Investment versus Speculation: Results to Be Expected by the Intelligent Investor

Through chances various, through all
vicissitudes, we make our way....
Aeneid

Preface to the Fourth Edition, by Warren E. Buffett (i)

A Note About Benjamin Graham, by Jason Zweig (iii)

Introduction: What This Book Expects to Accomplish 1

COMMENTARY ON THE INTRODUCTION 12

1. Investment versus Speculation: Results to Be

Expected by the Intelligent Investor 18

COMMENTARY ON CHAPTER 1 35

2. The Investor and Inflation 47

COMMENTARY ON CHAPTER 2 58

3. A Century of Stock-Market History:

The Level of Stock Prices in Early 1972 65

COMMENTARY ON CHAPTER 3 80

4. General Portfolio Policy: The Defensive Investor 88

COMMENTARY ON CHAPTER 4 101

5. The Defensive Investor and Common Stocks 112

COMMENTARY ON CHAPTER 5 124

6. Portfolio Policy for the Enterprising Investor:

Negative Approach 133

COMMENTARY ON CHAPTER 6 145

7. Portfolio Policy for the Enterprising Investor:

The Positive Side 155

COMMENTARY ON CHAPTER 7 179

8. The Investor and Market Fluctuations 188

COMMENTARY ON CHAPTER 8 213

9. Investing in Investment Funds 226

COMMENTARY ON CHAPTER 9 242

10. The Investor and His Advisers 257

COMMENTARY ON CHAPTER 10 272

11. Security Analysis for the Lay Investor:

General Approach 280

COMMENTARY ON CHAPTER 11 302

12. Things to Consider About Per-Share Earnings 310

COMMENTARY ON CHAPTER 12 322

13. A Comparison of Four Listed Companies 330

COMMENTARY ON CHAPTER 13 339

14. Stock Selection for the Defensive Investor 347

COMMENTARY ON CHAPTER 14 , 367

15. Stock Selection for the Enterprising Investor 376

COMMENTARY ON CHAPTER 15 396

16. Convertible Issues and Warrants 403

COMMENTARY ON CHAPTER 16 418

17. Four Extremely Instructive Case Histories 422

COMMENTARY ON CHAPTER 17 438

18. A Comparison of Eight Pairs of Companies 446

COMMENTARY ON CHAPTER 18 473

19. Shareholders and Managements: Dividend Policy 487

COMMENTARY ON CHAPTER 19 497

20. “Margin of Safety” as the Central Concept

of Investment 512

COMMENTARY ON CHAPTER 20 525

Postscript 532

COMMENTARY ON POSTSCRIPT 535

Appendixes

1. The Superinvestors of Graham-and-Doddsville 537

2. Important Rules Concerning Taxability of Investment

Income and Security Transactions (in 1972) 561

3. The Basics of Investment Taxation

(Updated as of 2003) 562

4. The New Speculation in Common Stocks 563

5. A Case History: Aetna Maintenance Co. 575

6. Tax Accounting for NVF’s Acquisition of

Sharon Steel Shares 576

7. Technological Companies as Investments 578

Endnotes 579

Acknowledgments from Jason Zweig 589

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The text reproduced here is the Fourth Revised Edition, updated by

Graham in 1971–1972 and initially published in 1973. Please be

advised that the text of Graham’s original footnotes (designated in his

chapters with superscript numerals) can be found in the Endnotes se-

ction beginning on p. 579. The new footnotes that Jason Zweig has intro-

duced appear at the bottom of Graham’s pages (and, in the typeface

used here, as occasional additions to Graham’s endnotes).
←

Preface to the Fourth Edition,
by Warren E. Buffett

I read the first edition of this book early in 1950, when I was nine-
teen. I thought then that it was by far the best book about investing
ever written. I still think it is.
To invest successfully over a lifetime does not require a strato-
spheric IQ, unusual business insights, or inside information.
What’s needed is a sound intellectual framework for making deci-
sions and the ability to keep emotions from corroding that frame-
work. This book precisely and clearly prescribes the proper
framework. You must supply the emotional discipline.
If you follow the behavioral and business principles that Gra-
ham advocates—and if you pay special attention to the invaluable
advice in Chapters 8 and 20—you will not get a poor result from
your investments. (That represents more of an accomplishment
than you might think.) Whether you achieve outstanding results
will depend on the effort and intellect you apply to your invest-
ments, as well as on the amplitudes of stock-market folly that pre-
vail during your investing career. The sillier the market’s behavior,
the greater the opportunity for the business-like investor. Follow
Graham and you will profit from folly rather than participate in it.
To me, Ben Graham was far more than an author or a teacher.
More than any other man except my father, he influenced my life.
Shortly after Ben’s death in 1976, I wrote the following short
remembrance about him in the Financial Analysts Journal. As you
read the book, I believe you’ll perceive some of the qualities I men-
tioned in this tribute.

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BENJAMIN GRAHAM
1894–1976
Several years ago Ben Graham, then almost eighty, expressed to a friend
the thought that he hoped every day to do “something foolish, something
creative and something generous.”
The inclusion of that first whimsical goal reflected his knack for pack-
aging ideas in a form that avoided any overtones of sermonizing or
self-importance. Although his ideas were powerful, their delivery was
unfailingly gentle.
Readers of this magazine need no elaboration of his achievements as
measured by the standard of creativity. It is rare that the founder of a disci-
pline does not find his work eclipsed in rather short order by successors.
But over forty years after publication of the book that brought structure
and logic to a disorderly and confused activity, it is difficult to think of pos-
sible candidates for even the runner-up position in the field of security
analysis. In an area where much looks foolish within weeks or months
after publication, Ben’s principles have remained sound—their value often
enhanced and better understood in the wake of financial storms that
demolished flimsier intellectual structures. His counsel of soundness
brought unfailing rewards to his followers—even to those with natural
abilities inferior to more gifted practitioners who stumbled while follow-
ing counsels of brilliance or fashion.
A remarkable aspect of Ben’s dominance of his professional field was
that he achieved it without that narrowness of mental activity that concen-
trates all effort on a single end. It was, rather, the incidental by-product of
an intellect whose breadth almost exceeded definition. Certainly I have
never met anyone with a mind of similar scope. Virtually total recall,
unending fascination with new knowledge, and an ability to recast it in a
form applicable to seemingly unrelated problems made exposure to his
thinking in any field a delight.
But his third imperative—generosity—was where he succeeded beyond
all others. I knew Ben as my teacher, my employer, and my friend. In each
relationship—just as with all his students, employees, and friends—there
was an absolutely open-ended, no-scores-kept generosity of ideas, time,
and spirit. If clarity of thinking was required, there was no better place to
go. And if encouragement or counsel was needed, Ben was there.
Walter Lippmann spoke of men who plant trees that other men will sit
under. Ben Graham was such a man.

Reprinted from the Financial Analysts Journal, November/December 1976.

A Note About Benjamin Graham
by Jason Zweig

Who was Benjamin Graham, and why should you listen to him?
Graham was not only one of the best investors who ever lived; he was
also the greatest practical investment thinker of all time. Before Graham,
money managers behaved much like a medieval guild, guided largely by
superstition, guesswork, and arcane rituals. Graham’s Security Analysis
was the textbook that transformed this musty circle into a modern pro-
fession.
And The Intelligent Investor is the first book ever to describe, for
individual investors, the emotional framework and analytical tools that
are essential to financial success. It remains the single best book on
investing ever written for the general public. The Intelligent Investor
was the first book I read when I joined Forbes Magazine as a cub
reporter in 1987, and I was struck by Graham’s certainty that, sooner
or later, all bull markets must end badly. That October, U.S. stocks suf-
fered their worst one-day crash in history, and I was hooked. (Today,
after the wild bull market of the late 1990s and the brutal bear market
that began in early 2000, The Intelligent Investor reads more prophet-
ically than ever.)
Graham came by his insights the hard way: by feeling firsthand the
anguish of financial loss and by studying for decades the history and
psychology of the markets. He was born Benjamin Grossbaum on
May 9, 1894, in London; his father was a dealer in china dishes and
figurines.2 The family moved to New York when Ben was a year old. At
first they lived the good life—with a maid, a cook, and a French gov

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1 Coauthored with David Dodd and first published in 1934.
2 The Grossbaums changed their name to Graham during World War I,
when German-sounding names were regarded with suspicion.

(iv)
erness—on upper Fifth Avenue. But Ben’s father died in 1903, the
porcelain business faltered, and the family slid haltingly into poverty.
Ben’s mother turned their home into a boardinghouse; then, borrow-
ing money to trade stocks “on margin,” she was wiped out in the crash
of 1907. For the rest of his life, Ben would recall the humiliation of
cashing a check for his mother and hearing the bank teller ask, “Is
Dorothy Grossbaum good for five dollars?”
Fortunately, Graham won a scholarship at Columbia, where his
brilliance burst into full flower. He graduated in 1914, second in his
class. Before the end of Graham’s final semester, three departments—
English, philosophy, and mathematics—asked him to join the faculty.
He was all of 20 years old.
Instead of academia, Graham decided to give Wall Street a shot.
He started as a clerk at a bond-trading firm, soon became an analyst,
then a partner, and before long was running his own investment part-
nership.
The Internet boom and bust would not have surprised Graham. In
April 1919, he earned a 250% return on the first day of trading for
Savold Tire, a new offering in the booming automotive business; by
October, the company had been exposed as a fraud and the stock
was worthless.
Graham became a master at researching stocks in microscopic,
almost molecular, detail. In 1925, plowing through the obscure
reports filed by oil pipelines with the U.S. Interstate Commerce Com-
mission, he learned that Northern Pipe Line Co.—then trading at $65
per share—held at least $80 per share in high-quality bonds. (He
bought the stock, pestered its managers into raising the dividend, and
came away with $110 per share three years later.)
Despite a harrowing loss of nearly 70% during the Great Crash of
1929–1932, Graham survived and thrived in its aftermath, harvesting
bargains from the wreckage of the bull market. There is no exact
record of Graham’s earliest returns, but from 1936 until he retired in
1956, his Graham-Newman Corp. gained at least 14.7% annually,
versus 12.2% for the stock market as a whole—one of the best long-
term track records on Wall Street history.3

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3 Graham-Newman Corp. was an open-end mutual fund (see Chapter 9)
that Graham ran in partnership with Jerome Newman, a skilled investor in his
own right. For much of its history, the fund was closed to new investors. I am

(v)
How did Graham do it? Combining his extraordinary intellectual
powers with profound common sense and vast experience, Graham
developed his core principles, which are at least as valid today as they
were during his lifetime:

• A stock is not just a ticker symbol or an electronic blip; it is an
ownership interest in an actual business, with an underlying value
that does not depend on its share price.
• The market is a pendulum that forever swings between unsustain-
able optimism (which makes stocks too expensive) and unjustified
pessimism (which makes them too cheap). The intelligent investor
is a realist who sells to optimists and buys from pessimists.
• The future value of every investment is a function of its present
price. The higher the price you pay, the lower your return will be.
• No matter how careful you are, the one risk no investor can ever
eliminate is the risk of being wrong. Only by insisting on what
Graham called the “margin of safety”—never overpaying, no mat-
ter how exciting an investment seems to be—can you minimize
your odds of error.
• The secret to your financial success is inside yourself. If you
become a critical thinker who takes no Wall Street “fact” on faith,
and you invest with patient confidence, you can take steady
advantage of even the worst bear markets. By developing your
discipline and courage, you can refuse to let other people’s mood
swings govern your financial destiny. In the end, how your invest-
ments behave is much less important than how you behave.

