Chapter 4 General Portfolio Policy:defensive investor

 The basic characteristics of a portfolio are usually determined by the situation and characteristics of its owner or owners. At one extreme we had savings banks, life-insurance companies, and small fiat trust funds. Until a generation ago, their investments were restricted by law in many states to high-grade bonds and, in some cases, high-grade preferred stocks. At the other extreme we have moneyed and experienced traders who can add to their portfolio any bond or stock they find attractive to buy.

There is an old and well-established principle that people who cannot take risk should limit their investment funds to relatively low returns. From this has evolved the idea that the investor should aim for a rate of return that is as low or as high as he can bear. Our view is different. The risk of a painful return should depend instead on how intelligently the investor is willing to try and work his way up. The lowest returns are obtained by our passive investor, who seeks both safety and freedom from worries. The highest returns are obtained by the cautious, enterprising investor, who does the most. In 1965 we added: The use of intelligence and risk "in many cases is more costly than the traditional bond purchase of a non-yielding bond with a great profit opportunity." In this statement, investors put a considerable portion of their chargeable value into interest rates.

The basic problem of bond-stock Allocation

we have already outlined very briefly the defensive investor's portfolio strategy. He should divide his funds between high-grade bonds and high-grade ordinary shares.We have recommended as a basic guiding rule that investors should never invest less than 25% and more than 75% of their funds in ordinary shares, and vice versa, in the range of 75% to 25% for bonds. This means that the standard split is to invest equally or 50-50 in these two major investment vehicles. Conventionally, there should be a compelling reason for increasing the percentage of investment in ordinary shares, such as reaching 'bargain price' levels in a prolonged bear market. Conversely, there should also be a compelling reason for reducing the ordinary share component below 50%, when an investor feels that market highs are dangerously high.These well-established maxims are easy to state, but difficult to follow because they go against the basic human nature that produces market extremes in bulls and bears. It is almost paradoxical to suggest a practicable policy for the average stockholder to reduce his holdings when the market rises past a certain point and then add to them in the subsequent downturn. That is because the average person's course of action, and perhaps course of action should be, is to do the opposite--there have been many ups and downs in the past, and the author believes there will be many in the future.If the distinction between investing and speculative operations were as clear as it is now, we could imagine a group of very shrewd and experienced investors who would sell high to unwary, hapless speculators and buy back from them low. This picture may have been somewhat vague in the past, but it is not easy to recognize it after the financial development since 1949. There is no indication that professional operations such as mutual funds are conducted in this way. The percentage of the portfolio devoted to equities by the major fund types—'balanced' and 'ordinary'—has changed little from year to year. Their selling activity is mainly related to efforts to acquire more and more promising holdings.As has been believed for a long time, the stock market has lost its connection with its old bonds and has not been able to establish them with the new ones. https://www.studyiq52.blog/2025/08/comment-on-chapter-3.html

So we cannot give the investor any reliable rule of thumb for reducing his holdings of ordinary shares to a minimum of 25% and then increasing them to a maximum of 75%. Our only request is that the investor should never put more than half his money into shares unless he is very confident of the state of the shares and is quite certain that he can withstand a market crash like that of 1969-70 with balance. It is difficult for us to see how such a firm certainty can be justified in light of the current level of the beginning of 1972. For this reason we are against a division of more than 50% into ordinary shares at this time, but for complementary reasons it is equally difficult to advise reducing the figure to less than 50% unless the investor is not troubled about current market levels and is at the same time content to increase his total funds in the near future by a limited participation, say 25%.So we want to pass on the 50-50 formula, which seems overly simplistic to most of our readers. The guiding rule in this plan is to have as equal a split as possible between bonds and share holdings as is practical. When a change in market levels causes the ordinary share component to rise to, say, 55%, sell one-eleventh of the Shaver portfolio and transfer the amount to bonds. Conversely, when the ordinary Shaver ratio falls to 45%, sell one-eleventh of the bond fund and use it to buy more shares.After 1937 Pell University followed a similar plan for many years, but the holdings of 'ordinary shares' were 35%. By the early 1950s, however, Yale seemed to have abandoned its famous formula, and in 1969 it put 61% of its portfolio (including some convertibles) into Chevrons. (At the time its 71 institutions' trust funds totaled $7.6 billion, 60.3% of which were invested in ordinary shares.) The Yale example illustrates the deleterious effect of rising markets on what was once the most popular investment formula. Nevertheless, we are convinced that the 50-50 version is better suited to defensive investors in our view. It is much simpler. It is unquestionably aimed in the right direction. By following it, the investor feels that he is at least doing something in response to what is happening in the market. Most importantly, this protects it from the greater attractiveness of ordinary shares when the market rises to greater heights.Additionally, for a truly conservative investor it would be satisfying to see a profit on half of his portfolio in a rising market, while even in a large decline he would be satisfied to see how much better off he is compared to his fellow investors.

