Tuesday, 26 March 2013

Benjamin Graham's Intelligent Investor: The investments the Defensive Investor's should buy and should avoid.

The Defensive Investor’s Portfolio Policy
Those who can not afford to take risks should be content with a relatively low return.  
The rate of return is dependent upon the amount of effort put forth by an investor. 
As previously stated, the defensive investor’s portfolio should consist of no less than 25% high grade bonds and no less than 25% large stocks.
Yet these maxims are difficult to follow, because like the herd of Wall Street, when the market has been advancing, the temptation is strong to bet heavily on stocks.
This is the same facet of human nature that produces bear markets.  
The time to invest in the stock market is after it has suffered a large loss.
A 50% ratio of stocks and bonds was a prudent choice except during periods of excessive increases or decreases in stock value. 
This simple formula guards against the mistakes caused by human nature even if it does not provide for the best returns. 
Again, Safety of Principal is Graham’s chief concern.
The decision between purchasing taxable and tax-free bonds depends mainly on the difference in income to the investor after taxes. 
Those in a higher bracket have a greater incentive to closely examine this issue. 
For example, in 1972, an investor may have lost 30% of his income from investing in municipal issues (“munis”) as opposed to taxable issues. 
Bonds come in many types, a description of which follows.
 US Savings Bonds are a great choice.  In 1972, they came in two series:  E and H.  The Series H Bond paid semi-annual interest.  Series E Bonds did not pay interest, but rather sold at a discount to their coupon rate.  In 1972, Series E bonds provided the right to defer income tax payments until the bond was redeemed, which in some cases increased the value by as much as one-third.  Both E and H Series Bonds are redeemable at any time providing bondholders protection from shrinkage of principal during periods of rising interest rates (or rather, the ability to benefit from rising rates).  Both series paid in or around 5% in 1972.  Federal, but not state, income tax was payable on both series.  Graham recommends US Bonds due to their assurance of transferability, coupon rate, and security. 
Other US Bonds come in many varieties. 
Federal taxes, but not state taxes, are charged on other US Bonds.  Some of these issues are discounted heavily. 
Others bonds are guaranteed, but not issued, by the US government.  As of 1972, the US government had fully honored its commitments under all guarantee obligations.  Federal guarantees, in essence, permit additional spending by various federal agencies outside of their formal budgets.
State and Municipal Bonds are exempt from federal and state tax in the State of their issue. 
However, not all of these bonds possess sufficient protection to be considered worthy of investment.  
To be worthy of investment, a bond should possess a minimum rating of “A”.   
Corporate Bonds are taxable and offer higher yields than all types of government issues bonds. 
Junk Bonds are those that are less than investment grade.  Their title is aptly given.  The investor should steer clear of these issues.  The additional yield that junk bonds provide is rarely worth their risk.
Savings and Money Market Accounts are a viable substitute for US Bonds.  They usually pay interest rates close to rates paid on short-term USbonds
Preferred Stocks should be avoided. 
Not only does the preferred holder lack the legal claim of a bondholder (as a creditor), but also he lacks the profit possibilities of the common stock holder (as a partner).  
The only time to purchase preferred stock, if ever, is when its price is unduly depressed during times of temporary adversity.
Early redemption of bonds by issuers was commonplace before 1970, and resulted in an unfair advantage for the issuer by not allowing the investor to participate in significant upside values if interest rates fell. 
However, this practice largely stopped.  
The investor should sacrifice a small amount of yield to ensure that his bonds are not callable.

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