the intelligent investor

Investment versus Speculation

"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

a good warning

"Those who do not remember the past are condemned to repeat it."

other speculation thigns to consider

* 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!

something else

1 Graham goes even further, fleshing out each of the key terms in his definition: "thorough analysis" means "the study of the facts in the light of established 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, provided he acts with reasonable intelligence." (Security Analysis, 1934 ed., pp. 55-56).

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. hk,j

A CHRONICLE OF CALAMITY'' Now let's take a moment to look at some of the major financial developments 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 Conseco, 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. 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.

part 2

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.*

a thing to remeber by graham

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.

optomistic forcast are wrong

8500 instead of 80000

gaham 1 policy

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.

something to think about

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 easily 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 business. No proprietor or majority holder would think of selling what he owned at so ridiculously low a figure. Strangely enough, such anomalies were not hard to find. In 1957 a list was published showing 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 dependable 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 various 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 average 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.

how to treat spection

All this reinforces Graham's warning that you must treat speculation 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.

part two of commentary 1

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.

the intelligent investor relized

As Graham shows so brilliantly in Chapter 8, this is exactly backwards. 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.

dopey ideas on wall street

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 formulas 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 statistical 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.

ARE YOU 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. math wizards dont make good investors

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 formula 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 distinctions between investing and speculating. Here are a few of the trendy formulas that fell flat: cash on the calendar the motley 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. 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%.

day trading

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 barbershops, kitchens and cafés, taxicabs and truck stops, financial websites 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 decoupled 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.

one inornic thing about people who invest

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 (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 experiencelater transformed them into "investments," and the entire stock-buying public into "investors."

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 period, no matter how dangerous or dumb their tactics, people boasted that they were "right." But the intelligent investor has no interest 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.

even he mot respected firms get antsy

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." right now people are trading stocks faster than ever

part 4

Furthermore, a common stock may be undervalued because of lack of interest or unjustified popular prejudice. We can go further 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 Investment crepancies between price and value. Thus it seems that any intelligent 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 neglected 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.

THE SILVER LINING

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 Securities 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.

part 3

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 estimate 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 considered. 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 earnings. 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 professional analysts at their favorite game of estimating long-term future earnings? We are thus led to the following logical if disconcerting conclusion: 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.

tips on specutation if you think it might work

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 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.

part 2 of this

In this matter, as in so many others in finance, we must base our views of future policy on a knowledge of past experience. Is inflation something new for this country, at least in the serious form it has taken since 1965? If we have seen comparable (or worse) inflations in living experience, what lessons can be learned from them in confronting the inflation of today? Let us start with Table 2-1, a condensed historical tabulation that contains much information about changes in the general price level and concomitant changes in the earnings and market value of common stocks. Our figures will begin with 1915, and thus cover 55 years, presented at fiveyear intervals. (We use 1946 instead of 1945 to avoid the last year of wartime price controls.) we had lots of inflation

inflation

Inflation, and the fight against it, has been very much in the public's mind in recent years. The shrinkage in the purchasing power of the dollar in the past, and particularly the fear (or hope by speculators) of a serious further decline in the future, has greatly influenced the thinking of Wall Street. It is clear that those with a fixed dollar income will suffer when the cost of living advances, and the same applies to a fixed amount of dollar principal. Holders of stocks, on the other hand, have the possibility that a loss of the dollar's purchasing power may be offset by advances in their dividends and the prices of their shares. their dividends and the prices of their shares. On the basis of these undeniable facts many financial authorities have concluded that (1) bonds are an inherently undesirable form of investment, and (2) consequently, common stocks are by their very nature more desirable investments than bonds. We have heard of charitable institutions being advised that their portfolios should consist 100% of stocks and zero percent of bonds.* This is quite a reversal from the earlier days when trust investments were restricted by law to high-grade bonds (and a few choice preferred stocks). Our readers must have enough intelligence to recognize that even high-quality stocks cannot be a better purchase than bonds under all conditions—i.e., regardless of how high the stock market may be and how low the current dividend return compared with the rates available on bonds. A statement of this kind would be as absurd as was the contrary one—too often heard years ago—that any bond is safer than any stock. In this chapter we shall try to apply various measurements to the inflation factor, in order to reach some conclusions as to the extent to which the investor may wisely be influenced by expectations regarding future rises in the price level.

how investors will do spectuation

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.

