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

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

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.

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 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.

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.

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.

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 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.

All of human unhappiness comes from one single thing: not

knowing how to remain at rest in a room.

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

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.

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.

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 mingle the money
in your speculative account with what’s in your investment 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.

It must be evident to the reader that we have no enthusiasm for

common stocks at these levels (892 for the DJIA). For reasons
already given we feel that the defensive investor cannot afford to
be without an appreciable proportion of common stocks in his
portfolio, even if we regard them as the lesser of two evils—the
greater being the risks in an all-bond holding.

Americans are getting stronger. Twenty years ago, it took two

people to carry ten dollars’ worth of groceries. Today, a fiveyear-old can do it.

You’ve got to be careful if you don’t know where you’re going,

’cause you might not get there.

The heart of Graham’s argument is that the intelligent investor must

never forecast the future exclusively by extrapolating the past.

The rate of return sought should be dependent, rather, on the amount of intelligent
effort the investor is willing and able to bring to bear on his task.

We have suggested as a fundamental guiding rule that the

investor should never have less than 25% or more than 75% of his
funds in common stocks, with a consequent inverse range of
between 75% and 25% in bonds. There is an implication here that
the standard division should be an equal one, or 50–50, between
the two major investment mediums.

1. There should be adequate though not excessive diversification. This might mean a
minimum of ten different issues and a
maximum of about thirty.†
2. Each company selected should be large, prominent, and conservatively financed.
Indefinite as these adjectives must be, their
general sense is clear. Observations on this point are added at the
end of the chapter.
3. Each company should have a long record of continuous dividend payments. (All the
issues in the Dow Jones Industrial Average met this dividend requirement in 1971.)
To be specific on this
point we would suggest the requirement of continuous dividend
payments beginning at least in 1950.*
4. The investor should impose some limit on the price he will
pay for an issue in relation to its average earnings over, say, the
past seven years. We suggest that this limit be set at 25 times such
average earnings, and not more than 20 times those of the last
twelve-month period. But such a restriction would eliminate
nearly all the strongest and most popular companies from the portfolio. In
particular, it would ban virtually the entire category of
“growth stocks,” which have for some years past been the favorites
of both speculators and institutional investors. We must give our
reasons for proposing so drastic an exclusion

Graham’s guideline of owning

between 10 and 30 stocks remains a good starting point for investors
who want to pick their own stocks, but you must make sure that you
are not overexposed to one industry.

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