happens all the time, at least in single issues. Moreover, an ordinary share may be undervalued due to lack of interest or unjust prevailing prejudice. If we go further, we will find that most people who trade in ordinary shares will not be able to distinguish one framework from the other. In this book we will give many examples (from the past) that will demonstrate discrepancies between price and price. Thus, it seems that for any intelligent person who is good at calculation, Ball Street is a picnic, where he has to be amused by the stupidity of other people. Well, it may seem so, but somehow it is not so simple. Buying an overlooked and therefore undervalued shaper for profits It is a long and varied experience. And in short that popular shaper may be called Beynaati Oshashvaityu, it is not only a test of a person's courage and endurance, but it also measures the depth of the pocketbook of power. This principle is solid, its complete application is not impossible, but it is not easy to master this art.There are also many special circumstances in which it can take years to generate 20% or better annual returns with minimal risk for those who know how to do it. They include security arbitrage, payment or liquidity estimation, special types of security hedges. The most common of these is a proposed acquisition in which the value of the shares is much higher than the date of their announcement. The number of such deals has increased a lot in the last few years, and this should have been a very profitable time for the investors, but with so many merger announcements, there have been many impasses in the mergers which sometimes lead to the deal not getting completed. Thus, even in such trusted operations, individuals have suffered losses. In addition, the rate of multiplication has also decreased due to the increased competition.Under these specific circumstances, the decline of profits appears to be a process of self-destruction, akin to the law of diminishing returns that I developed during the course of writing this book. The stock market fluctuations of 1949 could produce a study that supported a formula. Based on your own and current rates, DI isA level could be set to buy below the 'central' or 'intrinsic value' and sell above such a value. Here Robschild's motto 'buy cheap and sell cheap' was used. And this had the advantage that it was in direct contradiction to the Ball Street motto that stocks should be bought when prices are rising and sold as they are falling. Eventually, this formula became useless after 1949. Another example was the famous 'Dow Purely' about market dynamics, which showed excellent results between 1897-1933 for comparison and its performance was under question from 1934 onwards.The third and final example of precious opportunities not being available now: Our own operations on Wall Street were focused on buying up fake issues which could only be identified by the fact that they were being sold for less than their net working capital, without regard to plant accounts and other assets, and after first deducting all liabilities from the shares. It was obvious that these issues, being privately owned, were being sold at far below industry prices. No owner or majority holder would ever think of divvying up his balances at such an unusually low price, but strangely enough, such anomalies are not hard to find. In 1957, a list appeared in the market showing about 200 such issues. In practice, those cheap issues proved profitable in various ways, and their average annual returns proved more profitable than most other investment options, but in the next decade the reliable, shrewd and fast operating circle of enterprising investors also disappeared from the stock market. Then, in 1970, again a low share was seen.

 But such 'sub-working capital issues' appeared in large numbers, and even after a major recovery in the market, there were enough issues remaining by the end of the year to build a complete portfolio.There are a variety of opportunities for the enterprising investor to obtain better-than-average results in today's environment. The long list of marketable securities should include a number of stocks that can be considered undervalued on a reasonable and reasonably reliable scale. These may produce more satisfactory results than the average DJIA or some other such representative list. In our view, seeking them out is futile if it does not allow an investor to expect an average annual pre-tax return of more than about 5% on the stock portion of his portfolio. We must also seek to develop other approaches that the active investor can use in stock selection.

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Investment Regulations: The Results an Intecer Investor Seeks

 

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Henry David Thoreau, Walden

 

If you have built castles in the air, your work should not go to waste, they should remain there. Now start laying the foundation under them.– Henry David Thoreau, WaldenNote that Graham declares at the outset that this book will not teach you how to control the market. No true book can do that.Rather, this book will teach you three powerful lessons:. How you can avoid irreparable losses.How can you maximize consistent profits?How can you control self-destructive behaviour that prevents investors from realising their full potential?During the bull run of the late 1990s, when technology stocks seemed to double in value every day, the idea of losing all your money seemed absurd. But by the end of 2002, many dotcom and telecom giants had lost 95% or more. Once you lose 95%, you have to make a 1,000% profit to get back to where you started.' Any foolish risk can put you in a hole that is impossible to get out of. That's why Graham always emphasizes the importance of avoiding losses, not only in chapters 6, 14 and 20, but in the warnings he gives throughout the book.'To put this statement into perspective, consider how often it is that you buy a stock at $30 and are able to sell it for $600.

