FILLING IN THE POTHOLES

As the financial markets heave and crash their way up and down day after day, the defensive investor can take control of the chaos. Your very refusal to be active, your renunciation of any pretended ability to predict the future, can become your most powerful weapons. By putting every investment decision on autopilot, you drop any self-delusion that you know where stocks are headed, and you take away the market’s power to upset you no matter how bizarrely it bounces.
As Graham notes, “dollar-cost averaging” enables you to put a fixed amount of money into an investment at regular intervals. Every week, month, or calendar quarter, you buy more—whether the markets have gone (or are about to go) up, down, or sideways. Any major mutual fund company or brokerage firm can automatically and safely transfer the money electronically for you, so you never have to write a check or feel the conscious pang of payment. It’s all out of sight, out of mind.
The ideal way to dollar-cost average is into a portfolio of index funds, which own every stock or bond worth having. That way, you renounce not only the guessing game of where the market is going but which sectors of the market—and which particular stocks or bonds within them—will do the best.
Let’s say you can spare $500 a month. By owning and dollar-cost averaging into just three index funds—$300 into one that holds the total U.S. stock market, $100 into one that holds foreign stocks, and $100 into one that holds U.S. bonds—you can ensure that you own almost every investment on the planet that’s worth owning. Every month, like clockwork, you buy more. If the market has dropped, your preset amount goes further, buying you more shares than the month before. If the market has gone up, then your money buys you fewer shares. By putting your portfolio on permanent autopilot this way, you prevent yourself from either flinging money at the market just when it is seems most alluring (and is actually most dangerous) or refusing to buy more after a market crash has made investments truly cheaper (but seemingly more “risky”).
According to Ibbotson Associates, the leading financial research firm, if you had invested $12,000 in the Standard & Poor’s 500-stock index at the beginning of September 1929, 10 years later you would have had only $7,223 left. But if you had started with a paltry $100 and simply invested another $100 every single month, then by August 1939, your money would have grown to $15,571! That’s the power of disciplined buying—even in the face of the Great Depression and the worst bear market of all time.
Figure 5-1 shows the magic of dollar-cost averaging in a more recent bear market.
Best of all, once you build a permanent autopilot portfolio with index funds as its heart and core, you’ll be able to answer every market question with the most powerful response a defensive investor could ever have: “I don’t know and I don’t care.” If someone asks whether bonds will outperform stocks, just answer, “I don’t know and I don’t care”—after all, you’re automatically buying both. Will health-care stocks make high-tech stocks look sick? “I don’t know and I don’t
care”—you’re a permanent owner of both. What’s the next Microsoft?
“I don’t know and I don’t care”—as soon as it’s big enough to own, your index fund will have it, and you’ll go along for the ride. Will foreign stocks beat U.S. stocks next year? “I don’t know and I don’t care”—if they do, you’ll capture that gain; if they don’t, you’ll get to buy more at lower prices.
By enabling you to say “I don’t know and I don’t care,” a permanent autopilot portfolio liberates you from the feeling that you need to forecast what the financial markets are about to do—and the illusion that anyone else can. The knowledge of how little you can know about the future, coupled with the acceptance of your ignorance, is a defensive investor’s most powerful weapon.

From the end of 1999 through the end of 2002, the S & P 500-stock average fell
relentlessly. But if you had opened an index-fund account with a $3,000 minimum investment and added $100 every month, your total outlay of $6,600 would have lost 30.2%—considerably less than the 41.3% plunge in the market.
Better yet, your steady buying at lower prices would build the base for an explo-
sive recovery when the market rebounds.