Although the 50-50 split we propose is certainly the simplest 'all-purpose program' ever invented, it is not the best in terms of results. (Of course, there is no method, mechanical or otherwise, that can guarantee that it is better than any other.) For now, the much greater return income from good bonds than from representative stocks is a powerful argument in favor of the bond component. The choice between a 50% or less share in stocks depends mainly on the investor's own temperament and outlook. If he can wait for the right opportunity, he should hold on to as little as 25% of the stock component now and wait until the DJIA dividend yield is, say, two-thirds of the bond yield, after which he can strike a 50-50 balance between bonds and stocks. For the DJIA to start at 900 and a range of $36 per unit would require either a decline in the taxable bond yield from 7.5% to about 5.5% without any change in the current return on the leading stock or a decline in the DJIA to 660 if there is no reduction in the bond yield and no increase in dividends. Such intermediate treatment combinations could produce the same 'buying point'. Such a program is not particularly complex. The difficult thing is to adopt and stick to it, without ruling out the possibility that it may prove to be too conservative.

bond Component

the two major questions that govern the issue selection of the bond component of an investor's portfolio are whether to buy taxable or tax-exempt bonds, and whether they should be of short or long maturity. The tax question is mainly a matter of mathematics, depending on the difference between the yield and the investor's tax bracket. In January 1972, the 20-year maturity option was between 72% for grade 'AA' corporate bonds and 5.3% for the leading tax-exempt issues. (The term 'municipal' is usually used to describe all types of tax-exempt bonds, including state obligations). Moving from corporate to municipal at this maturity would result in a loss of about 30%. So if the investor was in the highest tax bracket above 30%, he would have a net gain by choosing municipal bonds. The opposite would be true if his maximum tax bracket was less than 30%. A single person is charged a 3% rate if their combined taxable income exceeds $10,000 after deductions. This rate applies to married couples if their combined taxable income exceeds $20,000. It is clear that a large number of investors in a successful marriage are likely to have higher after-tax returns. https://www.studyiq52.blog/2025/08/comment-on-chapter-3.html

The choice of long versus short maturities is a very different question, where the investor wants to protect himself against falling bond prices, but this may come at the cost of (1) a lower annual yield and (2) losing the potential for substantial appreciation in principal. We think it is better to discuss this question in Chapter 1 Investors and Market Volatility.For many years in the past, the only bond that directors could buy was a US Securities and Exchange Board of India issue. There was no doubt about its safety. These offered higher returns than other first-rate bond investments. They offered money-bank options as well as other features that made them even more attractive. In our earlier editions, we had devoted an entire chapter titled 'US Securities bonds are a boon for investors'.As he said, Pus Levitt Chands still has some special characteristics that make it a good buy for any private investor. For low-income individuals with no more than $10,000 to invest in bonds, we think this is the simplest and best option. But those with more money may find other options more appealing.Let us list some of the key bonds that investors should pay attention to, and also briefly discuss their general specifications, security, model, market price risk, general-tax status, and other features.