But no matter how careful you are, the value of your investments will fluctuate from time to time. Since no one can avoid this risk, Graham will tell you how to manage it and overcome all your fears.Are you an intelligent investor?Now let's answer an important question. What does Graham mean by an 'intelligent' investor? Graham defined it in the first edition of the book and he made it clear that this kind of intelligence has nothing to do with IQ or SAT. It simply means patience, discipline and a willingness to learn. You also need to be able to control your emotions and think for yourself. Graham describes this kind of intelligence as "more of a personality trait than a brain trait."It has been proven that high IQ and higher education are not enough to make an investor intelligent. In 1998, the hedge fund, Long-Term Capital Management LP was run by a battalion of mathematicians, computer scientists and two Nobel Prize winning economists. They lost $2 billion in a few weeks betting big that the bond market would return to 'normal', but the bond market kept getting more and more abnormal and LTCM borrowed so much money that its collapse upended the global financial system.As early as the spring of 1720, Sir Isaac Newton bought shares in the South Sea Company, the most popular stock in England. Sensing that the market was getting out of hand, the great physicist said that he could "calculate the motions of the outer planets, but not the madness of men." Newton sold his South Sea shares for $47,000, a 100% profit, but just a few months later, overwhelmed by the boom in the market, Newton bought them back at a higher price, losing $220,000 ($3 million today). For the rest of his life, he forbade anyone from even mentioning the name South Sea in front of him.* Benjamin Graham, The Intelligent Investor (Rape & Row, 1949), p. 4."Hedge funds are the flower of money. They are largely outside government control. They are used to invest aggressively on behalf of wealthy clients. For a brilliant account of the LTCM story, see How Genius Failed (Random House, 2000) by Roger Lowenstein.*See also John Caswell, The South Sea Book (Cassette Press, London, 1960), pp. 131, 199A.

When it comes to intelligence, Sir Isaac Newton was one of the most intelligent people who ever lived. Yet, according to Graham, Newton was far from being an intelligent investor. He let the roar of the crowd affect his decision. By doing this, the world's greatest scientist acted like a fool.In short, if you have failed at investing so far, it is not because you are stupid, but because you have not, like Sir Isaac Newton, developed the emotional discipline needed to succeed in investing. In Chapter 8, Graham explains how you can increase your intelligence by controlling your emotions and refusing to succumb to the irrationality of the market. Here you will master the lesson that to become an intelligent investor, 'personality' is more important than 'mood'.History of disasterSo let us now look at some of the major financial events of the past:

1. The value of U.S. stocks, the largest market decline since the Great Depression, fell 50.2% to $7.4 trillion between March 2000 and October 2012.

2. Some of the most popular companies whose stock prices fell sharply in the 1990s were AOL, Cisco, JDS Uniphase, Lucent, and Qualcomm Plus. Apart from this, the shares of hundreds of Internet companies also suffered huge losses.

3. In America, many large and respected corporations including Enron, Tyco and Xerox were accused of major financial fraud.

4. Once shining companies like Conseco, Global Cosing, WorldCom went bankrupt.

5. Accounting firms were accused of manipulating accounts and even destroying records to mislead their clients, the investing public.

6. Top executives of major companies were accused of embezzling hundreds of millions of dollars for their personal benefit.

7. It was proven that Wall Street securities analysts who publicly praised Labrie privately admitted that he was, in fact, a jack of all trades.

8. A stock market that, despite its stunning decline, appears to be only slightly valued at historical rates, with many analysts assuming stocks have more to fall.

9. The continued fall in interest rates has left investors with no attractive option other than shares.

10. The investment environment was fraught with the unexpected threat of global terrorism and war in the Middle East.Investors who learned and followed Graham's principles largely avoided such losses. As Graham said, "While enthusiasm is a good thing for moderate gains, it is a sure way to ruin on Wall Street. Those who went along with the flow of Internet stocks, 'high growth' stocks, and frothy stocks made the same mistake as Sir Isaac Newton. They allowed the judgments of other investors to cloud their own judgment. They ignored Graham's classic warning that the really terrible fortunes always occur when the buyer forgets to ask 'How much will it cost?' And, most tragic of all, they lost self-control just when they needed it most." These people confirmed Graham's claim that "the investor's chief problem—and even his greatest enemy—is himself."thing that was not certainMany of these people got carried away by their impulse buying, particularly because they believed the hype surrounding technology and internet stocks, claiming that these industries would remain the top performers for at least a few years, if not forever.In mid-1999, after earning a return of 117.3% in the first five months of the year, Alexander Gheung, portfolio manager of the Monument Internet Fund, predicted that his fund would grow by 50% over the next three to five years and average 35% annually over the next 20 years.'Constance Loilos, 'Few and Alex Chetang, Investment Sutra, May 17, 1999 page 381 The highest 20-year return in mutual fund history has been 25.9 percent per annum. Peter Liew of Fidelity Magellan achieved this return in the short period ending December 31, 1994. Liew had turned $10,000 into $922,000 in 20 years. Liew had predicted that his fund would turn $10,000 into 4% in this period.