The Bond Component

The choice of issues in the bond component of the investor’s portfolio will turn about two main questions: Should he buy taxable or tax-free bonds, and should he buy shorter- or longer-term maturities? The tax decision should be mainly a matter of arithmetic, turning on the difference in yields as compared with the
investor’s tax bracket. In January 1972 the choice in 20-year maturities was between obtaining, say, 71⁄ 2% on “grade Aa” corporate bonds and 5.3% on prime tax-free issues. (The term “municipals” is generally applied to all species of tax-exempt bonds, including state obligations.) There was thus for this maturity a loss in income of some 30% in passing from the corporate to the municipal field.
Hence if the investor was in a maximum tax bracket higher than 30% he would have a net saving after taxes by choosing the municipal bonds; the opposite, if his maximum tax was less than 30%. A single person starts paying a 30% rate when his income after deductions passes $10,000; for a married couple the rate applies when combined taxable income passes $20,000. It is evident that a
large proportion of individual investors would obtain a higher return after taxes from good municipals than from good corporate bonds.
The choice of longer versus shorter maturities involves quite a different question, viz.: Does the investor want to assure himself against a decline in the price of his bonds, but at the cost of (1) a lower annual yield and (2) loss of the possibility of an appreciable gain in principal value? For a period of many years in the past the only sensible bond purchases for individuals were the U.S. savings issues. Their safety was—and is—unquestioned; they gave a higher return than other bond investments of first quality; they had a money-back option and other privileges which added greatly to their attractiveness. In our earlier editions we had an entire chapter entitled “U.S. Savings Bonds: A Boon to Investors.”
As we shall point out, U.S. savings bonds still possess certain unique merits that make them a suitable purchase by any individual investor. For the man of modest capital—with, say, not more than $10,000 to put into bonds—we think they are still the easiest and the best choice. But those with larger funds may find other
mediums more desirable.
Let us list a few major types of bonds that deserve investor consideration, and discuss them briefly with respect to general description, safety, yield, market price, risk, income-tax status, and other features.
1. u.s. savings bonds, series e and series h. We shall first summarize their important provisions, and then discuss briefly the numerous advantages of these unique, attractive, and exceedingly convenient investments. The Series H bonds pay interest semiannually, as do other bonds. The rate is 4.29% for the first year, and then a flat 5.10% for the next nine years to maturity. Interest on the Series E bonds is not paid out, but accrues to the holder through increase in redemption value. The bonds are sold at 75% of their face value, and mature at 100% in 5 years 10 months after purchase. If held to maturity the yield works out at 5%, compounded semiannually. If redeemed earlier, the yield moves up from a minimum of 4.01% in the first year to an average of 5.20% in the next 45⁄ 6 years.
Interest on the bonds is subject to Federal income tax, but is exempt from state income tax. However, Federal income tax on the Series E bonds may be paid at the holder’s option either annually as the interest accrues (through higher redemption value), or not until the bond is actually disposed of.
Owners of Series E bonds may cash them in at any time (shortly after purchase) at their current redemption value. Holders of Series H bonds have similar rights to cash them in at par value (cost).
Series E bonds are exchangeable for Series H bonds, with certain tax advantages. Bonds lost, destroyed, or stolen may be replaced without cost. There are limitations on annual purchases, but liberal provisions for co-ownership by family members make it possible for most investors to buy as many as they can afford.
There is no other investment that combines (1) absolute assurance of principal and interest payments, (2) the right to demand full “money back” at any time, and (3) guarantee of at least a 5% interest rate for at least ten years. Holders of the earlier issues of Series E bonds have had the right to extend their bonds at maturity, and thus to continue to accumulate annual values at successively
higher rates. The deferral of income-tax payments over these long periods has been of great dollar advantage; we calculate it has increased the effective net-after-tax rate received by as much as a third in typical cases. Conversely, the right to cash in the bonds at cost price or better has given the purchasers in former years of low interest rates complete protection against the shrinkage in principal value that befell many bond investors; otherwise stated, it gave
