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Intelligent
Investor
Chapter
4:
General
Portfolio
Policy:
The
Defensive
Investor
• The
characteristics
of
an
investment
portfolio
are
determined
by
the
financial
position
and
individual
characteristics
of
the
owner
• Conventional
wisdom
says
that
the
rate
of
return
an
investor
should
aim
for
is
proportionate
to
the
amount
of
risk
he
is
willing
to
take
on
• Graham
disagrees
with
this
notion
and
believes
that
expected
rate
of
return
is
dependent
on
the
amount
of
intelligent
effort
the
investor
is
willing
to
apply
• The
passive,
or
defensive,
investor
should
expect
the
smallest
rate
of
return
due
to
his
preference
for
safety
and
freedom
from
concern
• The
enterprising
investor
who
maximizes
skill
and
intelligence
should
expect
to
achieve
the
largest
rate
of
return
• A
common
stock
issuance
purchased
at
a
bargain
price
can
offer
less
real
risk
than
a
high
grade
bond
purchased
at
full
price
• As
established
in
previous
chapters
it
is
a
fundamental
rule
that
the
investor
should
never
have
less
than
25%
or
more
than
75%
of
his
portfolio
in
common
stocks
• In
times
of
uncertainty
a
default
50%
allocation
to
each
asset
class
is
recommended
• If
the
investor
has
conviction
that
stocks
are
trading
at
bargain
levels
he
would
then
increase
his
allocation
• Conversely,
if
the
investor
believes
stocks
are
overvalued
he
would
reduce
his
allocation
to
equities
and
favor
bonds
• This
is
a
difficult
task
because
it
requires
the
investor
to
increase
his
stock
allocation
after
a
market
decline
and
reduce
his
stock
allocation
after
a
market
rally
• In
addition
to
conviction
the
investor
must
also
make
sure
that
he
has
the
correct
emotional
composure
to
deal
with
large
market
declines
before
he
increases
his
common
stock
allocation
• The
investor
must
also
rebalance
his
portfolio
to
keep
the
desired
allocation
intact
• Graham
uses
the
ratio
of
dividend
yield
on
common
stock
to
coupon
rate
of
high
quality
taxable
bonds
as
a
valuation
measure
• To
keep
his
portfolio
in
50%
equilibrium
he
wants
the
dividend
yield
on
a
common
stock
to
be
at
two
thirds
of
the
coupon
rate
of
a
high
quality
taxable
bond
• When
choosing
bonds
the
investor
should
have
two
main
questions
• Should
he
buy
taxable
or
tax-‐free
bonds?
• Should
he
consider
shorter
or
longer
term
maturities?
• If
the
investor
is
in
a
high
tax
bracket
that
will
make
his
after
tax
yield
lower
than
tax
free
bonds
he
should
stick
with
tax
free
bonds
• When
deciding
on
the
correct
maturity
length
of
his
bonds
the
investor
should
decide
between
the
loss
of
appreciable
value
and
a
lower
annual
yield
• A
shorter
term
maturity
bond
will
yield
less,
but
be
less
prone
to
swings
in
valuation
• A
longer
term
maturity
bond
will
yield
more,
but
be
susceptible
to
more
volatile
price
movements
• Types
of
bonds
(as
of
1972)
• U.S.
Savings
Bond
Series
E
and
H
§ Series
H
Bonds
pay
interest
semi-‐annually
§ Series
E
Bonds
are
purchased
at
75%
of
face
value
and
mature
at
100%
of
face
value
• Interest
is
not
paid
out
until
maturity
• Other
United
States
Bonds
§ Indirect
obligations
of
the
U.S.
government
offer
more
yield
than
direct
obligations
§ These
indirect
obligations
are
issued
by
departments
of
the
government,
like
the
Security
of
Transportation,
but
are
backed
by
the
full
faith
and
credit
of
the
U.S.