The goal of this revised edition of The Intelligent Investor is to apply
Graham’s ideas to today’s financial markets while leaving his text
entirely intact (with the exception of footnotes for clarification).4 After
each of Graham’s chapters you’ll find a new commentary. In these
reader’s guides, I’ve added recent examples that should show you just
how relevant—and how liberating—Graham’s principles remain today.

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grateful to Walter Schloss for providing data essential to estimating
Graham-Newman’s returns. The 20% annual average return that Graham
cites in his Postscript (p. 532) appears not to take management fees into
account.
4 The text reproduced here is the Fourth Revised Edition, updated by Gra-
ham in 1971–1972 and initially published in 1973.

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I envy you the excitement and enlightenment of reading Graham’s
masterpiece for the first time—or even the third or fourth time. Like all
classics, it alters how we view the world and renews itself by educat-
ing us. And the more you read it, the better it gets. With Graham as
your guide, you are guaranteed to become a vastly more intelligent
investor.

INTRODUCTION:
What This Book Expects to Accomplish

The purpose of this book is to supply, in a form suitable for lay-

men, guidance in the adoption and execution of an investment pol-

icy. Comparatively little will be said here about the technique of

analyzing securities; attention will be paid chiefly to investment

principles and investors’ attitudes. We shall, however, provide a

number of condensed comparisons of specific securities—chiefly in

pairs appearing side by side in the New York Stock Exchange list—

in order to bring home in concrete fashion the important elements

involved in specific choices of common stocks.

But much of our space will be devoted to the historical patterns

of financial markets, in some cases running back over many

decades. To invest intelligently in securities one should be fore-

armed with an adequate knowledge of how the various types of

bonds and stocks have actually behaved under varying condi-

tions—some of which, at least, one is likely to meet again in one’s

own experience. No statement is more true and better applicable to

Wall Street than the famous warning of Santayana: “Those who do

not remember the past are condemned to repeat it.”

Our text is directed to investors as distinguished from specula-

tors, and our first task will be to clarify and emphasize this now all

but forgotten distinction. We may say at the outset that this is not a

“how to make a million” book. There are no sure and easy paths to

riches on Wall Street or anywhere else. It may be well to point up

what we have just said by a bit of financial history—especially

since there is more than one moral to be drawn from it. In the cli-

mactic year 1929 John J. Raskob, a most important figure nationally

as well as on Wall Street, extolled the blessings of capitalism in an

article in the Ladies’ Home Journal, entitled “Everybody Ought to Be

Introduction 2

Rich.”* His thesis was that savings of only $15 per month invested

in good common stocks—with dividends reinvested—would pro-

duce an estate of $80,000 in twenty years against total contributions

of only $3,600. If the General Motors tycoon was right, this was

indeed a simple road to riches. How nearly right was he? Our

rough calculation—based on assumed investment in the 30 stocks

making up the Dow Jones Industrial Average (DJIA)—indicates

that if Raskob’s prescription had been followed during 1929–1948,

the investor’s holdings at the beginning of 1949 would have been

worth about $8,500. This is a far cry from the great man’s promise

of $80,000, and it shows how little reliance can be placed on such

optimistic forecasts and assurances. But, as an aside, we should

remark that the return actually realized by the 20-year operation

would have been better than 8% compounded annually—and this

despite the fact that the investor would have begun his purchases

with the DJIA at 300 and ended with a valuation based on the 1948

closing level of 177. This record may be regarded as a persuasive

argument for the principle of regular monthly purchases of strong

common stocks through thick and thin—a program known as

“dollar-cost averaging.”

Since our book is not addressed to speculators, it is not meant

for those who trade in the market. Most of these people are guided

by charts or other largely mechanical means of determining the

right moments to buy and sell. The one principle that applies to

nearly all these so-called “technical approaches” is that one should

buy because a stock or the market has gone up and one should sell

because it has declined. This is the exact opposite of sound business

sense everywhere else, and it is most unlikely that it can lead to

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* Raskob (1879–1950) was a director of Du Pont, the giant chemical com-

pany, and chairman of the finance committee at General Motors. He also

served as national chairman of the Democratic Party and was the driving

force behind the construction of the Empire State Building. Calculations by

finance professor Jeremy Siegel confirm that Raskob’s plan would have

grown to just under $9,000 after 20 years, although inflation would have

eaten away much of that gain. For the best recent look at Raskob’s views on

long-term stock investing, see the essay by financial adviser William Bern-

stein at www.efficientfrontier.com/ef/197/raskob.htm.

Introduction 3

lasting success on Wall Street. In our own stock-market experience

and observation, extending over 50 years, we have not known a

single person who has consistently or lastingly made money by

thus “following the market.” We do not hesitate to declare that this

approach is as fallacious as it is popular. We shall illustrate what

we have just said—though, of course this should not be taken as

proof—by a later brief discussion of the famous Dow theory for

trading in the stock market.*

Since its first publication in 1949, revisions of The Intelligent

Investor have appeared at intervals of approximately five years. In

updating the current version we shall have to deal with quite a

number of new developments since the 1965 edition was written.

These include:

1. An unprecedented advance in the interest rate on high-grade

bonds.

2. A fall of about 35% in the price level of leading common

stocks, ending in May 1970. This was the highest percentage

decline in some 30 years. (Countless issues of lower quality

had a much larger shrinkage.)

3. A persistent inflation of wholesale and consumer’s prices,

which gained momentum even in the face of a decline of gen-

eral business in 1970.

4. The rapid development of “conglomerate” companies, fran-

chise operations, and other relative novelties in business and

finance. (These include a number of tricky devices such as “let-

ter stock,”1 proliferation of stock-option warrants, misleading

names, use of foreign banks, and others.)†

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* Graham’s “brief discussion” is in two parts, on p. 33 and pp. 191–192.

For more detail on the Dow Theory, see http://viking.som.yale.edu/will/

dow/dowpage.html.

† Mutual funds bought “letter stock” in private transactions, then immedi-

ately revalued these shares at a higher public price (see Graham’s definition

on p. 579). That enabled these “go-go” funds to report unsustainably high

returns in the mid-1960s. The U.S. Securities and Exchange Commission

cracked down on this abuse in 1969, and it is no longer a concern for fund

investors. Stock-option warrants are explained in Chapter 16.

Introduction 4

5. Bankruptcy of our largest railroad, excessive short- and long-

term debt of many formerly strongly entrenched companies,

and even a disturbing problem of solvency among Wall Street

houses.*

6. The advent of the “performance” vogue in the management of

investment funds, including some bank-operated trust funds,

with disquieting results.

These phenomena will have our careful consideration, and some

will require changes in conclusions and emphasis from our previ-

ous edition. The underlying principles of sound investment should

not alter from decade to decade, but the application of these princi-

ples must be adapted to significant changes in the financial mecha-

nisms and climate.

The last statement was put to the test during the writing of the

present edition, the first draft of which was finished in January

1971. At that time the DJIA was in a strong recovery from its 1970

low of 632 and was advancing toward a 1971 high of 951, with

attendant general optimism. As the last draft was finished, in

November 1971, the market was in the throes of a new decline, car-

rying it down to 797 with a renewed general uneasiness about its

future. We have not allowed these fluctuations to affect our general

attitude toward sound investment policy, which remains substan-

tially unchanged since the first edition of this book in 1949.

The extent of the market’s shrinkage in 1969–70 should have

served to dispel an illusion that had been gaining ground dur-

ing the past two decades. This was that leading common stocks

could be bought at any time and at any price, with the assurance not

only of ultimate profit but also that any intervening loss would soon

be recouped by a renewed advance of the market to new high lev

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* The Penn Central Transportation Co., then the biggest railroad in the

United States, sought bankruptcy protection on June 21, 1970—shocking

investors, who had never expected such a giant company to go under (see

p. 423). Among the companies with “excessive” debt Graham had in mind

were Ling-Temco-Vought and National General Corp. (see pp. 425 and

463). The “problem of solvency” on Wall Street emerged between 1968

and 1971, when several prestigious brokerages suddenly went bust.

Introduction 5

els. That was too good to be true. At long last the stock market has

“returned to normal,” in the sense that both speculators and stock
investors must again be prepared to experience significant and per-

haps protracted falls as well as rises in the value of their holdings.

In the area of many secondary and third-line common stocks,

especially recently floated enterprises, the havoc wrought by the

last market break was catastrophic. This was nothing new in

itself—it had happened to a similar degree in 1961–62—but there

was now a novel element in the fact that some of the investment

funds had large commitments in highly speculative and obviously

overvalued issues of this type. Evidently it is not only the tyro who

needs to be warned that while enthusiasm may be necessary for

great accomplishments elsewhere, on Wall Street it almost invari-

ably leads to disaster.

The major question we shall have to deal with grows out of the

huge rise in the rate of interest on first-quality bonds. Since late 1967

the investor has been able to obtain more than twice as much

income from such bonds as he could from dividends on representa-

tive common stocks. At the beginning of 1972 the return was 7.19%

on highest-grade bonds versus only 2.76% on industrial stocks.

(This compares with 4.40% and 2.92% respectively at the end of

1964.) It is hard to realize that when we first wrote this book in 1949

the figures were almost the exact opposite: the bonds returned only

2.66% and the stocks yielded 6.82%.2 In previous editions we have

consistently urged that at least 25% of the conservative investor’s

portfolio be held in common stocks, and we have favored in general
a 50–50 division between the two media. We must now consider

whether the current great advantage of bond yields over stock

yields would justify an all-bond policy until a more sensible rela-

tionship returns, as we expect it will. Naturally the question of con-

tinued inflation will be of great importance in reaching our decision

here. A chapter will be devoted to this discussion.

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* See Chapter 2. As of the beginning of 2003, U.S. Treasury bonds matur-

ing in 10 years yielded 3.8%, while stocks (as measured by the Dow Jones

Industrial Average) yielded 1.9%. (Note that this relationship is not all that

different from the 1964 figures that Graham cites.) The income generated

by top-quality bonds has been falling steadily since 1981.

Introduction 6

In the past we have made a basic distinction between two kinds

of investors to whom this book was addressed—the “defensive”

and the “enterprising.” The defensive (or passive) investor will

place his chief emphasis on the avoidance of serious mistakes or

losses. His second aim will be freedom from effort, annoyance, and

the need for making frequent decisions. The determining trait of

the enterprising (or active, or aggressive) investor is his willingness

to devote time and care to the selection of securities that are both

sound and more attractive than the average. Over many decades

an enterprising investor of this sort could expect a worthwhile

reward for his extra skill and effort, in the form of a better average

return than that realized by the passive investor. We have some

doubt whether a really substantial extra recompense is promised to

the active investor under today’s conditions. But next year or the

years after may well be different. We shall accordingly continue to

devote attention to the possibilities for enterprising investment, as

they existed in former periods and may return.

It has long been the prevalent view that the art of success-

ful investment lies first in the choice of those industries that

are most likely to grow in the future and then in identifying the

most promising companies in these industries. For example, smart

investors—or their smart advisers—would long ago have recog-

nized the great growth possibilities of the computer industry as a

whole and of International Business Machines in particular. And

similarly for a number of other growth industries and growth com-

panies. But this is not as easy as it always looks in retrospect. To

bring this point home at the outset let us add here a paragraph that

we included first in the 1949 edition of this book.