them the possibility of benefiting from the rise in interest rates by switching their low-interest holdings into very-high-coupon issues on an even-money basis.
In our view the special advantages enjoyed by owners of savings bonds now will more than compensate for their lower current return as compared with other direct government obligations.
2. other united states bonds. A profusion of these issues exists, covering a wide variety of coupon rates and maturity dates. All of them are completely safe with respect to payment of interest and principal. They are subject to Federal income taxes but free from state income tax. In late 1971 the long-term issues—over ten years— showed an average yield of 6.09%, intermediate issues (three to five years) returned 6.35%, and short issues returned 6.03%.
In 1970 it was possible to buy a number of old issues at large discounts. Some of these are accepted at par in settlement of estate taxes. Example: The U.S. Treasury 31⁄2s due 1990 are in this category; they sold at 60 in 1970, but closed 1970 above 77.
It is interesting to note also that in many cases the indirect obligations of the U.S. government yield appreciably more than its direct obligations of the same maturity. As we write, an offering appears of 7.05% of “Certificates Fully Guaranteed by the Secretary of Transportation of the Department of Transportation of the United States.” The yield was fully 1% more than that on direct obligations of the U.S., maturing the same year (1986). The certificates were actually issued in the name of the Trustees of the Penn Central Transportation Co., but they were sold on the basis of a statement by the U.S. Attorney General that the guarantee “brings into being a general obligation of the United States, backed by its full faith and credit.” Quite a number of indirect obligations of this sort have been assumed by the U.S. government in the past, and all of them have been scrupulously honored.
The reader may wonder why all this hocus-pocus, involving an apparently “personal guarantee” by our Secretary of Transportation, and a higher cost to the taxpayer in the end. The chief reason for the indirection has been the debt limit imposed on government borrowing by the Congress. Apparently guarantees by the government are not regarded as debts—a semantic windfall for
shrewder investors. Perhaps the chief impact of this situation has been the creation of tax-free Housing Authority bonds, enjoying the equivalent of a U.S. guarantee, and virtually the only taxexempt issues that are equivalent to government bonds. Another type of government-backed issues is the recently created New Community Debentures, offered to yield 7.60% in September 1971.
3. state and municipal bonds. These enjoy exemption from Federal income tax. They are also ordinarily free of income tax in the state of issue but not elsewhere. They are either direct obligations of a state or subdivision, or “revenue bonds” dependent for interest payments on receipts from a toll road, bridge, building lease, etc. Not all tax-free bonds are strongly enough protected to justify their purchase by a defensive investor. He may be guided in his selection by the rating given to each issue by Moody’s or Standard & Poor’s. One of three highest ratings by both services—Aaa  (AAA), Aa (AA), or A—should constitute a sufficient indication of adequate safety. The yield on these bonds will vary both with the quality and the maturity, with the shorter maturities giving the lower return. In late 1971 the issues represented in Standard & Poor’s municipal bond index averaged AA in quality rating, 20 years in maturity, and 5.78% in yield. A typical offering of Vineland, N.J., bonds, rated AA for A and gave a yield of only 3% on the one-year maturity, rising to 5.8% to the 1995 and 1996 maturities.
4. corporation bonds. These bonds are subject to both Federal and state tax. In early 1972 those of highest quality yielded 7.19% for a 25-year maturity, as reflected in the published yield of Moody’s Aaa corporate bond index. The so-called lower-medium-grade issues—rated Baa—returned 8.23% for long maturities. In each class shorter-term issues would yield somewhat less than
longer-term obligations.
The above summaries indicate that the average investor has several choices among high-grade bonds. Those in high income-tax brackets can undoubtedly obtain a better net yield from good tax-free issues than from taxable ones. For others the early 1972 range of taxable yield would seem to be from 5.00% on
U.S. savings bonds, with their special options, to about 71⁄2% on high-grade corporate issues.