1. US Savings Bonds, Series E and Series H. We will first briefly describe their general provisions, and then briefly describe the many advantages of these uniquely attractive and relatively convenient investments. Series H bonds pay interest semi-annually, like other bonds. The rate is 42% for the first year and then a flat 5-10% for the next nine years until maturity. Series E bonds do not pay interest, but instead the redemption price is increased and payable to BARC. The bonds sell at 7.5% of their face value, and mature at 100% 5 years 10 years after sale. If held to maturity, they are compounded semi-annually for a total of 5 years. If redeemed early, the maximum yield can be 4.31% in the first year and 5.20% for the next 40 years.The interest on the bonds is subject to federal tax, but is exempt from state income taxes. However, the holder can choose to pay federal income taxes on the series either at the time of receipt of the loan (the annual higher redemption value), or when the bond is actually redeemed.The holder of Series E bonds can redeem them at any time for their current redemption value in cash (after purchase). Sorog H Chand's shares can also be redeemed or Series E bonds are free to redeem at face value (red). Series E bonds can be converted into Series H bonds with some tax benefits. Lost, destroyed, or stolen bonds can be replaced free of charge. There are some limits on annual purchases, but the liberal provision for co-ownership with family members allows most investors to buy as many as they want. Note: There is no other investment that offers (1) full security and security of interest payments, (2) full withdrawal rights at any time, and (3) a guaranteed minimum 5% interest rate for at least ten years. Prior issuers of Series E bonds have had the right to extend their bonds to maturity, and thus continue to earn annual value at progressively higher rates. The avoidance of income tax payments all the while has also been a major financial windfall. We calculate that this provides the third most impressive increase in after-tax yield in traditional cases. In contrast, the right to cash in bonds at cost or better gives leaders full protection against the erosion of principal during years of low interest rates that plague many bond investors. That is to say, it gives them the profitable potential of converting their low-interest holdings into ultra-high-coupon issues on an even basis when interest rates rise.In our view, the special advantage that savings bonds provide to owners more than compensates for their current lack of return, when compared with direct government liabilities.
2. Other United States bonds. There are many issues with a wide variety of coupon rates and maturity dates. All are fully secured in terms of interest payments and principal. They are subject to federal income taxes but are exempt from state income taxes. At the end of 1971, long-term issues with terms greater than ten years averaged a yield of 6.09%, intermediate issues (three to five years) yielded 6.35%, and short issues yielded 6.03%.In the 1970s it was possible to purchase many older issues at a steep discount. Some of these are accepted at par value in estate tax settlements. For example, the 1990 US Treasury 31/2s fall into this category. These sold at 60 in 1970 but closed at 77 in 1970.First, very interestingly, in many cases, indirect U.S. government obligations yield significantly more than direct obligations of the same maturity. As we write this, a new offering has appeared at 7.05%—certificates fully guaranteed by the Secretary of the U.S. Department of Transportation. This yield is 1% higher than the direct U.S. government obligation that was offered in the same year (1986).
The certificate was actually issued in the name of the trustees of the Penn Central Transportation Company, but it was backed by a statement from the US Attorney General that "being a general obligation of the US Government, it is guaranteed by its full faith and trust." Similar obligations had been granted by the US Government before, and all had been faithfully honored.The reader may wonder what a fraud this is, with a 'personal guarantee' of our Transport Secretary, and ultimately the taxpayers will pay a heavy price for it. The main reason for this indirection was the debt limit imposed by Parliament on the government, while the guarantee given by the government was not considered a loan, a perfect opportunity for shrewd investors. Perhaps the biggest impact of these conditions was the introduction of Tax Free Housing Authority bonds, which had a similar US guarantee, and were in fact the only tax exempt issue that was similar to government bonds. Another government backed issue was the recently created New Community Debentures, which offered 7.60% yield in September 1971.

3. State and Municipal Bonds These are exempt from federal income tax. They are generally not exempt from income tax anywhere except in the issuing state. These are either direct obligations of the state or of a subdivision, or revenue bonds that depend on interest payments from toll roads, bridges, building rents, etc. Not all tax-free bonds are strong enough to enable a defensive investor to justify their purchase. In selecting them, he may be guided by the rating given to each issue by Moody's or Standard & Poor's. The three highest ratings from both services are one of Aas (۸۸۸), Aa (AA), or A, which is a sufficient indication of the safety involved. The yield on these bonds may vary both in quality and maturity, with shorter-term maturities yielding lower returns. In late 1971, issues included in the Standard & Poor's Municipal Bond Index had an average quality rating of AA Chi, and a 5.78% yield on a 20-year maturity. Chinaland, N.J. bonds rated AA and A offered only a 3% yield on a one-year maturity, rising to 5.8% on 1995 and 1996 maturities.

4. Corporation Bonds These bonds were subject to both federal and state taxes. In early 1972, the highest quality yield was 7.19% for a 25-year maturity, as shown in the Moody's Corporate Bond Index. Long-term maturities of these so-called low-middle grade issues had a yield of 8.2.3%. In each category, yields on short-term issues were generally somewhat lower than those on longer-term obligations.

Note: The above summary shows that the AUS investor has a number of options in high-grade bonds. Those in the higher tax rate brackets can undoubtedly obtain better yields from good tax-exempt issues than from taxable issues. For others, the range of taxable yields in early 1972 appears to be from 5.00% in US Savings Bonds with special options to about 7.5% in high-grade corporate issues.

High-Yield Bond Investing

if the investor sacrifices quality, he can still get a higher income return on his bonds. Long experience shows that the average investor is smart enough to avoid these high-yield bonds, because although, overall, they perform only slightly better than top quality issues in terms of total return, they still pose a great deal of risk to their owners from a number of adverse events, ranging from a precipitous price decline to an actual default. (Or it is true that bargain opportunities are often found in lower-grade bonds, but this requires special study and skill to successfully exploit the opportunities).Perhaps we should also mention here that the limits imposed by Congress on US direct bond issues have created at least two types of 'bargain opportunities' for investors in purchasing government-backed obligations. First, there are tax-exempt 'New Housing' issues, and the second are the recently created (taxable), New Community Debentures. The New Housing issues had yields as high as 5.8% in July 1971, free of federal and state taxes, while the New Community Debentures (taxable) sold in September 1971 had a yield of 7.60%. Both obligations had the full faith and backing of the US government and so their safety was beyond question. And combined, their yields are significantly higher than those of other normal US bonds.