After his Amerindo Technology Fund rose by a spectacular 240.9% in 1999, portfolio manager Alberto Villar defied anyone who doubted the Internet's potential as a perpetual money-making machine: "If you're out of the loop, you're not doing optimally. You're in a horse-drawn carriage, and I'm in a Porsche. If you don't want to grow tenfold, invest somewhere else."In February 2000, hedge-fund manager James J. Camer declared that Internet-related companies were the ones to buy. "They are the new champions of the universe," as he called them, "the only ones that will continue to grow in good times and bad." Camer even attacked Graham, saying, "You should throw away all your pre-Web formulas and models ... If we followed anything Graham and Dodd taught, we wouldn't be a dime a dozen."All of these so-called experts ignored Graham's polite warning that "apparent prospects for material advancement in business do not necessarily translate into apparent profits for investors." While it is easy to foresee which industries will grow the fastest, this foreknowledge is of little value if most investors already expect it to grow. Unless everyone decides that it is a business, it will grow rapidly...Instead of dismissing Cheung's overoptimism, people showered him with money. Over the next year, people invested more than $100 million in his fund. Meanwhile, a $10,000 investment in the Monument Internet Fund in May 1999 would have turned into about $2,000 by the end of 2002. (The Monument Fund no longer exists in its original form. It is now known as the Orbitex Emerging Technology Fund.)* Lipsa Reilly Cullen, The Triple Digit Club, Money, December 1999, page 120. If you had invested $10,000 in Villar's fund at the end of 1999, you would have had $1,195 by the end of 2002—the largest asset value drop in mutual fund history.7 See Kaiser's preferred stock prices did not go up consistently through good times and bad. By the end of 2002, one of the 10 stocks Kaiser chose had gone bankrupt. Moreover, a $10,000 investment in Kaiser's chosen stocks would have lost 15 percent in value to just $597.44 during that period. Kaiser probably meant that his stocks would be winners not in the "new world," but in the world to come.

The industry is clearly the best place to invest in. By then, its shaver prices would have become so high that its future returns would simply go down.At least no one will have the nerve to still try to claim technology is the world’s biggest growth industry: “Those who claim that the next sure thing will be health care, or energy, or real estate, or gold, are likely to be proven wrong in the end, just as the technology evangelists have been.”silver liningIf no price seemed too high for stocks in the 1990s, in 2003 we reached a point where no price seemed low enough. The pendulum was swinging from irrational exuberance to irrational pessimism just as we always knew it. In 2002, investors withdrew $27 billion from stock mutual funds, and a survey by the Securities Industry Association found that one in 10 investors cut their holdings in stocks by at least 25%. People who were tempted to buy stocks in the late 1990s when prices were rising and making them expensive sold them when prices fell, or were clearly cheap.As Graham brilliantly shows in Chapter 8, it's just the opposite. The intelligent investor knows that a stock becomes more risky, not less, as its price rises, and less risky, not more, as its price falls. The intelligent investor avoids a bull market, because it is more expensive to buy stocks in one. And conversely (as long as you have enough money to cover your needs), you should welcome a bear market, because stocks tend to sell off again.* The only exception to this rule may be an investor who is long retired and will not live to see a prolonged downturn in the market. However, even an older investor should not sell his shavers just because their value has fallen. Such a move not only turns a loss on paper into a real loss, but also deprives his heirs of the opportunity to acquire the stock at a lower price from a tax perspective.

So stay motivated. A bull market ending is not as bad a sign as many assume. Thank God stock prices are down, now is a safer and more sensible time to build wealth. Read this book and Graham will show you how to do it.