Such an investor may for example be a buyer of air-transport

stocks because he believes their future is even more brilliant than

the trend the market already reflects. For this class of investor the

value of our book will lie more in its warnings against the pitfalls

lurking in this favorite investment approach than in any positive

technique that will help him along his path.* 6 Introduction *

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“Air-transport stocks,” of course, generated as much excitement in the late

1940s and early 1950s as Internet stocks did a half century later. Among

the hottest mutual funds of that era were Aeronautical Securities and the

Introduction 7

The pitfalls have proved particularly dangerous in the industry

we mentioned. It was, of course, easy to forecast that the volume of

air traffic would grow spectacularly over the years. Because of this

factor their shares became a favorite choice of the investment

funds. But despite the expansion of revenues—at a pace even

greater than in the computer industry—a combination of techno-

logical problems and overexpansion of capacity made for fluctuat

ing and even disastrous profit figures. In the year 1970, despite a

new high in traffic figures, the airlines sustained a loss of some

$200 million for their shareholders. (They had shown losses also in

1945 and 1961.) The stocks of these companies once again showed a

greater decline in 1969–70 than did the general market. The record

shows that even the highly paid full-time experts of the mutual

funds were completely wrong about the fairly short-term future of

a major and nonesoteric industry.

On the other hand, while the investment funds had substantial

investments and substantial gains in IBM, the combination of its

apparently high price and the impossibility of being certain about

its rate of growth prevented them from having more than, say, 3%

of their funds in this wonderful performer. Hence the effect of

this excellent choice on their overall results was by no means

decisive. Furthermore, many—if not most—of their investments in

computer-industry companies other than IBM appear to have been

unprofitable. From these two broad examples we draw two morals

for our readers:

1. Obvious prospects for physical growth in a business do not

translate into obvious profits for investors.

2. The experts do not have dependable ways of selecting and

concentrating on the most promising companies in the most

promising industries.

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Missiles-Rockets-Jets & Automation Fund. They, like the stocks they owned,

turned out to be an investing disaster. It is commonly accepted today that

the cumulative earnings of the airline industry over its entire history have

been negative. The lesson Graham is driving at is not that you should avoid

buying airline stocks, but that you should never succumb to the “certainty”

that any industry will outperform all others in the future.

Introduction 8

The author did not follow this approach in his financial career as

fund manager, and he cannot offer either specific counsel or much

encouragement to those who may wish to try it.

What then will we aim to accomplish in this book? Our main

objective will be to guide the reader against the areas of possible

substantial error and to develop policies with which he will be

comfortable. We shall say quite a bit about the psychology of

investors. For indeed, the investor’s chief problem—and even his

worst enemy—is likely to be himself. (“The fault, dear investor, is

not in our stars—and not in our stocks—but in ourselves. . . .”) This

has proved the more true over recent decades as it has become

more necessary for conservative investors to acquire common

stocks and thus to expose themselves, willy-nilly, to the excitement

and the temptations of the stock market. By arguments, examples,

and exhortation, we hope to aid our readers to establish the proper

mental and emotional attitudes toward their investment decisions.

We have seen much more money made and kept by “ordinary peo-

ple” who were temperamentally well suited for the investment

process than by those who lacked this quality, even though they

had an extensive knowledge of finance, accounting, and stock-

market lore.

Additionally, we hope to implant in the reader a tendency to

measure or quantify. For 99 issues out of 100 we could say that at

some price they are cheap enough to buy and at some other price

they would be so dear that they should be sold. The habit of relat-

ing what is paid to what is being offered is an invaluable trait in

investment. In an article in a women’s magazine many years ago

we advised the readers to buy their stocks as they bought their gro-

ceries, not as they bought their perfume. The really dreadful losses

of the past few years (and on many similar occasions before) were

realized in those common-stock issues where the buyer forgot to

ask “How much?”

In June 1970 the question “How much?” could be answered by

the magic figure 9.40%—the yield obtainable on new offerings of

high-grade public-utility bonds. This has now dropped to about

7.3%, but even that return tempts us to ask, “Why give any other

answer?” But there are other possible answers, and these must be

carefully considered. Besides which, we repeat that both we and

our readers must be prepared in advance for the possibly quite dif-

ferent conditions of, say, 1973–1977.

Introduction 9

We shall therefore present in some detail a positive program for

common-stock investment, part of which is within the purview of

both classes of investors and part is intended mainly for the enter-

prising group. Strangely enough, we shall suggest as one of our

chief requirements here that our readers limit themselves to issues

selling not far above their tangible-asset value.* The reason for

this seemingly outmoded counsel is both practical and psychologi-

cal. Experience has taught us that, while there are many good

growth companies worth several times net assets, the buyer of

such shares will be too dependent on the vagaries and fluctuations

of the stock market. By contrast, the investor in shares, say, of

public-utility companies at about their net-asset value can always

consider himself the owner of an interest in sound and expanding

businesses, acquired at a rational price—regardless of what the

stock market might say to the contrary. The ultimate result of such

a conservative policy is likely to work out better than exciting

adventures into the glamorous and dangerous fields of anticipated

growth.

The art of investment has one characteristic that is not generally

appreciated. A creditable, if unspectacular, result can be achieved

by the lay investor with a minimum of effort and capability; but to

improve this easily attainable standard requires much application

and more than a trace of wisdom. If you merely try to bring just a

little extra knowledge and cleverness to bear upon your investment

program, instead of realizing a little better than normal results, you

may well find that you have done worse.

Since anyone—by just buying and holding a representative

list—can equal the performance of the market averages, it would

seem a comparatively simple matter to “beat the averages”; but as

a matter of fact the proportion of smart people who try this and fail

is surprisingly large. Even the majority of the investment funds,

with all their experienced personnel, have not performed so well

→

* Tangible assets include a company’s physical property (like real estate,

factories, equipment, and inventories) as well as its financial balances (such

as cash, short-term investments, and accounts receivable). Among the ele-

ments not included in tangible assets are brands, copyrights, patents, fran-

chises, goodwill, and trademarks. To see how to calculate tangible-asset

value, see footnote † on p. 198.

Introduction 10

over the years as has the general market. Allied to the foregoing

is the record of the published stock-market predictions of the

brokerage houses, for there is strong evidence that their calculated

forecasts have been somewhat less reliable than the simple tossing

of a coin.

In writing this book we have tried to keep this basic pitfall of

investment in mind. The virtues of a simple portfolio policy have

been emphasized—the purchase of high-grade bonds plus a diver-

sified list of leading common stocks—which any investor can carry

out with a little expert assistance. The adventure beyond this safe

and sound territory has been presented as fraught with challeng-

ing difficulties, especially in the area of temperament. Before

attempting such a venture the investor should feel sure of himself

and of his advisers—particularly as to whether they have a clear

concept of the differences between investment and speculation and

between market price and underlying value.

A strong-minded approach to investment, firmly based on the

margin-of-safety principle, can yield handsome rewards. But a

decision to try for these emoluments rather than for the assured

fruits of defensive investment should not be made without much

self-examination.

A final retrospective thought. When the young author entered

Wall Street in June 1914 no one had any inkling of what the next

half-century had in store. (The stock market did not even suspect

that a World War was to break out in two months, and close down

the New York Stock Exchange.) Now, in 1972, we find ourselves the

richest and most powerful country on earth, but beset by all sorts

of major problems and more apprehensive than confident of the

future. Yet if we confine our attention to American investment

experience, there is some comfort to be gleaned from the last 57

years. Through all their vicissitudes and casualties, as earth-

shaking as they were unforeseen, it remained true that sound

investment principles produced generally sound results. We must

act on the assumption that they will continue to do so.

Note to the Reader: This book does not address itself to the overall

financial policy of savers and investors; it deals only with that

portion of their funds which they are prepared to place in mar-

ketable (or redeemable) securities, that is, in bonds and stocks.

Introduction 11

Consequently we do not discuss such important media as savings

and time desposits, savings-and-loan-association accounts, life

insurance, annuities, and real-estate mortgages or equity owner-

ship. The reader should bear in mind that when he finds the word
“now,” or the equivalent, in the text, it refers to late 1971 or

early 1972.

COMMENTARY ON THE INTRODUCTION

If you have built castles in the air, your work need not be lost;

that is where they should be. Now put the foundations under

them.

—Henry David Thoreau, Walden

Notice that Graham announces from the start that this book will not

tell you how to beat the market. No truthful book can.

Instead, this book will teach you three powerful lessons:

• how you can minimize the odds of suffering irreversible losses;

• how you can maximize the chances of achieving sustainable gains;

• how you can control the self-defeating behavior that keeps most

investors from reaching their full potential.

Back in the boom years of the late 1990s, when technology stocks

seemed to be doubling in value every day, the notion that you could

lose almost all your money seemed absurd. But, by the end of 2002,

many of the dot-com and telecom stocks had lost 95% of their value

or more. Once you lose 95% of your money, you have to gain 1,900%

just to get back to where you started.1 Taking a foolish risk can put

you so deep in the hole that it’s virtually impossible to get out. That’s

why Graham constantly emphasizes the importance of avoiding

losses—not just in Chapters 6, 14, and 20, but in the threads of warn-

ing that he has woven throughout his entire text.

But no matter how careful you are, the price of your investments

will go down from time to time. While no one can eliminate that risk,

→

1 To put this statement in perspective, consider how often you are likely to

buy a stock at $30 and be able to sell it at $600.

Commentary on the Introduction 13

Graham will show you how to manage it—and how to get your fears

under control.

ARE YOU AN INTELLIGENT INVESTOR?

Now let’s answer a vitally important question. What exactly does Gra-

ham mean by an “intelligent” investor? Back in the first edition of this

book, Graham defines the term—and he makes it clear that this kind of
intelligence has nothing to do with IQ or SAT scores. It simply means

being patient, disciplined, and eager to learn; you must also be able to

harness your emotions and think for yourself. This kind of intelligence,

explains Graham, “is a trait more of the character than of the brain.” 2

There’s proof that high IQ and higher education are not enough to

make an investor intelligent. In 1998, Long-Term Capital Management

L.P., a hedge fund run by a battalion of mathematicians, computer

scientists, and two Nobel Prize–winning economists, lost more than

$2 billion in a matter of weeks on a huge bet that the bond market

would return to “normal.” But the bond market kept right on becoming

more and more abnormal—and LTCM had borrowed so much money

that its collapse nearly capsized the global financial system.3

And back in the spring of 1720, Sir Isaac Newton owned shares in

the South Sea Company, the hottest stock in England. Sensing that

the market was getting out of hand, the great physicist muttered that

he “could calculate the motions of the heavenly bodies, but not the

madness of the people.” Newton dumped his South Sea shares, pock-

eting a 100% profit totaling £7,000. But just months later, swept up in

the wild enthusiasm of the market, Newton jumped back in at a much

higher price—and lost £20,000 (or more than $3 million in today’s

money). For the rest of his life, he forbade anyone to speak the words

“South Sea” in his presence.4

→

2 Benjamin Graham, The Intelligent Investor (Harper & Row, 1949), p. 4.

3 A “hedge fund” is a pool of money, largely unregulated by the government,

invested aggressively for wealthy clients. For a superb telling of the LTCM

story, see Roger Lowenstein, When Genius Failed (Random House, 2000).

4 John Carswell, The South Sea Bubble (Cresset Press, London, 1960),

pp. 131, 199. Also see www.harvard-magazine.com/issues/mj99/damnd.

html.

Commentary on the Introduction 14

Sir Isaac Newton was one of the most intelligent people who ever

lived, as most of us would define intelligence. But, in Graham’s terms,

Newton was far from an intelligent investor. By letting the roar of the

crowd override his own judgment, the world’s greatest scientist acted

like a fool.

In short, if you’ve failed at investing so far, it’s not because you’re

stupid. It’s because, like Sir Isaac Newton, you haven’t developed the

emotional discipline that successful investing requires. In Chapter 8,

Graham describes how to enhance your intelligence by harnessing

your emotions and refusing to stoop to the market’s level of irrational-

ity. There you can master his lesson that being an intelligent investor is

more a matter of “character” than “brain.”