Savings deposits instead of bonds

An investor can get a much higher interest rate in a savings account (or a bank certificate of deposit) with a commercial or savings bank than he can get on a short maturity yield category bond. The interest rate on a bank savings account may come down in the future but in the current situation it is a suitable option for an individual's short-term bond investment.

convertible Shares

these are discussed in Chapter 16. Sentiment variations in bonds are generally covered in Chapter 8, Investors and Market Volatility.

call Provisions

in previous editions we have discussed at length the bond financing aspect, as it involved a serious but lesser-known unfairness to the investor. Traditionally bonds were redeemable very soon after issuance, and that too at a nominal premium over the issue price - say 5%. This meant that the investor had to bear the full brunt of adverse changes during large fluctuations in the underlying interest rates and was deprived of the full benefits of a small participation.Example: Our standard example is the issue of American Gas & Electric 100-year 59% debentures, which were sold to the public at $101 in 1928. Four years later, in near-shortage conditions, the price of these good bonds fell to $6212, yielding $10. By 1946, in a great turnaround, such bonds sold at a yield of only 3%, and 5% issues could be quoted near $160, but the company then took advantage of a call provision and redeemed the issue at just $106.The call feature of these bond contracts was a 'heads are mine, tails are mine' behind the scenes deal. Eventually, bond-buying institutions refused to accept this unfair arrangement. In recent years, most long-term high-coupon issues have been protected from redemption for ten years or more from issuance. This has kept their price appreciation still limited, but not uneconomic.In practical terms, we advise investors in long-term issues to take a small amount of risk to gain the security of non-collateralization over 20 or 25 years. Similarly, buying low-coupon bonds at a discount is more profitable.

It is advantageous to buy high-coupon bonds instead, which are available at par and are callable for only a few years. At a discount, for example, buying a 35% bond at 63.5% yield at 7.85% implies full protection from the opposite call action.

Straight – that is, non-convertible – preferred Stock

here are some general points about preferred shares. There can, and indeed are, good preferred stocks, but they are good in spite of their fundamentally bad investment structure. Traditionally preferred shareholders depend for their security on the ability and willingness of the company to pay ordinary share dividends. Once the ordinary dividend is not received, or is threatened, their own position becomes precarious, as there is no pressure on the directors to continue paying it, unless they pay it on the ordinary shares as well. On the other hand, traditional preferred shares have no share in the company's profits beyond the fixed dividend rate. Thus preferred holders have neither the watch claim of bondholders (or lenders) nor the prospects of profit of ordinary shapers (or partners).These legal weaknesses of preferred shares have been exposed time and again during recessions. Of all preferred issues, only a few stand firm as infallible investments through volatility. Experience teaches that the time to buy preferred shares is when their price is significantly depressed due to temporary problems. (At such times they are favorable to aggressive investors, but too unconventional for defensive investors).In other words, either buy them at a bargain or don't. We call these latter convertibles and such privileged issues, which have some special potential for gains. These are not often chosen in conservative portfolios.One more common feature of preferred stocks is worth mentioning. They have a better tax profile for corporate buyers, not for private investors. Corporations must pay only a 15% tax rate on their profits but income taxes on the full amount of their ordinary dividends. Since the corporate rate was 17% in 1972, this means that $100 in preferred stocks would be taxed on only $7-20, while $100 in bond interest would be taxed on $48. Private investors, on the other hand, pay the same taxes on preferred-stock investments as they do on bond interest, with a nominal exemption. Thus, logically, All investment grade preferred stocks should be purchased by corporations, as should all tax-exempt bonds, which should be purchased by investors who pay income taxes.

security Structure

the bond dividend and the preferred-stock dividend discussed so far are simple in form and easily understood. The bond holder is entitled to receive payment of principal at a fixed and specified date. The owner of a preferred stock is not entitled to anything except river dividends, which must be paid before other ordinary dividends. He does not receive the value of his principal at a fixed date. (Dividends are of the cumulative and non-cumulative types. They may or may not be entitled to accrual rights).The standard provisions above, of course, define most bonds and preferred issues, but there are many deviations from these bonds. The best-known types include convertible and common issues, and income bonds. Income bonds do not have to pay interest until the company has earned it. (Unpaid interest may be included as a charge against future income, but this period is usually limited to three years). (1) the right to collect interest on the loan, (2) the right to a security structure other than bankruptcy proceedings if the interest is not earned or paid. The terms of income bonds can be modified to provide the most favorable return for both borrower and lender (of course, this will include conversion features). The widespread acceptance of the intrinsically weak preferred-stock structure and the rejection of the strong income-bond structure interestingly illustrates the way in which habits and traditional institutions generally work on Wall Street, even when new conditions require a fresh approach. With each new wave of optimism or pessimism we are willing to abandon history and time-tested principles, but we invariably cling to our prejudices.