Higher-Yielding Bond Investments
By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they
expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default. (It is true that bargain opportunities occur fairly often in lower-grade bonds, but these require special study and skill to exploit successfully.)
Perhaps we should add here that the limits imposed by Congress on direct bond issues of the United States have produced at least two sorts of “bargain opportunities” for investors in the purchase of government-backed obligations. One is provided by the tax-exempt “New Housing” issues, and the other by the recently created (taxable) “New Community debentures.” An offering of New Housing issues in July 1971 yielded as high as 5.8%, free from both Federal and state taxes, while an issue of (taxable) New Community debentures sold in September 1971 yielded 7.60%. Both obligations have the “full faith and credit” of the United States government behind them and hence are safe without question.
And—on a net basis—they yield considerably more than ordinary United States bonds.

Savings Deposits in Lieu of Bonds
An investor may now obtain as high an interest rate from a savings deposit in a commercial or savings bank (or from a bank certificate of deposit) as he can from a first-grade bond of short maturity. The interest rate on bank savings accounts may be lowered in the future, but under present conditions they are a suitable substitute for short-term bond investment by the individual.

Convertible Issues
These are discussed in Chapter 16. The price variability of bonds in general is treated in Chapter 8, The Investor and Market Fluctuations.

Call Provisions
In previous editions we had a fairly long discussion of this aspect of bond financing, because it involved a serious but little noticed injustice to the investor. In the typical case bonds were callable fairly soon after issuance, and at modest premiums—say 5%—above the issue price. This meant that during a period of wide fluctuations in the underlying interest rates the investor had to bear the full brunt of unfavorable changes and was deprived of all but a meager participation in favorable ones.
Example: Our standard example has been the issue of American Gas & Electric 100-year 5% debentures, sold to the public at 101 in 1928. Four years later, under near-panic conditions, the price of these good bonds fell to 621⁄2, yielding 8%. By 1946, in a great reversal, bonds of this type could be sold to yield only 3%, and the 5% issue should have been quoted at close to 160. But at that point the company took advantage of the call provision and redeemed the issue at a mere 106.
The call feature in these bond contracts was a thinly disguised instance of “heads I win, tails you lose.” At long last, the bond-buying institutions refused to accept this unfair arrangement; in recent years most long-term high-coupon issues have been protected against redemption for ten years or more after issuance. This still limits their possible price rise, but not inequitably.
In practical terms, we advise the investor in long-term issues to sacrifice a small amount of yield to obtain the assurance of noncallability—say for 20 or 25 years. Similarly, there is an advantage in buying a low-coupon bond* at a discount rather than a high-coupon bond selling at about par and callable in a few years. For the discount—e.g., of a 31⁄ 2% bond at 631 ⁄ 2%, yielding 7.85%—carries
full protection against adverse call action.

The Basic Problem of Bond-Stock Allocation

We have already outlined in briefest form the portfolio policy of the defensive investor. He should divide his funds between highgrade bonds and high-grade common stocks.
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. According to tradition the
sound reason for increasing the percentage in common stocks would be the appearance of the “bargain price” levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgment of the investor the market level has become dangerously high.
These copybook maxims have always been easy to enunciate and always difficult to follow—because they go against that very human nature which produces that excesses of bull and bear markets. It is almost a contradiction in terms to suggest as a feasible policy for the average stockowner that he lighten his holdings when the market advances beyond a certain point and add to them after a corresponding decline. It is because the average man operates, and apparently must operate, in opposite fashion that we have had the great advances and collapses of the past; and—this writer believes—we are likely to have them in the future.
If the division between investment and speculative operations were as clear now as once it was, we might be able to envisage investors as a shrewd, experienced group who sell out to the heedless, hapless speculators at high prices and buy back from them at depressed levels. This picture may have had some verisimilitude in bygone days, but it is hard to identify it with financial developments since 1949. There is no indication that such professional
operations as those of the mutual funds have been conducted in this fashion. The percentage of the portfolio held in equities by the two major types of funds—“balanced” and “common-stock”—has changed very little from year to year. Their selling activities have been largely related to endeavors to switch from less to more promising holdings.
If, as we have long believed, the stock market has lost contact with its old bounds, and if new ones have not yet been established, then we can give the investor no reliable rules by which to reduce his common-stock holdings toward the 25% minimum and rebuild them later to the 75% maximum. We can urge that in general the investor should not have more than one-half in equities unless he
has strong confidence in the soundness of his stock position and is sure that he could view a market decline of the 1969–70 type with equanimity. It is hard for us to see how such strong confidence can be justified at the levels existing in early 1972. Thus we would counsel against a greater than 50% apportionment to common stocks at this time. But, for complementary reasons, it is almost
equally difficult to advise a reduction of the figure well below 50%, unless the investor is disquieted in his own mind about the current market level, and will be satisfied also to limit his participation in any further rise to, say, 25% of his total funds.
We are thus led to put forward for most of our readers what may appear to be an oversimplified 50–50 formula. Under this plan the guiding rule is to maintain as nearly as practicable an equal division between bond and stock holdings. When changes in the market level have raised the common-stock component to, say, 55%, the balance would be restored by a sale of one-eleventh of the stock
portfolio and the transfer of the proceeds to bonds. Conversely, a fall in the common-stock proportion to 45% would call for the use of one-eleventh of the bond fund to buy additional equities.
Yale University followed a somewhat similar plan for a number of years after 1937, but it was geared around a 35% “normal holding” in common stocks. In the early 1950s, however, Yale seems to have given up its once famous formula, and in 1969 held 61% of its portfolio in equities (including some convertibles). (At that time the endowment funds of 71 such institutions, totaling $7.6 billion,
held 60.3% in common stocks.) The Yale example illustrates the almost lethal effect of the great market advance upon the once popular formula approach to investment. Nonetheless we are convinced that our 50–50 version of this approach makes good sense for the defensive investor. It is extremely simple; it aims unquestionably in the right direction; it gives the follower the feeling that he is at least making some moves in response to market developments; most
important of all, it will restrain him from being drawn more and more heavily into common stocks as the market rises to more and more dangerous heights.
Furthermore, a truly conservative investor will be satisfied with the gains shown on half his portfolio in a rising market, while in a severe decline he may derive much solace from reflecting how much better off he is than many of his more venturesome friends. While our proposed 50–50 division is undoubtedly the simplest “all-purpose program” devisable, it may not turn out to be the best
in terms of results achieved. (Of course, no approach, mechanical or otherwise, can be advanced with any assurance that it will work out better than another.) The much larger income return now offered by good bonds than by representative stocks is a potent argument for favoring the bond component. The investor’s choice between 50% or a lower figure in stocks may well rest mainly on his own temperament and attitude. If he can act as a cold-blooded
weigher of the odds, he would be likely to favor the low 25% stock component at this time, with the idea of waiting until the DJIA dividend yield was, say, two-thirds of the bond yield before he would establish his median 50–50 division between bonds and stocks.
Starting from 900 for the DJIA and dividends of $36 on the unit, this would require either a fall in taxable bond yields from 71.2% to about 5.5% without any change in the present return on leading stocks, or a fall in the DJIA to as low as 660 if there is no reduction in bond yields and no increase in dividends. A combination of intermediate changes could produce the same “buying point.” A
program of that kind is not especially complicated; the hard part is to adopt it and to stick to it not to mention the possibility that it may turn out to have been much too conservative.