A CHRONICLE OF CALAMITY

Now let’s take a moment to look at some of the major financial devel-

opments of the past few years:

1. The worst market crash since the Great Depression, with U.S.

stocks losing 50.2% of their value—or $7.4 trillion—between

March 2000 and October 2002.

2. Far deeper drops in the share prices of the hottest companies of

the 1990s, including AOL, Cisco, JDS Uniphase, Lucent, and

Qualcomm—plus the utter destruction of hundreds of Internet

stocks.

3. Accusations of massive financial fraud at some of the largest and

most respected corporations in America, including Enron, Tyco,

and Xerox.

4. The bankruptcies of such once-glistening companies as Con-

seco, Global Crossing, and WorldCom.

5. Allegations that accounting firms cooked the books, and even

destroyed records, to help their clients mislead the investing public.

6. Charges that top executives at leading companies siphoned off

hundreds of millions of dollars for their own personal gain.

7. Proof that security analysts on Wall Street praised stocks publicly

but admitted privately that they were garbage.

8. A stock market that, even after its bloodcurdling decline, seems

overvalued by historical measures, suggesting to many experts

that stocks have further yet to fall.

Commentary on the Introduction 15

9. A relentless decline in interest rates that has left investors with no

attractive alternative to stocks.

10. An investing environment bristling with the unpredictable menace

of global terrorism and war in the Middle East.

Much of this damage could have been (and was!) avoided by

investors who learned and lived by Graham’s principles. As Graham

puts it, “while enthusiasm may be necessary for great accomplish-

ments elsewhere, on Wall Street it almost invariably leads to disaster.”

By letting themselves get carried away—on Internet stocks, on big

“growth” stocks, on stocks as a whole—many people made the same

stupid mistakes as Sir Isaac Newton. They let other investors’ judg-

ments determine their own. They ignored Graham’s warning that “the
really dreadful losses” always occur after “the buyer forgot to ask

‘How much?’ ” Most painfully of all, by losing their self-control just

when they needed it the most, these people proved Graham’s asser-

tion that “the investor’s chief problem—and even his worst enemy—is

likely to be himself.”

THE SURE THING THAT WASN’T

Many of those people got especially carried away on technology and

Internet stocks, believing the high-tech hype that this industry would

keep outgrowing every other for years to come, if not forever:

• In mid-1999, after earning a 117.3% return in just the first five

months of the year, Monument Internet Fund portfolio manager

Alexander Cheung predicted that his fund would gain 50% a year

over the next three to five years and an annual average of 35%

“over the next 20 years.”5

→

5 Constance Loizos, “Q&A: Alex Cheung,” InvestmentNews, May 17, 1999,

p. 38. The highest 20-year return in mutual fund history was 25.8% per year,

achieved by the legendary Peter Lynch of Fidelity Magellan over the two

decades ending December 31, 1994. Lynch’s performance turned $10,000

into more than $982,000 in 20 years. Cheung was predicting that his fund

would turn $10,000 into more than $4 million over the same length of time.

Instead of regarding Cheung as ridiculously overoptimistic, investors threw

Commentary on the Introduction 16

• After his Amerindo Technology Fund rose an incredible 248.9%

in 1999, portfolio manager Alberto Vilar ridiculed anyone who

dared to doubt that the Internet was a perpetual moneymaking

machine: “If you’re out of this sector, you’re going to underper-

form. You’re in a horse and buggy, and I’m in a Porsche. You

don’t like tenfold growth opportunities? Then go with someone

else.” 6

• In February 2000, hedge-fund manager James J. Cramer pro-

claimed that Internet-related companies “are the only ones worth

owning right now.” These “winners of the new world,” as he called

them, “are the only ones that are going higher consistently in

good days and bad.” Cramer even took a potshot at Graham: “You

have to throw out all of the matrices and formulas and texts that

existed before the Web. . . . If we used any of what Graham and

Dodd teach us, we wouldn’t have a dime under management.” 7

All these so-called experts ignored Graham’s sober words of warn-

ing: “Obvious prospects for physical growth in a business do not

translate into obvious profits for investors.” While it seems easy to

foresee which industry will grow the fastest, that foresight has no real

value if most other investors are already expecting the same thing. By

the time everyone decides that a given industry is “obviously” the best

→

money at him, flinging more than $100 million into his fund over the next

year. A $10,000 investment in the Monument Internet Fund in May 1999

would have shrunk to roughly $2,000 by year-end 2002. (The Monument

fund no longer exists in its original form and is now known as Orbitex

Emerging Technology Fund.)

6 Lisa Reilly Cullen, “The Triple Digit Club,” Money, December, 1999, p. 170.

If you had invested $10,000 in Vilar’s fund at the end of 1999, you would

have finished 2002 with just $1,195 left—one of the worst destructions of

wealth in the history of the mutual-fund industry.

7 See www.thestreet.com/funds/smarter/891820.html. Cramer’s favorite

stocks did not go “higher consistently in good days and bad.” By year-end

2002, one of the 10 had already gone bankrupt, and a $10,000 investment

spread equally across Cramer’s picks would have lost 94%, leaving you

with a grand total of $597.44. Perhaps Cramer meant that his stocks would

be “winners” not in “the new world,” but in the world to come.

Commentary on the Introduction 17

one to invest in, the prices of its stocks have been bid up so high that
its future returns have nowhere to go but down.

For now at least, no one has the gall to try claiming that technology

will still be the world’s greatest growth industry. But make sure you

remember this: The people who now claim that the next “sure thing”

will be health care, or energy, or real estate, or gold, are no more likely
to be right in the end than the hypesters of high tech turned out to be.

TH E S I LVE R LI N I NG

If no price seemed too high for stocks in the 1990s, in 2003 we’ve

reached the point at which no price appears to be low enough. The

pendulum has swung, as Graham knew it always does, from irrational

exuberance to unjustifiable pessimism. In 2002, investors yanked $27

billion out of stock mutual funds, and a survey conducted by the Secu-

rities Industry Association found that one out of 10 investors had cut

back on stocks by at least 25%. The same people who were eager to
buy stocks in the late 1990s—when they were going up in price and,

therefore, becoming expensive—sold stocks as they went down in

price and, by definition, became cheaper.

As Graham shows so brilliantly in Chapter 8, this is exactly back-

wards. The intelligent investor realizes that stocks become more risky,
not less, as their prices rise—and less risky, not more, as their prices

fall. The intelligent investor dreads a bull market, since it makes stocks

more costly to buy. And conversely (so long as you keep enough cash

on hand to meet your spending needs), you should welcome a bear

market, since it puts stocks back on sale.8

So take heart: The death of the bull market is not the bad news

everyone believes it to be. Thanks to the decline in stock prices, now

is a considerably safer—and saner—time to be building wealth. Read

on, and let Graham show you how.

→

8 The only exception to this rule is an investor in the advanced stage of

retirement, who may not be able to outlast a long bear market. Yet even an

elderly investor should not sell her stocks merely because they have gone

down in price; that approach not only turns her paper losses into real ones

but deprives her heirs of the potential to inherit those stocks at lower costs

for tax purposes.

CHAPTER 1
Investment versus Speculation: Results to
Be Expected by the Intelligent Investor

This chapter will outline the viewpoints that will be set forth in
the remainder of the book. In particular we wish to develop at the
outset our concept of appropriate portfolio policy for the individ-
ual, nonprofessional investor.

Investment versus Speculation

What do we mean by “investor”? Throughout this book the

term will be used in contradistinction to “speculator.” As far back

as 1934, in our textbook Security Analysis,1 we attempted a precise

formulation of the difference between the two, as follows: “An

investment operation is one which, upon thorough analysis prom-

ises safety of principal and an adequate return. Operations not

meeting these requirements are speculative.”

While we have clung tenaciously to this definition over the

ensuing 38 years, it is worthwhile noting the radical changes that

have occurred in the use of the term “investor” during this period.

After the great market decline of 1929–1932 all common stocks

were widely regarded as speculative by nature. (A leading autho-

rity stated flatly that only bonds could be bought for investment.2 )

Thus we had then to defend our definition against the charge that

it gave too wide scope to the concept of investment.

Now our concern is of the opposite sort. We must prevent our

readers from accepting the common jargon which applies the term

“investor” to anybody and everybody in the stock market. In our

last edition we cited the following headline of a front-page article

of our leading financial journal in June 1962:

The Investment Versus Speculation 19

SMALL INVESTORS BEARISH, THEY ARE SELLING ODD-LOTS SHORT

In October 1970 the same journal had an editorial critical of what it

called “reckless investors,” who this time were rushing in on the

buying side.

These quotations well illustrate the confusion that has been

dominant for many years in the use of the words investment and

speculation. Think of our suggested definition of investment given

above, and compare it with the sale of a few shares of stock by an

inexperienced member of the public, who does not even own what

he is selling, and has some largely emotional conviction that he

will be able to buy them back at a much lower price. (It is not irrel-

evant to point out that when the 1962 article appeared the market

had already experienced a decline of major size, and was now get-

ting ready for an even greater upswing. It was about as poor a time

as possible for selling short.) In a more general sense, the later-used

phrase “reckless investors” could be regarded as a laughable con-

tradiction in terms—something like “spendthrift misers”—were

this misuse of language not so mischievous.

The newspaper employed the word “investor” in these

instances because, in the easy language of Wall Street, everyone

who buys or sells a security has become an investor, regardless of

what he buys, or for what purpose, or at what price, or whether for

cash or on margin. Compare this with the attitude of the public

toward common stocks in 1948, when over 90% of those queried

expressed themselves as opposed to the purchase of common

stocks.3 About half gave as their reason “not safe, a gamble,” and

about half, the reason “not familiar with.”* It is indeed ironical

* The survey Graham cites was conducted for the Fed by the University of

Michigan and was published in the Federal Reserve Bulletin, July, 1948.

People were asked, “Suppose a man decides not to spend his money. He

can either put it in a bank or in bonds or he can invest it. What do you think

would be the wisest thing for him to do with the money nowadays—put it in

the bank, buy savings bonds with it, invest it in real estate, or buy common

stock with it?” Only 4% thought common stock would offer a “satisfactory”

return; 26% considered it “not safe” or a “gamble.” From 1949 through

1958, the stock market earned one of its highest 10-year returns in history,

The Investment Versus Speculation 20
(though not surprising) that common-stock purchases of all kinds

were quite generally regarded as highly speculative or risky at a

time when they were selling on a most attractive basis, and due

soon to begin their greatest advance in history; conversely the very

fact they had advanced to what were undoubtedly dangerous lev-

els as judged by past experience later transformed them into “invest-

ments,” and the entire stock-buying public into “investors.”

The distinction between investment and speculation in common

stocks has always been a useful one and its disappearance is a

cause for concern. We have often said that Wall Street as an institu-

tion would be well advised to reinstate this distinction and to

emphasize it in all its dealings with the public. Otherwise the stock

exchanges may some day be blamed for heavy speculative losses,

which those who suffered them had not been properly warned

against. Ironically, once more, much of the recent financial embar-

rassment of some stock-exchange firms seems to have come from

the inclusion of speculative common stocks in their own capital

funds. We trust that the reader of this book will gain a reasonably

clear idea of the risks that are inherent in common-stock commit-

ments—risks which are inseparable from the opportunities of

profit that they offer, and both of which must be allowed for in the

investor’s calculations.

What we have just said indicates that there may no longer be

such a thing as a simon-pure investment policy comprising repr-

esentative common stocks—in the sense that one can always wait to

buy them at a price that involves no risk of a market or “quota-

tional” loss large enough to be disquieting. In most periods the

investor must recognize the existence of a speculative factor in his

common-stock holdings. It is his task to keep this component

within minor limits, and to be prepared financially and psycholog-

ically for adverse results that may be of short or long duration.