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What to expect from this book

 The objective of this book is to provide layman-friendly guidance that can be adopted and applied to an investment strategy. There will be little discussion of comparative securities analysis techniques and the focus will be primarily on investment theories and investor behavior, although we will provide some substantial comparisons between certain securities that are listed side by side on the New York Stock Exchange to provide a solid understanding of the key factors involved in specific choices for common shares.But much of it is devoted to historical patterns of financial markets, going back in some cases many decades. To invest wisely in securities one must already know enough about how different types of bonds and stocks actually behave under a variety of circumstances, some or at least one of which one will surely encounter in one's own experience. Santiago's famous dictum that "those who do not remember the past are condemned to repeat it" applies more accurately and better to Wall Street than to anyone else.Our book is addressed to investors, as distinct from speculators, and our first task is to clarify and emphasize this now forgotten distinction. We say at the outset that this is not a book on how to get rich. There is no sure or easy way to get rich on Wall Street or anywhere. To illustrate what we have just said, a bit of financial history may be useful—especially since there is more than one lesson to be learned from it. At the height of the boom in 1929, John J. Raskob was one of the most powerful men in Wall Street and in the country.

He was a common man. He wrote an article in the Lehi Hum Journal extolling the blessings of capitalism, titled "Everyone Ought to Be Rich." His thesis was that by making just $15 a month and investing it in good common stock and reinvesting the dividends, you could have a fortune of $80,000 in twenty years, with your total contribution being just $3,600. If the General Motors tycoon is right, it certainly is an easy way to get rich. To what extent was he right? Our rough estimate - based on a hypothetical investment in the 30 stocks of the Dow Jeet Industrial Average (DJIA) - indicates that if Harkov's prescription had been followed during 1929-1948, the value of an investor's holding in early 1949 would have been about $8,500. This is a far cry from the $80,000 promised by the median and shows how little weight should be placed on such optimistic predictions and assurances, but as an aside, we would point out that the actual return over 20 years of operations would have been better than the annual growth, despite the fact that the investor would have started at 300 on the DJIA and ended 1948 with a valuation of 172. This release is taken as a reference to the persuasive argument for regular monthly purchases of FAT ordinary shares amid rising prices, a program known as 'dollar cost averaging.'Because our book is not addressed to speculators, it is not for those who trade the markets. Most of these people are guided by charts or other big bombs to identify the right moment to buy and sell. One principle that applies to almost all of these popular technical feats is that it

That one should buy because a stock or market is rising and sell because it is falling. This is the exact opposite of every common trading wisdom, and is the reason why there is no stable success on Wall Street. From our own experience and observation of the stock market, spanning more than 50 years, we do not know of a single person who has made consistent and stable money by 'trickling the market' in this way. We have no hesitation in declaring that this method is as popular as it is false. We will briefly summarize what we have said below, which is a well-known theory of trading in the stock market, although it should not be taken as proof.The book was first published in 1948 and revised editions of The Intelligent Investor have been published approximately every five years. To update the current edition we must go through several developments since the 1965 edition, including:1. Unprecedented increase in interest rates of high-grade bonds.2. The price level of major common denominators fell by almost 35% in the period ending May 1970. This was the biggest decline in the last 30 years. (This contraction was further aggravated by a large number of low quality issues).3. Persistent inflation in boco and retail prices, which had also accelerated in pace during the trade recession of the 1970s.4. The rapid growth of 'conglomerate' companies, franchise operations and other elements in business and finance. (These include the use of foreign banks offering a variety of complex instruments such as letter stock, stick-open warrants, among others.

5. The bankruptcy of our largest railroad, excessive short- and long-term debt of many formerly strong and safe companies, and the troubling problem of the ability to repay debts even among the Volkstrup houses.6. The advent and prevalence of 'performance' in investment fund management, including in bank-operated trust segments, which had disturbing results.We will carefully consider these developments. Some of the emphasis and conclusions we drew in the last edition may need to be modified. The basic principles of sound investing remain unchanged for decades, but the application of these principles must be adapted to the major changes in the financial system and environment.This last statement was hammered out during the writing of the first draft of the present edition, which we finished in January 1971. At that time the DJIA was continuing its strong upward trend, rising from its 1970 low of 632 to its 1971 high of 951, raising expectations. By the time the final draft was finished in November 1971, the market was in the throes of a new downturn that took it as low as 797 and led to a new general uneasiness about its future. We did not allow these fluctuations to affect our general approach to the Chop's investment policy, which has not changed much since the first edition of the book in 1949.The extent of the market contraction in 1969-70 should be used to dispel the illusion that had been gaining ground during the previous two decades. The idea was that major ordinary shares could be bought at any given price, with the proviso that a profit could eventually be made, as well as losses in the intervening period, and renewed gains could be expected when the market reached new lows. This is the crux of the truth. After all,

