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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 individual, nonprofessional investor.

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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 individual,
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 promises
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 authority
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:
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 irrelevant
to point out that when the 1962 article appeared the market
had already experienced a decline of major size, and was now getting
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 contradiction
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
Investment versus Speculation 19
* 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,
(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 levels
as judged by past experience later transformed them into “investments,”
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 institution
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 embarrassment
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 commitments—
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 representative
common stocks—in the sense that one can always wait to
buy them at a price that involves no risk of a market or “quotational”
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 psychologically
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.
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 substantial
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 seriously
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
Investment versus Speculation 21
* 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 eliminated)
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.
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 interested
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 taxable
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 underlying
value (and in the “normal market price”) of a representative
stock list of about the same amount, giving a return from dividends
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 averaged
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 market
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
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.
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 conditions,
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 current
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 various
companies of a corresponding amount annually out of undistributed
profits. On a before-tax basis the combined return of his
stocks would then average, say, 7.5%, somewhat less than his interest
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 follows
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.)
of the fact that the interest and principal payments on good bonds
are much better protected and therefore more certain than the dividends
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 significantly
in favor of stocks.
But of course we cannot be certain that bonds will work out better
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 justify
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 considerations,
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.)
for defensive investors—namely that at all times they have a significant
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 minimum
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 Average.
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 companies
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 major point here is that the defensive investor’s overall results
are not likely to be decisively different from one diversified or representative
list than from another, or—more accurately—that neither
he nor his advisers could predict with certainty whatever
differences would ultimately develop. It is true that the art of skillful
or shrewd investment is supposed to lie particularly in the
selection of issues that will give better results than the general market.
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 performance.*
(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 outperform
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 companies
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 lowcost
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.
a list.) Aggressive investors may buy other types of common
stocks, but they should be on a definitely attractive basis as established
by intelligent analysis.
To conclude this section, let us mention briefly three supplementary
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 investment-
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 speaking,
this method is an application of a broader approach known as
“formula investing.” The latter was already alluded to in our suggestion
that the investor may vary his holdings of common stocks
between the 25% minimum and the 75% maximum, in inverse relationship
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
Investment versus Speculation 29
* 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.
which courses of action offer reasonable chances of success and
which do not.
First let us consider several ways in which investors and speculators
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 companies
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 continue
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.*

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