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: All these so-called experts ignored Graham's sober words of warning: "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 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.

however some notes on spectation

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.

graham on wall street

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 accomplishments elsewhere, on Wall Street it almost invariably leads to disaster." 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' judgments 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 assertion that "the investor's chief problem—and even his worst enemy—is likely to be himself."

4

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 matter how exciting an investment seems to be—can you minimize your odds of error.

ocsar wilde

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 Blodget, an analyst at CIBC Oppenheimer, warned that "as with all Internet stocks, a valuation is clearly more art than science." Then, citing only the possibility of future growth, he jacked up his "price target" on 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

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 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:

what did the crowd do to issac newton

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. how he lost 3 million dollars in the stock market. 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 irrationality. There you can master his lesson that being an intelligent investor is more a matter of "character" than "brain."

what is something that wouldn't surpise graham

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.

chapter 2

The Investor and Inflation

4 part

The answer to these questions is somewhat complicated. Common stocks have indeed done better than bonds over a long period of time in the past. The rise of the DJIA from an average of 77 in 1915 to an average of 753 in 1970 works out at an annual compounded rate of just about 4%, to which we may add another 4% for average dividend return. (The corresponding figures for the S & Pcomposite are about the same.) These combined figures of 8% per year are of course much better than the return enjoyed from bonds over the same 55-year period. But they do not exceed that now offered by high-grade bonds. This brings us to the next logical question: Is there a persuasive reason to believe that common stocks are likely to do much better in future years than they have in the last five and one-half decades? Our answer to this crucial question must be a flat no. Common stocks may do better in the future than in the past, but they are far from certain to do so. We must deal here with two different time elements in investment results. The first covers what is likely to occur over the long-term future—say, the next 25 years. The second applies to what is likely to happen to the investor—both financially and psychologically—over short or intermediate periods, say five years or less. His frame of mind, his hopes and apprehensions, his satisfaction or discontent with what he has done, above all his decisions what to do next, are all determined not in the retrospect of a lifetime of investment but rather by his experience from year to year. On this point we can be categorical. There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices. The obvious example is the recent period, 1966-1970. The rise in the cost of living was 22%, the largest in a five-year period since 1946-1950. But both stock earnings and stock prices as a whole have declined since 1965. There are similar contradictions in both directions in the record of previous five-year periods.

the certainty in stocks

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.

2

The market is a pendulum that forever swings between unsustainable 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.

sepcial situtations

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 arbitrages, payouts or workouts in liquidations, protected hedges of certain kinds. The most typical case is a projected merger or acquisition 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.† 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 fluctuations 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 governing 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 illustration 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.

unsafe at high speed 2

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 starting all over.

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 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."

however even grahams policy has risk .

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.

the part 3

What would be the implications of such an advance? It would eat up, in higher living costs, about one-half the income now obtainable on good medium-term tax-free bonds (or our assumed after-tax equivalent from high-grade corporate bonds). This would be a serious shrinkage, but it should not be exaggerated. It would not mean that the true value, or the purchasing power, of the investor's fortune need be reduced over the years. If he spent half his interest income after taxes he would maintain this buying power intact, even against a 3% annual inflation.

COMMENTARY ON CHAPTER 1

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 investing, you lower your own odds of building wealth and raise someone else's 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: 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.

the investors biggest problem is himself

becuase we can fall into the traps also 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?"

the price of your investments will go down from time to time.

no matter how careful you are,

graham lessons and however

no one can beat the market • 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.

one person that has never made consistent money in the stock market is

the person who spectivtly trades in the stock market, when it is up or when it is down.

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.

this is the true approach

the people who claim 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.

3

• 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

5

• 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 investments behave is much less important than how you behave.