The Level of Stock Prices in Early 1972

The investor’s portfolio of common stocks will represent a small cross-section of that immense and formidable institution known as the stock market. Prudence suggests that he have an adequate idea of stock-market history, in terms particularly of the major fluctuations in its price level and of the varying relationships between stock prices as a whole and their earnings and dividends. With this background he may be in a position to form some worthwhile
judgment of the attractiveness or dangers of the level of the market as it presents itself at different times. By a coincidence, useful statistical data on prices, earnings, and dividends go back just 100 years, to 1871. (The material is not nearly as full or dependable in the first half-period as in the second, but it will serve.) The first is to show the general manner in which stocks have made their underlying advance through the many cycles of the past century. The second is to view the picture in terms of successive ten-year averages, not only of stock prices but of earnings and dividends as well, to bring out the varying
relationship between the three important factors. With this wealth of material as a background we shall pass to a consideration of the level of stock prices at the beginning of 1972.
The long-term history of the stock market is summarized in two tables and a chart. Table 3-1 sets forth the low and high points of nineteen bear- and bull-market cycles in the past 100 years. We have used two indexes here. The first represents a combination of an early study by the Cowles Commission going back to 1870, which has been spliced on to and continued to date in the well
known Standard & Poor’s composite index of 500 stocks. The second is the even more celebrated Dow Jones Industrial Average (the DJIA, or “the Dow”), which dates back to 1897; it contains 30 companies, of which one is American Telephone & Telegraph and the other 29 are large industrial enterprises.

Chart I, presented by courtesy of Standard & Poor’s, depicts the market fluctuations of its 425-industrial-stock index from 1900 through 1970. (A corresponding chart available for the DJIA will look very much the same.) The reader will note three quite distinct patterns, each covering about a third of the 70 years. The first runs from 1900 to 1924, and shows for the most part a series of rather similar market cycles lasting from three to five years. The annual
advance in this period averaged just about 3%. We move on to the “New Era” bull market, culminating in 1929, with its terrible aftermath of collapse, followed by quite irregular fluctuations until 1949. Comparing the average level of 1949 with that of 1924, we find the annual rate of advance to be a mere 11.2%; hence the close of our second period found the public with no enthusiasm at all for
common stocks. By the rule of opposites the time was ripe for the beginning of the greatest bull market in our history, presented in the last third of our chart. This phenomenon may have reached its culmination in December 1968 at 118 for Standard & Poor’s 425 industrials (and 108 for its 500-stock composite). As Table 3-1 shows, there were fairly important setbacks between 1949 and 1968
(especially in 1956–57 and 1961–62), but the recoveries therefrom were so rapid that they had to be denominated (in the long-accepted semantics) as recessions in a single bull market, rather than as separate market cycles. Between the low level of 162 for “the Dow” in mid-1949 and the high of 995 in early 1966, the
advance had been more than sixfold in 17 years—which is at the average compounded rate of 11% per year, not counting dividends of, say, 31 ⁄ 2% per annum. (The advance for the Standard & Poor’s composite index was somewhat greater than that of the DJIA—actually from 14 to 96.)
These 14% and better returns were documented in 1963, and later, in a much publicized study. It created a natural satisfaction on Wall Street with such fine achievements, and a quite illogical and dangerous conviction that equally marvelous results could be expected for common stocks in the future. Few people seem to have been bothered by the thought that the very extent of the rise might indicate that it had been overdone. The subsequent decline from the 1968 high to the 1970 low was 36% for the Standard & Poor’s composite (and 37% for the DJIA), the largest since the 44% suffered in 1939–1942, which had reflected the perils and uncertainties after Pearl Harbor. In the dramatic manner so characteristic of Wall Street, the low level of May 1970 was followed by a massive and speedy recovery of both averages, and the establishment of a new
all-time high for the Standard & Poor’s industrials in early 1972.
The annual rate of price advance between 1949 and 1970 works out at about 9% for the S & P composite (or the industrial index), using the average figures for both years. That rate of climb was, of course, much greater than for any similar period before 1950. (But in the last decade the rate of advance was much lower—51 ⁄ 4% for the S & P composite index and only the once familiar 3% for the DJIA.)