Two paragraphs should be added about stock speculation per

se, as distinguished from the speculative component now inherent

20 The Intelligent Investor

→
averaging 18.7% annually. In a fascinating echo of that early Fed survey, a

poll conducted by BusinessWeek at year-end 2002 found that only 24% of

investors were willing to invest more in their mutual funds or stock portfolios,

down from 47% just three years earlier.

The Investment Versus Speculation 21
in most representative common stocks. Outright speculation is

neither illegal, immoral, nor (for most people) fattening to the

pocketbook. More than that, some speculation is necessary and

unavoidable, for in many common-stock situations there are sub-

stantial possibilities of both profit and loss, and the risks therein

must be assumed by someone.* There is intelligent speculation as

there is intelligent investing. But there are many ways in which

speculation may be unintelligent. Of these the foremost are: (1)

speculating when you think you are investing; (2) speculating seri-

ously instead of as a pastime, when you lack proper knowledge

and skill for it; and (3) risking more money in speculation than you

can afford to lose.

In our conservative view every nonprofessional who operates

on margin† should recognize that he is ipso facto speculating, and it

is his broker’s duty so to advise him. And everyone who buys a

so-called “hot” common-stock issue, or makes a purchase in any

way similar thereto, is either speculating or gambling. Speculation

is always fascinating, and it can be a lot of fun while you are ahead

of the game. If you want to try your luck at it, put aside a portion—

the smaller the better—of your capital in a separate fund for this

purpose. Never add more money to this account just because the

→

* Speculation is beneficial on two levels: First, without speculation, untested

new companies (like Amazon.com or, in earlier times, the Edison Electric

Light Co.) would never be able to raise the necessary capital for expansion.

The alluring, long-shot chance of a huge gain is the grease that lubricates

the machinery of innovation. Secondly, risk is exchanged (but never elimi-

nated) every time a stock is bought or sold. The buyer purchases the primary

risk that this stock may go down. Meanwhile, the seller still retains a residual

risk—the chance that the stock he just sold may go up!

† A margin account enables you to buy stocks using money you borrow

from the brokerage firm. By investing with borrowed money, you make more

when your stocks go up—but you can be wiped out when they go down. The

collateral for the loan is the value of the investments in your account—so you

must put up more money if that value falls below the amount you borrowed.

For more information about margin accounts, see www.sec.gov/investor/

pubs/margin.htm, www.sia.com/publications/pdf/MarginsA.pdf, and www. nyse.com/pdfs/2001_factbook_09.pdf.

The Investment Versus Speculation 22
market has gone up and profits are rolling in. (That’s the time to

think of taking money out of your speculative fund.) Never mingle

your speculative and investment operations in the same account,

nor in any part of your thinking.

Results to Be Expected by the Defensive Investor

We have already defined the defensive investor as one inter-

ested chiefly in safety plus freedom from bother. In general what

course should he follow and what return can he expect under

“average normal conditions”—if such conditions really exist? To

answer these questions we shall consider first what we wrote on

the subject seven years ago, next what significant changes have

occurred since then in the underlying factors governing the

investor’s expectable return, and finally what he should do and

what he should expect under present-day (early 1972) conditions.

1. What We Said Six Years Ago

We recommended that the investor divide his holdings between

high-grade bonds and leading common stocks; that the proportion

held in bonds be never less than 25% or more than 75%, with the

converse being necessarily true for the common-stock component;

that his simplest choice would be to maintain a 50–50 proportion

between the two, with adjustments to restore the equality when

market developments had disturbed it by as much as, say, 5%. As

an alternative policy he might choose to reduce his common-stock

component to 25% “if he felt the market was dangerously high,”

and conversely to advance it toward the maximum of 75% “if he

felt that a decline in stock prices was making them increasingly

attractive.”

In 1965 the investor could obtain about 41 ⁄2% on high-grade tax-

able bonds and 31 ⁄4% on good tax-free bonds. The dividend return

on leading common stocks (with the DJIA at 892) was only about

3.2%. This fact, and others, suggested caution. We implied that “at

normal levels of the market” the investor should be able to obtain

an initial dividend return of between 31 ⁄2% and 41 ⁄2% on his stock

purchases, to which should be added a steady increase in underly-

ing value (and in the “normal market price”) of a representative

The Investment Versus Speculation 23

stock list of about the same amount, giving a return from divi-

dends and appreciation combined of about 71 ⁄2% per year. The half

and half division between bonds and stocks would yield about 6%

before income tax. We added that the stock component should

carry a fair degree of protection against a loss of purchasing power

caused by large-scale inflation.

It should be pointed out that the above arithmetic indicated

expectation of a much lower rate of advance in the stock market

than had been realized between 1949 and 1964. That rate had aver-

aged a good deal better than 10% for listed stocks as a whole, and it

was quite generally regarded as a sort of guarantee that similarly

satisfactory results could be counted on in the future. Few people

were willing to consider seriously the possibility that the high rate

of advance in the past means that stock prices are “now too high,”

and hence that “the wonderful results since 1949 would imply not

very good but bad results for the future.”4

2. What Has Happened Since 1964

The major change since 1964 has been the rise in interest rates on

first-grade bonds to record high levels, although there has since

been a considerable recovery from the lowest prices of 1970.

The obtainable return on good corporate issues is now about 71 ⁄2% and

even more against 41 ⁄2% in 1964. In the meantime the dividend

return on DJIA-type stocks had a fair advance also during the mar-

ket decline of 1969–70, but as we write (with “the Dow” at 900) it is

less than 3.5% against 3.2% at the end of 1964. The change in going

interest rates produced a maximum decline of about 38% in the

market price of medium-term (say 20-year) bonds during this

period.

There is a paradoxical aspect to these developments. In 1964 we

discussed at length the possibility that the price of stocks might be

too high and subject ultimately to a serious decline; but we did not

consider specifically the possibility that the same might happen to

the price of high-grade bonds. (Neither did anyone else that we

know of.) We did warn (on p. 90) that “a long-term bond may vary

widely in price in response to changes in interest rates.” In the light

of what has since happened we think that this warning—with

attendant examples—was insufficiently stressed. For the fact is that

The Investment Versus Speculation 24

if the investor had a given sum in the DJIA at its closing price of

874 in 1964 he would have had a small profit thereon in late 1971;

even at the lowest level (631) in 1970 his indicated loss would have

been less than that shown on good long-term bonds. On the other

hand, if he had confined his bond-type investments to U.S. savings

bonds, short-term corporate issues, or savings accounts, he would

have had no loss in market value of his principal during this period

and he would have enjoyed a higher income return than was

offered by good stocks. It turned out, therefore, that true “cash

equivalents” proved to be better investments in 1964 than common

stocks—in spite of the inflation experience that in theory should

have favored stocks over cash. The decline in quoted principal

value of good longer-term bonds was due to developments in the

money market, an abstruse area which ordinarily does not have an

important bearing on the investment policy of individuals.

This is just another of an endless series of experiences over time

that have demonstrated that the future of security prices is never

predictable.* Almost always bonds have fluctuated much less than

stock prices, and investors generally could buy good bonds of any

maturity without having to worry about changes in their market

value. There were a few exceptions to this rule, and the period after

1964 proved to be one of them. We shall have more to say about

change in bond prices in a later chapter.

3. Expectations and Policy in Late 1971 and Early 1972

Toward the end of 1971 it was possible to obtain 8% taxable

interest on good medium-term corporate bonds, and 5.7% tax-free

on good state or municipal securities. In the shorter-term field the

investor could realize about 6% on U.S. government issues due in

five years. In the latter case the buyer need not be concerned about

→

* Read Graham’s sentence again, and note what this greatest of investing

experts is saying: The future of security prices is never predictable. And as

you read ahead in the book, notice how everything else Graham tells you is

designed to help you grapple with that truth. Since you cannot predict the

behavior of the markets, you must learn how to predict and control your own

behavior.

The Investment Versus Speculation 25
a possible loss in market value, since he is sure of full repayment,

including the 6% interest return, at the end of a comparatively

short holding period. The DJIA at its recurrent price level of 900 in

1971 yields only 3.5%.

Let us assume that now, as in the past, the basic policy decision

to be made is how to divide the fund between high-grade bonds

(or other so-called “cash equivalents”) and leading DJIA-type

stocks. What course should the investor follow under present con-

ditions, if we have no strong reason to predict either a significant

upward or a significant downward movement for some time in the

future? First let us point out that if there is no serious adverse

change, the defensive investor should be able to count on the cur-

rent 3.5% dividend return on his stocks and also on an average

annual appreciation of about 4%. As we shall explain later this

appreciation is based essentially on the reinvestment by the var-

ious companies of a corresponding amount annually out of undis-

tributed profits. On a before-tax basis the combined return of his

stocks would then average, say, 7.5%, somewhat less than his inter-

est on high-grade bonds.* On an after-tax basis the average return

on stocks would work out at some 5.3%.5 This would be about the

same as is now obtainable on good tax-free medium-term bonds.

These expectations are much less favorable for stocks against

bonds than they were in our 1964 analysis. (That conclusion fol-

lows inevitably from the basic fact that bond yields have gone up

much more than stock yields since 1964.) We must never lose sight.

→

* How well did Graham’s forecast pan out? At first blush, it seems, very

well: From the beginning of 1972 through the end of 1981, stocks earned

an annual average return of 6.5%. (Graham did not specify the time period

for his forecast, but it’s plausible to assume that he was thinking of a 10-

year time horizon.) However, inflation raged at 8.6% annually over this

period, eating up the entire gain that stocks produced. In this section of his

chapter, Graham is summarizing what is known as the “Gordon equation,”

which essentially holds that the stock market’s future return is the sum of the

current dividend yield plus expected earnings growth. With a dividend yield

of just under 2% in early 2003, and long-term earnings growth of around

2%, plus inflation at a bit over 2%, a future average annual return of roughly

6% is plausible. (See the commentary on Chapter 3.)

The Investment Versus Speculation 26

of the fact that the interest and principal payments on good bonds

are much better protected and therefore more certain than the divi-

dends and price appreciation on stocks. Consequently we are

forced to the conclusion that now, toward the end of 1971, bond

investment appears clearly preferable to stock investment. If we

could be sure that this conclusion is right we would have to advise

the defensive investor to put all his money in bonds and none in

common stocks until the current yield relationship changes signifi-

cantly in favor of stocks.

But of course we cannot be certain that bonds will work out bet-

ter than stocks from today’s levels. The reader will immediately

think of the inflation factor as a potent reason on the other side. In

the next chapter we shall argue that our considerable experience

with inflation in the United States during this century would not

support the choice of stocks against bonds at present differentials

in yield. But there is always the possibility—though we consider it

remote—of an accelerating inflation, which in one way or another

would have to make stock equities preferable to bonds payable in a

fixed amount of dollars.* There is the alternative possibility—

which we also consider highly unlikely—that American business

will become so profitable, without stepped-up inflation, as to jus-

tify a large increase in common-stock values in the next few years

. Finally, there is the more familiar possibility that we shall witness

another great speculative rise in the stock market without a real

justification in the underlying values. Any of these reasons, and

perhaps others we haven’t thought of, might cause the investor to

regret a 100% concentration on bonds even at their more favorable

yield levels.

Hence, after this foreshortened discussion of the major consider-

ations, we once again enunciate the same basic compromise policy

→

* Since 1997, when Treasury Inflation-Protected Securities (or TIPS) were

introduced, stocks have no longer been the automatically superior choice

for investors who expect inflation to increase. TIPS, unlike other bonds, rise

in value if the Consumer Price Index goes up, effectively immunizing the

investor against losing money after inflation. Stocks carry no such guarantee

and, in fact, are a relatively poor hedge against high rates of inflation. (For

more details, see the commentary to Chapter 2.)