The stock market has to return to normal, in the sense that while both speculators and stock investors see an increase in the value of their holdings, they also begin preparing to experience a sharp and long downturn again.Previous market crashes in the sector of many secondary and third-order ordinary shares, especially in recently emerging industries, were disastrous and led to disaster. This is nothing new. The same thing happened in 1961-62, but now there was a novel element in that some investment funds had large commitments to apparently overvalued issues and maximum speculation. Clearly it was not only novices who had to be warned that enthusiasm is necessary to make it big anywhere, but on Wall Street it is almost always disastrous.The key question of whether the interest rates of first-grade bonds will increase significantly remains the issue. Since 1967, investors have earned more than twice as much from such bonds as they would have earned from dividends on representative ordinary shares. In early 1972, the highest-grade bonds had a return of 7.19%, compared with only 2.76% on industrial shares. (Compare this with 4.40% and 2.92% respectively at the end of 1964. This was hard to imagine because when we first wrote this book in 1949, the figures were almost exactly the opposite: bonds returned just 2.66% and shares a whopping 6.82%. In previous editions we have consistently urged conservative investors to put at least 25% of their portfolios in ordinary shares, and we have been in favour of a 50-50 split between the two instruments. We must now consider whether the current spectacular run-up of bond yields over share yields fully justifies a hawkish policy, as long as it continues to deliver a more relative return, as we expect. Naturally, the question of persistent inflation will be a key factor in making the decision here. There is an entire chapter devoted to this discussion.In the past we have spoken of there being basically two types of investors, to whom this book is addressed: the 'creative' and the 'entrepreneurial'.

The whole point of investing is to avoid being overwhelmed. The other is to avoid the need to make quick and frequent decisions. The key quality of the enterprising (or active) investor is his ability to put in the time and effort to select domestic securities that are both cheap and more attractive than the average. For decades such patient investors have been rewarded for their extra effort in the form of better than average returns to the average investor. We are skeptical whether today's conditions really hold true for the active investor's promise of greater compensation, but next year or the years ahead may be different. We should view the enterprising investor's prospects accordingly, as they have been in earlier times and may return.The view has long held that the key to successful investing lies first in choosing industries that are likely to grow in the future and then in identifying the most promising companies in those industries. Astute investors or their shrewd advisers long ago recognized the tremendous growth that was to be made in the computer industry as a whole and International Business Machines in particular. And there are other industries and companies that are growing in a similar way, but in retrospect, it is not as simple as it may seem. To illustrate the point, here is a paragraph from Hopf, which we included in the first edition of this book in 1949.For example, an investor buys an air transport stock because he thinks its future is going to be even brighter than the market is already showing. More than any positive technology to help along the way, the value of our book to this type of investor lies in the fact that it warns them against falling into the trap of the hidden pitfalls of this favorite investment method.

These hidden problems have proved particularly dangerous for the industries we have mentioned. Of course, it was easy to predict that air traffic would grow substantially in the years ahead. For that reason alone, their stocks remained a favorite choice for investment funds, but despite revenue expansion—at a pace that was even faster than the computer industry—the combination of technical problems and overexpansion of capacity led to volatility and disastrous profit figures. In 1970, airline shareholders lost $200 million even as traffic figures hit new highs. (They had also posted losses in 1945 and 1961). In 1969-70, too, these companies' shares fell more than the general market. The record shows that even the highest-paid full-time experts in mutual funds were completely wrong about such a short-term future for a major and well-known industry.On the other hand, while investment funds had significant exposure to IBM and significant profits, its high price and lack of certainty in growth rates prevented this strong fund from exceeding 3%. Thus, this strong selection was in no way decisive in overall results. In addition, some, if not most, investments in computer-industry companies other than IBM did not produce significant profits. These two great examples offer our readers two lessons:1. Clear physical growth prospects in any business do not translate into clear profits for investors.2. Experts have no reliable method to select the most promising companies across all promising industries and focus statements on them.