government
§ This
allows
Congress
to
stay
under
their
debt
limits
because
guarantees
are
not
considered
the
same
as
debts
• State
and
Municipal
Bonds
§ These
bonds
are
free
of
Federal
income
tax
and
income
tax
in
the
state
which
they
are
issued
§ They
are
either
direct
obligation
bonds
or
revenue
bonds
• Revenue
bonds
are
backed
by
a
particular
project
such
as
a
toll
road
or
a
bridge
§ Not
all
of
these
issues
are
suitable
for
the
defensive
investor
• Corporation
Bonds
§ These
bonds
are
subject
to
Federal
and
State
tax
§ They
are
issued
by
corporations
and
have
a
higher
claim
on
assets
in
bankruptcy
than
common
stock
§ Graham
recommends
that
the
defensive
investor
avoid
high
yield
bonds
• Savings
Deposits
in
Lieu
of
Bonds
§ Depending
on
the
interest
rate
environment
savings
deposits
may
yield
more
than
first-‐grade
bonds
of
short
maturity
• Graham
also
warns
the
investor
against
call
provisions
which
give
the
issuer
the
right
to
buy
back
the
bond
slightly
above
maturity
if
prices
rise
and
yields
decline
• This
is
unfavorable
to
the
investor
because
during
times
of
price
declines
the
investor
bears
the
losses,
but
during
times
of
price
gains
the
investor
is
not
able
to
achieve
the
upside
• Investors
should
sacrifice
small
amounts
of
yield
in
order
to
avoid
call
provisions
for
at
least
20
years
• Preferred
stocks
according
to
Graham
are
an
inherently
bad
investment
form
• The
preferred
holder’s
dividend
is
dependent
on
the
company’s
ability
to
pay
a
dividend
on
its
common
stock
• The
preferred
stock
holder
is
entitled
to
nothing
above
his
fixed
dividend
rate
• Therefore
he
lacks
the
legal
claim
of
the
bondholder
and
the
profit
possibilities
of
the
common
stock
owner
• They
also
suffer
from
a
disadvantageous
tax
treatment
for
individual
investors
• A
preferred
stock
also
has
no
fixed
maturity
date
at
which
the
principal
must
be
returned
• Bondholders
should
demand
the
following
two
features
• Unconditional
right
to
receive
interest
when
it
is
earned
by
the
company
• Rights
to
other
forms
of
protection
than
bankruptcy
proceedings
if
interest
is
not
paid
• Commentary
on
Chapter
4
• “When
you
leave
it
to
chance,
then
all
of
a
sudden
you
don’t
have
any
more
luck.”
–
Pat
Riley
• There
are
two
methods
to
being
an
intelligent
investor
§ by
continually
researching,
selecting
and
monitoring
a
mix
of
stocks
and
bonds
§ or
by
creating
a
permanent
portfolio
that
runs
on
autopilot
and
requires
no
further
effort
• The
first
approach
is
active
or
enterprising
investing
§ This
method
requires
an
abundance
of
effort
and
energy
• The
second
approach
is
passive
or
defensive
investing
§ This
method
requires
little
time
and
effort,
but
demands
emotional
detachment
and
discipline
from
the
swings
of
the
market
• Graham’s
distinction
between
active
and
passive
investing
is
a
reminder
that
financial
risk
lies
primarily
with
the
investor
himself
• When
Graham
discusses
portfolio
allocation
between
stocks
and
bonds
notice
that
he
never
mentions
the
investors
age
§ Conventional
wisdom
is
that
the
younger
the
investor
the
greater
the
portion
of
their
portfolio
that
should
be
in
stocks
§ Conversely,
older
investors
should
be
more
heavily
weighted
toward
bonds
• Because
unexpected
circumstances
can
occur
at
any
time
it
is
advisable
for
the
investor
to
have
some
portion
of
their
portfolio
in
cash
• One
of
the
greatest
challenges
investors
face
is
having
the
emotional
fortitude
to
stay
with
their
investment
allocation
in
the
face
of
market
declines
• Graham’s
approach
is
based
on
replacing
guesswork
with
discipline
• Rebalancing
your
portfolio
should
be
done
on
a
predictable
and
patient
schedule
§ The
author
recommends
every
six
months
• Unless
an
investor
is
in
the
lowest
tax
bracket
they
should
hold
tax
free
municipal
bonds
§ The
exception
is
in
a
401(k)
which
is
sheltered
from
taxes
• Bonds
with
intermediate
maturities,
five
to
ten
years,
are
a
nice
way
to
balance
yield
with
price
volatility
• Bond
funds
offer
investors
with
smaller
sums
of
investable
assets
the
opportunity
to
diversify
their
holdings
§ This
is
often
not
possible
with
individual
bonds
because
they
are
sold
in
$10,000
lots
• Cash
is
not
trash
and
should
make
up
a
portion
of
every
investors
portfolio
• Types
of
bonds
§ Treasury
securities
are
obligations
of
the
U.S.
government
and
carry
very
little
credit
risk
• The
government
can
raise
taxes
or
print
more
money
in
order
to
meet
its
obligations
• These
bonds
are
taxed
at
the
federal,
but
not
state
level
§ Savings
bonds
are
similar
to
Treasuries,
but
they
can’t
be
sold
to
other
investors
making
them
suitable
only
for
money
that
does
not
need
to
be
liquidated
in
the
near
future
§ Mortgage
securities
are
thousands
of
individual
home
loans
that
are
pooled
together
by
agencies
like
Fannie
Mae
and
Ginnie
Mae
• They
aren’t
backed
by
the
U.S.
government
so
they
carry
higher
yields
• Other
yield
alternatives
§ Preferred
shares,
which
are
less
secure
than
bonds
and
offer
less
profit
potential
than
common
stocks
§ Common
stocks
with
dividend
yields
can
provide
more
yield
than
Treasury
bonds
in
a
low
interest
rate
environment