The Investment Versus Speculation 27
for defensive investors—namely that at all times they have a signif-

icant part of their funds in bond-type holdings and a significant

part also in equities. It is still true that they may choose between

maintaining a simple 50–50 division between the two components

or a ratio, dependent on their judgment, varying between a mini-

mum of 25% and a maximum of 75% of either. We shall give our

more detailed view of these alternative policies in a later chapter.

Since at present the overall return envisaged from common stocks

is nearly the same as that from bonds, the presently expectable

return (including growth of stock values) for the investor would

change little regardless of how he divides his fund between the

two components. As calculated above, the aggregate return from

both parts should be about 7.8% before taxes or 5.5% on a tax-free

(or estimated tax-paid) basis. A return of this order is appreciably

higher than that realized by the typical conservative investor over

most of the long-term past. It may not seem attractive in relation to

the 14%, or so, return shown by common stocks during the 20

years of the predominantly bull market after 1949. But it should be

remembered that between 1949 and 1969 the price of the DJIA had

advanced more than fivefold while its earnings and dividends had

about doubled. Hence the greater part of the impressive market

record for that period was based on a change in investors’ and

speculators’ attitudes rather than in underlying corporate values.

To that extent it might well be called a “bootstrap operation.”

In discussing the common-stock portfolio of the defensive

investor, we have spoken only of leading issues of the type

included in the 30 components of the Dow Jones Industrial Aver-

age. We have done this for convenience, and not to imply that these

30 issues alone are suitable for purchase by him. Actually, there are

many other companies of quality equal to or excelling the average

of the Dow Jones list; these would include a host of public utilities

(which have a separate Dow Jones average to represent them).* But

→

* Today, the most widely available alternatives to the Dow Jones Industrial

Average are the Standard & Poor’s 500-stock index (the “S & P”) and the

Wilshire 5000 index. The S & P focuses on 500 large, well-known compa-

nies that make up roughly 70% of the total value of the U.S. equity market.

The Wilshire 5000 follows the returns of nearly every significant, publicly

The Investment Versus Speculation 28
the major point here is that the defensive investor’s overall results

are not likely to be decisively different from one diversified or rep-

resentative list than from another, or—more accurately—that nei-

ther he nor his advisers could predict with certainty whatever

differences would ultimately develop. It is true that the art of skill-

ful or shrewd investment is supposed to lie particularly in the

selection of issues that will give better results than the general mar-

ket. For reasons to be developed elsewhere we are skeptical of the

ability of defensive investors generally to get better than average

results—which in fact would mean to beat their own overall per-

formance.* (Our skepticism extends to the management of large

funds by experts.)

Let us illustrate our point by an example that at first may seem

to prove the opposite. Between December 1960 and December 1970

the DJIA advanced from 616 to 839, or 36%. But in the same period

the much larger Standard & Poor’s weighted index of 500 stocks

rose from 58.11 to 92.15, or 58%. Obviously the second group had

proved a better “buy” than the first. But who would have been so

rash as to predict in 1960 that what seemed like a miscellaneous

assortment of all sorts of common stocks would definitely outper-

form the aristocratic “thirty tyrants” of the Dow? All this proves,

we insist, that only rarely can one make dependable predictions

about price changes, absolute or relative.

We shall repeat here without apology—for the warning cannot

be given too often—that the investor cannot hope for better than

average results by buying new offerings, or “hot” issues of any

sort, meaning thereby those recommended for a quick profit.† The

contrary is almost certain to be true in the long run. The defensive

investor must confine himself to the shares of important companies

with a long record of profitable operations and in strong financial

condition. (Any security analyst worth his salt could make up such

→

traded stock in America, roughly 6,700 in all; but, since the largest compa-

nies account for most of the total value of the index, the return of the

Wilshire 5000 is usually quite similar to that of the S & P 500. Several low-

cost mutual funds enable investors to hold the stocks in these indexes as a

single, convenient portfolio. (See Chapter 9.)

* See pp. 363–366 and pp. 376–380.

† For greater detail, see Chapter 6.

The Investment Versus Speculation 29
a list.) Aggressive investors may buy other types of common

stocks, but they should be on a definitely attractive basis as estab-

lished by intelligent analysis.

To conclude this section, let us mention briefly three supplemen-

tary concepts or practices for the defensive investor. The first is the

purchase of the shares of well-established investment funds as an

alternative to creating his own common-stock portfolio. He might

also utilize one of the “common trust funds,” or “commingled

funds,” operated by trust companies and banks in many states; or,

if his funds are substantial, use the services of a recognized invest-

ment-counsel firm. This will give him professional administration

of his investment program along standard lines. The third is the

device of “dollar-cost averaging,” which means simply that the

practitioner invests in common stocks the same number of dollars

each month or each quarter. In this way he buys more shares when

the market is low than when it is high, and he is likely to end up

with a satisfactory overall price for all his holdings. Strictly speak-

ing, this method is an application of a broader approach known as

“formula investing.” The latter was already alluded to in our sug-

gestion that the investor may vary his holdings of common stocks

between the 25% minimum and the 75% maximum, in inverse rela-

tionship to the action of the market. These ideas have merit for the

defensive investor, and they will be discussed more amply in later

chapters.*

Results to Be Expected by the Aggressive Investor

Our enterprising security buyer, of course, will desire and

expect to attain better overall results than his defensive or passive

companion. But first he must make sure that his results will not be

worse. It is no difficult trick to bring a great deal of energy, study,

and native ability into Wall Street and to end up with losses instead

of profits. These virtues, if channeled in the wrong directions,

become indistinguishable from handicaps. Thus it is most essential

that the enterprising investor start with a clear conception as to

→

* For more advice on “well-established investment funds,” see Chapter 9.

“Professional administration” by “a recognized investment-counsel firm” is

discussed in Chapter 10. “Dollar-cost averaging” is explained in Chapter 5.

The Investment Versus Speculation 30
which courses of action offer reasonable chances of success and

which do not.

First let us consider several ways in which investors and specu-

lators generally have endeavored to obtain better than average

results. These include:

1. Trading in the market. This usually means buying stocks

when the market has been advancing and selling them after it has

turned downward. The stocks selected are likely to be among those

which have been “behaving” better than the market average. A

small number of professionals frequently engage in short selling.

Here they will sell issues they do not own but borrow through the

established mechanism of the stock exchanges. Their object is to

benefit from a subsequent decline in the price of these issues, by

buying them back at a price lower than they sold them for. (As our

quotation from the Wall Street Journal on p. 19 indicates, even

“small investors”—perish the term!—sometimes try their unskilled

hand at short selling.)

2. Short-term selectivity. This means buying stocks of compa-

nies which are reporting or expected to report increased earnings,

or for which some other favorable development is anticipated.

3. Long-term selectivity. Here the usual emphasis is on an

excellent record of past growth, which is considered likely to con-

tinue in the future. In some cases also the “investor” may choose

companies which have not yet shown impressive results, but are

expected to establish a high earning power later. (Such companies

belong frequently in some technological area—e.g., computers,

drugs, electronics—and they often are developing new processes

or products that are deemed to be especially promising.)

We have already expressed a negative view about the investor’s

overall chances of success in these areas of activity. The first we

have ruled out, on both theoretical and realistic grounds, from the

domain of investment. Stock trading is not an operation “which, on

thorough analysis, offers safety of principal and a satisfactory

return.” More will be said on stock trading in a later chapter.*

→
* See Chapter 8

The Investment Versus Speculation 31

In his endeavor to select the most promising stocks either for the

near term or the longer future, the investor faces obstacles of two

kinds—the first stemming from human fallibility and the second

from the nature of his competition. He may be wrong in his esti-

mate of the future; or even if he is right, the current market price

may already fully reflect what he is anticipating. In the area of

near-term selectivity, the current year’s results of the company are

generally common property on Wall Street; next year’s results, to

the extent they are predictable, are already being carefully consid-

ered. Hence the investor who selects issues chiefly on the basis of

this year’s superior results, or on what he is told he may expect for

next year, is likely to find that others have done the same thing for

the same reason.

In choosing stocks for their long-term prospects, the investor’s

handicaps are basically the same. The possibility of outright error

in the prediction—which we illustrated by our airlines example on

p. 6—is no doubt greater than when dealing with near-term earn-

ings. Because the experts frequently go astray in such forecasts, it is

theoretically possible for an investor to benefit greatly by making

correct predictions when Wall Street as a whole is making incorrect

ones. But that is only theoretical. How many enterprising investors

could count on having the acumen or prophetic gift to beat the pro-

fessional analysts at their favorite game of estimating long-term

future earnings?

We are thus led to the following logical if disconcerting conclu-

sion: To enjoy a reasonable chance for continued better than average

results, the investor must follow policies which are (1) inherently

sound and promising, and (2) not popular on Wall Street.

Are there any such policies available for the enterprising

investor? In theory once again, the answer should be yes; and there

are broad reasons to think that the answer should be affirmative in

practice as well. Everyone knows that speculative stock move-

ments are carried too far in both directions, frequently in the gen-

eral market and at all times in at least some of the individual

issues. Furthermore, a common stock may be undervalued because

of lack of interest or unjustified popular prejudice. We can go fur-

ther and assert that in an astonishingly large proportion of the

trading in common stocks, those engaged therein don’t appear to

know—in polite terms—one part of their anatomy from another. In

this book we shall point out numerous examples of (past) dis-

The Investment Versus Speculation 32
crepancies between price and value. Thus it seems that any intelli-
gent person, with a good head for figures, should have a veritable
picnic on Wall Street, battening off other people’s foolishness. So it
seems, but somehow it doesn’t work out that simply. Buying a neg-
lected and therefore undervalued issue for profit generally proves
a protracted and patience-trying experience. And selling short a
too popular and therefore overvalued issue is apt to be a test not
only of one’s courage and stamina but also of the depth of one’s
pocketbook.* The principle is sound, its successful application is
not impossible, but it is distinctly not an easy art to master.
There is also a fairly wide group of “special situations,” which
over many years could be counted on to bring a nice annual return
of 20% or better, with a minimum of overall risk to those who knew
their way around in this field. They include intersecurity arbi-
trages, payouts or workouts in liquidations, protected hedges of
certain kinds. The most typical case is a projected merger or acqui-
sition which offers a substantially higher value for certain shares
than their price on the date of the announcement. The number of
such deals increased greatly in recent years, and it should have
been a highly profitable period for the cognoscenti. But with the
multiplication of merger announcements came a multiplication of
obstacles to mergers and of deals that didn’t go through; quite a
few individual losses were thus realized in these once-reliable
operations. Perhaps, too, the overall rate of profit was diminished
by too much competition.†

* In “selling short” (or “shorting”) a stock, you make a bet that its share
price will go down, not up. Shorting is a three-step process: First, you bo-
rrow shares from someone who owns them; then you immediately sell the
borrowed shares; finally, you replace them with shares you buy later. If the
stock drops, you will be able to buy your replacement shares at a lower
price. The difference between the price at which you sold your borrowed
shares and the price you paid for the replacement shares is your gross profit
(reduced by dividend or interest charges, along with brokerage costs). How-
ever, if the stock goes up in price instead of down, your potential loss is
unlimited—making short sales unacceptably speculative for most individual
investors.
† In the late 1980s, as hostile corporate takeovers and leveraged buyouts
multiplied, Wall Street set up institutional arbitrage desks to profit from any