The author never followed this method during his financial career as a fund manager, and cannot offer any specific advice or much encouragement to those who might want to try it.So what do we hope to achieve with this book? Our main goal is to help readers avoid making potentially costly mistakes and develop strategies that will work for them. We would also like to touch upon the mindset of the investor. Of course, the biggest problem, or rather the worst enemy, for the investor is probably himself. ("Dear investors, the fault lies not in our stars nor in our stocks, but in ourselves..."). This has been even more true in recent decades, as it has become increasingly common for even conservative investors to buy ordinary stocks and thus, unwittingly, fall prey to the excitement and thrills of the stock market. But we hope that by reasoning, example, and encouragement we can instill in our readers the proper mindset and emotional approach to their investment decisions. We have seen many more 'ordinary people' make and keep more money with the right mindset for the investment process than with those who lacked this quality, despite having a great deal of knowledge of finance, accounting, and stock market lore.In addition, we hope to inculcate in our readers the habit of measuring and quantifying. In 99 out of 100 issues we can say that at one price they are cheap enough to buy and at another price they are expensive enough to sell. This habit of relating what is paid to what is received is a valuable asset in investing. In an article we wrote for a women's magazine several years ago, we advised readers to buy stocks as they buy groceries, not as they buy perfume. Some of the really terrible losses of the last few years (and many before) were in ordinary shaver issues in which buyers forgot to ask "How much will I get?"In June 1970, the question of "how much will you get" could be answered by the magic number of 9.4%, the return possible on new shy-bed public utility bonds. It has since fallen to about 7.3%, but even at this return we are tempted to ask, "Why another year?" But there are other possibilities and these too should be considered with seriousness. Also, we would like to reiterate that we and our readers should be prepared for the possibility of a different scenario, such as 1923-4977.

We therefore offer a broad positive plan for ordinary share investment, partly for both types of investors and partly for the entrepreneurial group. It is strange that we should advise our readers, as a prime requirement, to limit themselves to issues which are not selling for much more than their current asset value. The reason for this seemingly outdated advice is both psychological and practical. We have learned from experience that while there are many good companies which are worth many times more than their net assets, the purchaser of such shares is very much dependent on the vagaries and volatility of the stock market. In contrast, an investor in shares who buys shares in companies standing at a net asset value, assuming these companies are publicly owned, should always consider himself to be owning a solid and growing business which has been acquired at a reasonable price - even if the stock market suggests otherwise. The end result of such conservative policies is likely to be better than that of enthusiastic adventures into the tempting and risky field of anticipated growth.There is a characteristic of the art of investing that is not generally appreciated. The average investor can achieve reliable and modest results with a minimum of effort and ability, but to improve on this easily attainable scale requires a great deal of effort and more than a modicum of knowledge. If you apply only a little extra knowledge and ingenuity to your investment plan, instead of achieving a far better result than usual, you may do much worse.Since anyone can perform as well as the market average simply by buying and holding from a representative list, it may seem a relatively simple case of being 'better than average', but the reality is that the proportion of smart people who try this and fail is surprisingly large. Even major investment funds, all staffed with experienced individuals, have not performed as well as the general market in the past. Continuing on this record, stock market forecasts published by brokerage houses, are a great indication of the fact that investors are not necessarily buying stocks.

There is strong evidence that their predictions are less reliable than decisions made by simply tossing a coin.In writing this book we have kept this fundamental difficulty of investing in mind. The merits of a simple portfolio policy of buying high-grade stocks and a diversified list of leading ordinary shares are emphasized - which an investor can build with a little expert help. Venturing outside this safe and solid territory, particularly in the area of idiosyncrasy, will be fraught with daunting difficulties. Before making any such attempt the investor needs to be sure of himself and his advisers - particularly whether they clearly understand the difference between investing and speculation and between market price and underlying value.A solid-minded approach to investing, based on the margin-of-safety principle, can yield impressive results, but the decision to pursue these gains instead of the surer fruits of defensive investing should not be made without thorough self-analysis.A final retrospective thought is that, when the young author entered Wall Street in June 1914, no one had any idea what the next half century would hold. (The stock market had little idea that World War II was about to break out in two months, and that the New York Stock Exchange would be closed.) In 1972 we found ourselves the richest and most powerful nation in the world, but with all the distractions of major problems we are more fearful than confident about the future. Still, if we limit our focus to the American investment experience, the past six decades offer some relief. Amid all the unexpected upheavals and losses that have rocked the world, it has proven true that solid investment principles usually yield solid results. We should assume that this will continue to be the case.Message to readers: This book is not a comprehensive financial policy for savers and investors. It deals only with the portion of funds they are willing to invest in marketable (or redeemable) securities, i.e. bonds and stocks. Hence, we will not discuss such instruments as savings and time deposits, savings and loan association accounts, life insurance, annuities, real estate assets or equity ownership. The reader should keep in mind that whenever he comes across the words now or similar in the book, it means the end of 1971 or the beginning of 1972.

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