The record of price movements should be supplemented by corresponding figures for earnings and dividends, in order to provide an overall view of what has happened to our share economy over the ten decades. It is a good deal to expect from the reader that he study all these figures with care, but for some we hope they will be interesting and instructive.
The full decade figures smooth out the year-to-year fluctuations and leave a general picture of persistent growth. Only two of the nine decades after the
first show a decrease in earnings and average prices (in 1891–1900 and 1931–1940), and no decade after 1900 shows a decrease in average dividends. But the rates of growth in all three categories are quite variable. In general the performance since World War II has been superior to that of earlier decades, but the advance in the 1960s was less pronounced than that of the 1950s. Today’s investor cannot tell from this record what percentage gain in earnings dividends and prices he may expect in the next ten years, but it does supply all the encouragement he needs for a consistent policy of common-stock investment.
However, a point should be made here that is not disclosed in our table. The year 1970 was marked by a definite deterioration in the overall earnings posture of our corporations. The rate of profit on invested capital fell to the lowest percentage since the World War years. Equally striking is the fact that a considerable number of companies reported net losses for the year; many became “financially troubled,” and for the first time in three decades there were
quite a few important bankruptcy proceedings. These facts as much as any others have prompted the statement made above that the great boom era may have come to an end in 1969–1970. A striking feature of Table 3-2 is the change in the price/earnings ratios since World War II.† In June 1949 the S&P composite
index sold at only 6.3 times the applicable earnings of the past 12 months; in March 1961 the ratio was 22.9 times. Similarly, the dividend yield on the S & P index had fallen from over 7% in 1949 to only 3.0% in 1961, a contrast heightened by the fact that interest rates on high-grade bonds had meanwhile risen from 2.60% to 4.50%. This is certainly the most remarkable turnabout in the public’s attitude in all stock-market history.
To people of long experience and innate caution the passage from one extreme to another carried a strong warning of trouble ahead. They could not help thinking apprehensively of the 1926–1929 bull market and its tragic aftermath. But these fears have not been confirmed by the event. True, the closing price of the DJIA in 1970 was the same as it was 61⁄2 years earlier, and the much heralded “Soaring Sixties” proved to be mainly a march up a series of high hills and then down again. But nothing has happened either to business or to stock prices that can compare with the bear market and depression of 1929–1932.

HALF A HEDGE

What, then, can the intelligent investor do to guard against inflation?
The standard answer is “buy stocks”—but, as common answers so often are, it is not entirely true.
Figure 2-1 shows, for each year from 1926 through 2002, the relationship between inflation and stock prices.
As you can see, in years when the prices of consumer goods and services fell, as on the left side of the graph, stock returns were terrible—with the market losing up to 43% of its value. When inflation shot above 6%, as in the years on the right end of the graph, stocks also stank. The stock market lost money in eight of the 14 years in which inflation exceeded 6%; the average return for those 14 years was a measly 2.6%.
While mild inflation allows companies to pass the increased costs of their own raw materials on to customers, high inflation wreaks havoc—forcing customers to slash their purchases and depressing activity throughout the economy.
The historical evidence is clear: Since the advent of accurate stock-market data in 1926, there have been 64 five-year periods (i.e., 1926–1930, 1927–1931, 1928–1932, and so on through 1998–2002). In 50 of those 64 five-year periods (or 78% of the time), stocks outpaced inflation. That’s impressive, but imperfect; it means that stocks failed to keep up with inflation about one-fifth of the time.