The Investment Versus Speculation 33
The lessened profitability of these special situations appears one
manifestation of a kind of self-destructive process—akin to the law
of diminishing returns—which has developed during the lifetime
of this book. In 1949 we could present a study of stock-market fluc-
tuations over the preceding 75 years, which supported a formula—
based on earnings and current interest rates—for determining a
level to buy the DJIA below its “central” or “intrinsic” value,
and to sell out above such value. It was an application of the gov-
erning maxim of the Rothschilds: “Buy cheap and sell dear.”* And
it had the advantage of running directly counter to the ingrained
and pernicious maxim of Wall Street that stocks should be bought
because they have gone up and sold because they have gone down.
Alas, after 1949 this formula no longer worked. A second illustra-
tion is provided by the famous “Dow Theory” of stock-market
movements, in a comparison of its indicated splendid results for
1897–1933 and its much more questionable performance since
1934.
A third and final example of the golden opportunities not
recently available: A good part of our own operations on Wall
Street had been concentrated on the purchase of bargain issues ea-
sily identified as such by the fact that they were selling at less than
their share in the net current assets (working capital) alone, not
counting the plant account and other assets, and after deducting all
liabilities ahead of the stock. It is clear that these issues were selling
at a price well below the value of the enterprise as a private busi-
ness. No proprietor or majority holder would think of selling what
he owned at so ridiculously low a figure. Strangely enough, such

→
errors in pricing these complex deals. They became so good at it that
the easy profits disappeared and many of these desks have been closed down.
Although Graham does discuss it again (see pp. 174–175), this sort of trad-
ing is no longer feasible or appropriate for most people, since only multi-
million-dollar trades are large enough to generate worthwhile profits.
Wealthy individuals and institutions can utilize this strategy through hedge
funds that specialize in merger or “event” arbitrage.
* The Rothschild family, led by Nathan Mayer Rothschild, was the dominant
power in European investment banking and brokerage in the nineteenth
century. For a brilliant history, see Niall Ferguson, The House of Rothschild:
Money’s Prophets, 1798–1848 (Viking, 1998).

The Investment Versus Speculation 34
anomalies were not hard to find. In 1957 a list was published show-
ing nearly 200 issues of this type available in the market. In various
ways practically all these bargain issues turned out to be profitable,
and the average annual result proved much more remunerative
than most other investments. But they too virtually disappeared
from the stock market in the next decade, and with them a depend-
able area for shrewd and successful operation by the enterprising
investor. However, at the low prices of 1970 there again appeared a
considerable number of such “sub-working-capital” issues, and
despite the strong recovery of the market, enough of them
remained at the end of the year to make up a full-sized portfolio.
The enterprising investor under today’s conditions still has vari-
ous possibilities of achieving better than average results. The huge
list of marketable securities must include a fair number that can be
identified as undervalued by logical and reasonably dependable
standards. These should yield more satisfactory results on the
average than will the DJIA or any similarly representative list. In
our view the search for these would not be worth the investor’s
effort unless he could hope to add, say, 5% before taxes to the aver-
age annual return from the stock portion of his portfolio. We shall
try to develop one or more such approaches to stock selection for
use by the active investor. 34 The Intelligent Investor.

COMMENTARY ON CHAPTER 1

All of human unhappiness comes from one single thing: not

knowing how to remain at rest in a room.

—Blaise Pascal

Why do you suppose the brokers on the floor of the New York Stock

Exchange always cheer at the sound of the closing bell—no matter

what the market did that day? Because whenever you trade, they

make money—whether you did or not. By speculating instead of invest-

ing, you lower your own odds of building wealth and raise someone

else’s.

Graham’s definition of investing could not be clearer: “An invest-

ment operation is one which, upon thorough analysis, promises safety

of principal and an adequate return.” 1 Note that investing, according to

Graham, consists equally of three elements:

• you must thoroughly analyze a company, and the soundness of its

underlying businesses, before you buy its stock;

• you must deliberately protect yourself against serious losses;

• you must aspire to “adequate,” not extraordinary, performance.

→

1 Graham goes even further, fleshing out each of the key terms in his defini-

tion: “thorough analysis” means “the study of the facts in the light of estab-

lished standards of safety and value” while “safety of principal” signifies

“protection against loss under all normal or reasonably likely conditions or

variations” and “adequate” (or “satisfactory”) return refers to “any rate or

amount of return, however low, which the investor is willing to accept, pro-

vided he acts with reasonable intelligence.” (Security Analysis, 1934 ed.,

pp. 55–56).

Commentary on Chapter 1- 36

An investor calculates what a stock is worth, based on the value of

its businesses. A speculator gambles that a stock will go up in price

because somebody else will pay even more for it. As Graham once

put it, investors judge “the market price by established standards of

value,” while speculators “base [their] standards of value upon the

market price.” 2 For a speculator, the incessant stream of stock quotes

is like oxygen; cut it off and he dies. For an investor, what Graham

called “quotational” values matter much less. Graham urges you to

invest only if you would be comfortable owning a stock even if you had

no way of knowing its daily share price.3

Like casino gambling or betting on the horses, speculating in the

market can be exciting or even rewarding (if you happen to get lucky).

But it’s the worst imaginable way to build your wealth. That’s because

Wall Street, like Las Vegas or the racetrack, has calibrated the odds

so that the house always prevails, in the end, against everyone who

tries to beat the house at its own speculative game.

On the other hand, investing is a unique kind of casino—one where

you cannot lose in the end, so long as you play only by the rules that

put the odds squarely in your favor. People who invest make money for

themselves; people who speculate make money for their brokers. And

that, in turn, is why Wall Street perennially downplays the durable

virtues of investing and hypes the gaudy appeal of speculation.

UNSAFE AT HIGH SPEED

Confusing speculation with investment, Graham warns, is always a

mistake. In the 1990s, that confusion led to mass destruction. Almost

everyone, it seems, ran out of patience at once, and America became

the Speculation Nation, populated with traders who went shooting

from stock to stock like grasshoppers whizzing around in an August

hay field.

People began believing that the test of an investment technique

was simply whether it “worked.” If they beat the market over any

→

2 Security Analysis, 1934 ed., p. 310.

3 As Graham advised in an interview, “Ask yourself: If there was no market

for these shares, would I be willing to have an investment in this company on

these terms?” (Forbes, January 1, 1972, p. 90.)

Commentary on Chapter 1- 37

period, no matter how dangerous or dumb their tactics, people

boasted that they were “right.” But the intelligent investor has no inter-

est in being temporarily right. To reach your long-term financial goals,

you must be sustainably and reliably right. The techniques that

became so trendy in the 1990s—day trading, ignoring diversification,

flipping hot mutual funds, following stock-picking “systems”—seemed

to work. But they had no chance of prevailing in the long run, because

they failed to meet all three of Graham’s criteria for investing.

To see why temporarily high returns don’t prove anything, imagine

that two places are 130 miles apart. If I observe the 65-mph speed

limit, I can drive that distance in two hours. But if I drive 130 mph, I

can get there in one hour. If I try this and survive, am I “right”? Should

you be tempted to try it, too, because you hear me bragging that it

“worked”? Flashy gimmicks for beating the market are much the

same: In short streaks, so long as your luck holds out, they work. Over

time, they will get you killed.

In 1973, when Graham last revised The Intelligent Investor, the

annual turnover rate on the New York Stock Exchange was 20%,

meaning that the typical shareholder held a stock for five years before

selling it. By 2002, the turnover rate had hit 105%—a holding period of

only 11.4 months. Back in 1973, the average mutual fund held on to a

stock for nearly three years; by 2002, that ownership period had

shrunk to just 10.9 months. It’s as if mutual-fund managers were

studying their stocks just long enough to learn they shouldn’t have

bought them in the first place, then promptly dumping them and start-

ing all over.

Even the most respected money-management firms got antsy. In

early 1995, Jeffrey Vinik, manager of Fidelity Magellan (then the

world’s largest mutual fund), had 42.5% of its assets in technology

stocks. Vinik proclaimed that most of his shareholders “have invested

in the fund for goals that are years away. . . . I think their objectives are

the same as mine, and that they believe, as I do, that a long-term

approach is best.” But six months after he wrote those high-minded

words, Vinik sold off almost all his technology shares, unloading nearly

$19 billion worth in eight frenzied weeks. So much for the “long term”!

And by 1999, Fidelity’s discount brokerage division was egging on its

clients to trade anywhere, anytime, using a Palm handheld computer—

which was perfectly in tune with the firm’s new slogan, “Every second

counts.”

Commentary on Chapter 1- 38

FIGURE 1-1

And on the NASDAQ exchange, turnover hit warp speed, as Fig-

ure 1-1 shows.4

In 1999, shares in Puma Technology, for instance, changed hands

an average of once every 5.7 days. Despite NASDAQ’s grandiose

motto—“The Stock Market for the Next Hundred Years”—many of its

customers could barely hold on to a stock for a hundred hours.

THE FINANCIAL VIDEO GAME

Wall Street made online trading sound like an instant way to mint

money: Discover Brokerage, the online arm of the venerable firm of

→

4 Source: Steve Galbraith, Sanford C. Bernstein & Co. research report, Jan-

uary 10, 2000. The stocks in this table had an average return of 1196.4% in

1999. They lost an average of 79.1% in 2000, 35.5% in 2001, and 44.5%

in 2002—destroying all the gains of 1999, and then some.

Commentary on Chapter 1- 39

Morgan Stanley, ran a TV commercial in which a scruffy tow-truck

driver picks up a prosperous-looking executive. Spotting a photo of a

tropical beachfront posted on the dashboard, the executive asks,

“Vacation?” “Actually,” replies the driver, “that’s my home.” Taken

aback, the suit says, “Looks like an island.” With quiet triumph, the

driver answers, “Technically, it’s a country.”

The propaganda went further. Online trading would take no work

and require no thought. A television ad from Ameritrade, the online

broker, showed two housewives just back from jogging; one logs on

to her computer, clicks the mouse a few times, and exults, “I think I just

made about $1,700!” In a TV commercial for the Waterhouse broker-

age firm, someone asked basketball coach Phil Jackson, “You know

anything about the trade?” His answer: “I’m going to make it right

now.” (How many games would Jackson’s NBA teams have won if he

had brought that philosophy to courtside? Somehow, knowing noth-

ing about the other team, but saying, “I’m ready to play them right

now,” doesn’t sound like a championship formula.)

By 1999 at least six million people were trading online—and roughly

a tenth of them were “day trading,” using the Internet to buy and sell

stocks at lightning speed. Everyone from showbiz diva Barbra

Streisand to Nicholas Birbas, a 25-year-old former waiter in Queens,

New York, was flinging stocks around like live coals. “Before,” scoffed

Birbas, “I was investing for the long term and I found out that it was not

smart.” Now, Birbas traded stocks up to 10 times a day and expected

to earn $100,000 in a year. “I can’t stand to see red in my profit-or-loss

column,” Streisand shuddered in an interview with Fortune. “I’m Taurus

the bull, so I react to red. If I see red, I sell my stocks quickly.” 5

By pouring continuous data about stocks into bars and barber-

shops, kitchens and cafés, taxicabs and truck stops, financial web-

sites and financial TV turned the stock market into a nonstop national

video game. The public felt more knowledgeable about the markets

than ever before. Unfortunately, while people were drowning in data,

knowledge was nowhere to be found. Stocks became entirely decou-

→

5 Instead of stargazing, Streisand should have been channeling Graham.

The intelligent investor never dumps a stock purely because its share price

has fallen; she always asks first whether the value of the company’s underly-

ing businesses has changed.

Commentary on Chapter 1- 40

pled from the companies that had issued them—pure abstractions, just

blips moving across a TV or computer screen. If the blips were moving

up, nothing else mattered.

On December 20, 1999, Juno Online Services unveiled a trailblaz-

ing business plan: to lose as much money as possible, on purpose.

Juno announced that it would henceforth offer all its retail services for

free—no charge for e-mail, no charge for Internet access—and that it

would spend millions of dollars more on advertising over the next year.

On this declaration of corporate hara-kiri, Juno’s stock roared up from

$16.375 to $66.75 in two days.6

Why bother learning whether a business was profitable, or what

goods or services a company produced, or who its management was,

or even what the company’s name was? All you needed to know

about stocks was the catchy code of their ticker symbols: CBLT, INKT,

PCLN, TGLO, VRSN, WBVN.7 That way you could buy them even

faster, without the pesky two-second delay of looking them up on an

Internet search engine. In late 1998, the stock of a tiny, rarely traded

building-maintenance company, Temco Services, nearly tripled in a

matter of minutes on record-high volume. Why? In a bizarre form of

financial dyslexia, thousands of traders bought Temco after mistaking

its ticker symbol, TMCO, for that of Ticketmaster Online (TMCS), an

Internet darling whose stock began trading publicly for the first time

that day.8

Oscar Wilde joked that a cynic “knows the price of everything, and

the value of nothing.” Under that definition, the stock market is always

cynical, but by the late 1990s it would have shocked Oscar himself. A

single half-baked opinion on price could double a company’s stock

even as its value went entirely unexamined. In late 1998, Henry Blod-

get, an analyst at CIBC Oppenheimer, warned that “as with all Inter-

net stocks, a valuation is clearly more art than science.” Then, citing

only the possibility of future growth, he jacked up his “price target” on

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6 Just 12 months later, Juno’s shares had shriveled to $1.093.

7 A ticker symbol is an abbreviation, usually one to four letters long, of a

company’s name used as shorthand to identify a stock for trading purposes.

8 This was not an isolated incident; on at least three other occasions in the

late 1990s, day traders sent the wrong stock soaring when they mistook its

ticker symbol for that of a newly minted Internet company.

Commentary on Chapter 1- 41

Amazon.com from $150 to $400 in one fell swoop. Amazon.com shot

up 19% that day and—despite Blodget’s protest that his price target

was a one-year forecast—soared past $400 in just three weeks. A year

later, PaineWebber analyst Walter Piecyk predicted that Qualcomm

stock would hit $1,000 a share over the next 12 months. The stock—

already up 1,842% that year—soared another 31% that day, hitting

$659 a share.9

FROM FORMULA TO FIASCO

But trading as if your underpants are on fire is not the only form of

speculation. Throughout the past decade or so, one speculative for-

mula after another was promoted, popularized, and then thrown aside.

All of them shared a few traits—This is quick! This is easy! And it won’t

hurt a bit!—and all of them violated at least one of Graham’s distinc-

tions between investing and speculating. Here are a few of the trendy

formulas that fell flat:

• Cash in on the calendar. The “January effect”—the tendency of

small stocks to produce big gains around the turn of the year—

was widely promoted in scholarly articles and popular books pub-

lished in the 1980s. These studies showed that if you piled into

small stocks in the second half of December and held them into

January, you would beat the market by five to 10 percentage

points. That amazed many experts. After all, if it were this easy,

surely everyone would hear about it, lots of people would do it,

and the opportunity would wither away.

What caused the January jolt? First of all, many investors sell

their crummiest stocks late in the year to lock in losses that can

cut their tax bills. Second, professional money managers grow

more cautious as the year draws to a close, seeking to preserve

their outperformance (or minimize their underperformance). That

makes them reluctant to buy (or even hang on to) a falling stock.

And if an underperforming stock is also small and obscure, a

money manager will be even less eager to show it in his year-end

→

9 In 2000 and 2001, Amazon.com and Qualcomm lost a cumulative total of

85.8% and 71.3% of their value, respectively.

Commentary on Chapter 1- 42

list of holdings. All these factors turn small stocks into momentary

bargains; when the tax-driven selling ceases in January, they typi-

cally bounce back, producing a robust and rapid gain.

The January effect has not withered away, but it has weakened.

According to finance professor William Schwert of the University of

Rochester, if you had bought small stocks in late December and

sold them in early January, you would have beaten the market by 8.5

percentage points from 1962 through 1979, by 4.4 points from

1980 through 1989, and by 5.8 points from 1990 through 2001.10

As more people learned about the January effect, more traders

bought small stocks in December, making them less of a bargain

and thus reducing their returns. Also, the January effect is biggest

among the smallest stocks—but according to Plexus Group, the

leading authority on brokerage expenses, the total cost of buying

and selling such tiny stocks can run up to 8% of your investment.

11 Sadly, by the time you’re done paying your broker, all your

gains on the January effect will melt away.

• Just do “what works.” In 1996, an obscure money manager

named James O’Shaughnessy published a book called What

Works on Wall Street. In it, he argued that “investors can do

much better than the market.” O’Shaughnessy made a stunning

claim: From 1954 through 1994, you could have turned $10,000

into $8,074,504, beating the market by more than 10-fold—a tow-

ering 18.2% average annual return. How? By buying a basket of

50 stocks with the highest one-year returns, five straight years of

rising earnings, and share prices less than 1.5 times their corpo-

rate revenues.12 As if he were the Edison of Wall Street,

O’Shaughnessy obtained U.S. Patent No. 5,978,778 for his “auto-

mated strategies” and launched a group of four mutual funds

based on his findings. By late 1999 the funds had sucked in more

than $175 million from the public—and, in his annual letter to

shareholders, O’Shaughnessy stated grandly: “As always, I hope

→

10 Schwert discusses these findings in a brilliant research paper, “Anomalies and

Market Efficiency,” available at http://schwert.ssb.rochester.edu/papers.htm.

11 See Plexus Group Commentary 54, “The Official Icebergs of Transaction

Costs,” January, 1998, at www.plexusgroup.com/fs_research.html.

12 James O’Shaughnessy, What Works on Wall Street (McGraw-Hill, 1996),

pp. xvi, 273–295.

Commentary on Chapter 1- 43

that together, we can reach our long-term goals by staying the

course and sticking with our time-tested investment strategies.”

But “what works on Wall Street” stopped working right after

O’Shaughnessy publicized it. As Figure 1-2 shows, two of his

funds stank so badly that they shut down in early 2000, and the

FIGURE 1-2

Commentary on Chapter 1- 44

overall stock market (as measured by the S & P 500 index) wal-

loped every O’Shaughnessy fund almost nonstop for nearly four

years running.

In June 2000, O’Shaughnessy moved closer to his own “long-

term goals” by turning the funds over to a new manager, leaving

his customers to fend for themselves with those “time-tested

investment strategies.” 13 O’Shaughnessy’s shareholders might

have been less upset if he had given his book a more precise

title—for instance, What Used to Work on Wall Street . . . Until I

Wrote This Book.

• Follow “The Foolish Four.” In the mid-1990s, the Motley Fool

website (and several books) hyped the daylights out of a tech-

nique called “The Foolish Four.” According to the Motley Fool, you

would have “trashed the market averages over the last 25 years”

and could “crush your mutual funds” by spending “only 15 minutes

a year” on planning your investments. Best of all, this technique had

“minimal risk.” All you needed to do was this:

1. Take the five stocks in the Dow Jones Industrial Average with

the lowest stock prices and highest dividend yields.

2. Discard the one with the lowest price.

3. Put 40% of your money in the stock with the second-lowest

price.

4. Put 20% in each of the three remaining stocks.

5. One year later, sort the Dow the same way and reset the

portfolio according to steps 1 through 4.

6. Repeat until wealthy.

Over a 25-year period, the Motley Fool claimed, this technique

would have beaten the market by a remarkable 10.1 percentage

→

13 In a remarkable irony, the surviving two O’Shaughnessy funds (now

known as the Hennessy funds) began performing quite well just as

O’Shaughnessy announced that he was turning over the management to

another company. The funds’ shareholders were furious. In a chat room at

www.morningstar.com, one fumed: “I guess ‘long term’ for O’S is 3 years.

. . . I feel your pain. I, too, had faith in O’S’s method. . . . I had told several

friends and relatives about this fund, and now am glad they didn’t act on my

advice.”

Commentary on Chapter 1- 45

points annually. Over the next two decades, they suggested,

$20,000 invested in The Foolish Four should flower into

$1,791,000. (And, they claimed, you could do still better by pick-

ing the five Dow stocks with the highest ratio of dividend yield to

the square root of stock price, dropping the one that scored the

highest, and buying the next four.)

Let’s consider whether this “strategy” could meet Graham’s

definitions of an investment:

• What kind of “thorough analysis” could justify discarding the

stock with the single most attractive price and dividend—but

keeping the four that score lower for those desirable qualities?

• How could putting 40% of your money into only one stock be a

“minimal risk”?

• And how could a portfolio of only four stocks be diversified

enough to provide “safety of principal”?

The Foolish Four, in short, was one of the most cockamamie

stock-picking formulas ever concocted. The Fools made the same

mistake as O’Shaughnessy: If you look at a large quantity of data

long enough, a huge number of patterns will emerge—if only by

chance. By random luck alone, the companies that produce

above-average stock returns will have plenty of things in common.

But unless those factors cause the stocks to outperform, they

can’t be used to predict future returns.

None of the factors that the Motley Fools “discovered” with

such fanfare—dropping the stock with the best score, doubling up

on the one with the second-highest score, dividing the dividend

yield by the square root of stock price—could possibly cause or

explain the future performance of a stock. Money Magazine found

that a portfolio made up of stocks whose names contained no

repeating letters would have performed nearly as well as The

Foolish Four—and for the same reason: luck alone.14 As Graham

never stops reminding us, stocks do well or poorly in the future

because the businesses behind them do well or poorly—nothing

more, and nothing less.

→

14 See Jason Zweig, “False Profits,” Money, August, 1999, pp. 55–57. A

thorough discussion of The Foolish Four can also be found at www.investor

home.com/fool.htm.

Commentary on Chapter 1- 46

Sure enough, instead of crushing the market, The Foolish Four

crushed the thousands of people who were fooled into believing

that it was a form of investing. In 2000 alone, the four Foolish

stocks—Caterpillar, Eastman Kodak, SBC, and General Motors—

lost 14% while the Dow dropped by just 4.7%.

As these examples show, there’s only one thing that never suffers a

bear market on Wall Street: dopey ideas. Each of these so-called

investing approaches fell prey to Graham’s Law. All mechanical formu-

las for earning higher stock performance are “a kind of self-destructive

process—akin to the law of diminishing returns.” There are two reasons

the returns fade away. If the formula was just based on random statis-

tical flukes (like The Foolish Four), the mere passage of time will

expose that it made no sense in the first place. On the other hand, if

the formula actually did work in the past (like the January effect), then

by publicizing it, market pundits always erode—and usually eliminate—

its ability to do so in the future.

All this reinforces Graham’s warning that you must treat specula-

tion as veteran gamblers treat their trips to the casino:

• You must never delude yourself into thinking that you’re investing

when you’re speculating.

• Speculating becomes mortally dangerous the moment you begin

to take it seriously.

• You must put strict limits on the amount you are willing to wager.

Just as sensible gamblers take, say, $100 down to the casino floor

and leave the rest of their money locked in the safe in their hotel room,

the intelligent investor designates a tiny portion of her total portfolio as

a “mad money” account. For most of us, 10% of our overall wealth is

the maximum permissible amount to put at speculative risk. Never min-

gle the money in your speculative account with what’s in your invest-

ment accounts; never allow your speculative thinking to spill over into

your investing activities; and never put more than 10% of your assets

into your mad money account, no matter what happens.

For better or worse, the gambling instinct is part of human nature—

so it’s futile for most people even to try suppressing it. But you must

confine and restrain it. That’s the single best way to make sure you will

never fool yourself into confusing speculation with investment.

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