TWO ACRONYMS TO THE RESCUE
Fortunately, you can bolster your defenses against inflation by branching out beyond stocks. Since Graham last wrote, two inflation-fighters have become widely available to investors:
REITs. Real Estate Investment Trusts, or REITs (pronounced “reets”), are companies that own and collect rent from commercial and residential properties.10 Bundled into real-estate mutual funds, REITs do a decent job of combating inflation. The best choice is Vanguard REIT Index Fund; other relatively low-cost choices include Cohen & Steers Realty Shares, Columbia Real Estate Equity Fund, and Fidelity Real Estate Investment Fund. While a REIT fund is unlikely to be a foolproof inflation-fighter, in the long run it should give
you some defense against the erosion of purchasing power without
hampering your overall returns.
TIPS. Treasury Inflation-Protected Securities, or TIPS, are U.S. government bonds, first issued in 1997, that automatically go up in value when inflation rises. Because the full faith and credit of the United States stands behind them, all Treasury bonds are safe from the risk of default (or nonpayment of interest). But TIPS also guarantee that the value of your investment won’t be eroded by inflation. In one easy package, you insure yourself against financial loss and the
loss of purchasing power.
There is one catch, however. When the value of your TIPS bond rises as inflation heats up, the Internal Revenue Service regards that increase in value as taxable income—even though it is purely a paper gain (unless you sold the bond at its newly higher price). Why does this make sense to the IRS? The intelligent investor will remember the wise words of financial analyst Mark Schweber: “The one question never to ask a bureaucrat is ‘Why?’ ” Because of this exasperating tax complication, TIPS are best suited for a tax-deferred retirement
account like an IRA, Keogh, or 401(k), where they will not jack up your taxable income.
Do not trade them: TIPS can be volatile in the short run, so they work best as a permanent, lifelong holding. For most investors, allocating at least 10% of your retirement assets to TIPS is an intelligent way to keep a portion of your money absolutely safe—and entirely beyond the reach of the long, invisible claws of inflation.

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 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 published 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 list of holdings. All these factors turn small stocks into momentary bargains; when the tax-driven selling ceases in January, they typically 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.
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 towering 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 corporate revenues.12 As if he were the Edison of Wall Street, O’Shaughnessy obtained U.S. Patent No. 5,978,778 for his “automated 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 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 overall stock market (as measured by the S & P 500 index) walloped every O’Shaughnessy fund almost nonstop for nearly four
years running.



 Follow “The Foolish Four”. In the mid-1990s, the Motley Fool website (and several books) hyped the daylights out of a technique 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 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 picking 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. 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.
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 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. 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.
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.

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.
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.”

And on the NASDAQ exchange, turnover hit warp speed, as Figure 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 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 brokerage 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 nothing 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.” By pouring continuous data about stocks into bars and barbershops, 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 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.
On December 20, 1999, Juno Online Services unveiled a trailblazing 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.
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. 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.
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.

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.)
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. 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 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 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 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.

ARE YOU AN INTELLIGENT INVESTOR ?

Now let’s answer a vitally important question. What exactly does Graham 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.” 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. 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, pocketing 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. 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. 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.”

A CHRONICLE OF CALAMITY
Now let’s take a moment to look at some of the major financial developments of the past few years:

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.
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.
Accusations of massive financial fraud at some of the largest and most respected corporations in America, including Enron, Tyco, and Xerox.
The bankruptcies of such once-glistening companies as Conseco, Global Crossing, and WorldCom.
Allegations that accounting firms cooked the books, and even destroyed records, to help their clients mislead the investing public.
Charges that top executives at leading companies siphoned off
hundreds of millions of dollars for their own personal gain.
Proof that security analysts on Wall Street praised stocks publicly
but admitted privately that they were garbage.
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.
A relentless decline in interest rates that has left investors with no attractive alternative to stocks.
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 accomplishments 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.”

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

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 underperform. 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.”
In February 2000, hedge-fund manager James J. Cramer proclaimed 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.” 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.
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.