Chapter 4 -- General Portfolio Policy: The Defensive Investor

The characteristics of a portfolio are determined by the owner!

Those that can't take risks should be happy with a low return? No, Graham's view is that return is based on the investor's effort on task.

The minimum return is given to the passive investor, who wants safety and no worries. The maximum return is found by the "alert and enterprising investor who exercises maximum intelligence and skill".

Graham reflects at a past statement, which says that there's less risk buying a bargain issue (stocks being typically deemed as 'risky') compare to buying a bond (which is deemed as safe). This statement had a lot of truth in it, as interests rates rised and long-term bonds lost their value.

A bargain purchase involves assets acquired for less than fair market value.

The Basic Problem of Bond-Stock Allocation

Reminder: In chapter 2 Graham recommends a portfolio made of stocks and bonds, where either should not be greater than 75% or be less than 25%. A further step is to reduce the stock part below 50% if the market has become dangerously high.

The second recommendation is very hard - it goes against our human nature. It sounds like a contradiction - reduce your holding when it's high? Add more when it's in decline? It's the very fact that the average participant in the market thinks this way, that you have to be the opposite.

Again - don't have more than a half of your portfolio as stocks, unless you are confident of your stock position, and you can live out a market decline as great as 1969-1970.

Graham recommends the 50-50 formula, or as close as practically possible. Example usage: your portfolio starts off at 50/50. Prices change and now your split becomes 55/45 stocks/bonds. Now you have 55% stocks, so you sell off that additional 5% of stocks, and put it into bonds. If the stock proportion was 45%, you'd sell off 5% of your bonds to buy 5% more stock. A balancing act!

Four additional reasons why, this activity is good:

  • you get the feeling you are responding to market movements
  • you'll have restraint from being too drawn into stocks as they get too high and dangerous
  • In a rising market, a conservative investor (which we should all be) should be happy with the half of your portfolio that rises
  • In a decline, you are doing better than most

Bond Allocation

Taxable or tax-free? Depends on the yield & the tax bracket you're in. Do some example calcuations on this.

Short or long term? Depends on whether you want insurance against price drops, or insurance against the potential of gains (more to come in chapter 8)

For a period, US savings issues were very attractive. They had unquestionable safety, higher return than other bonds, a money-back option, and other privileges. These are great for a person of modest capital, but for larger funds, there may be other mediums.

There is no other investment that provides:

  1. absolute assurance of principal and interest payments
  2. the right to demand full "money back" at anytime
  3. guarantee of at least 5% interest rate, for at least 10 years

You defer income tax payments = great dollar advantage. Your effective net after tax rate can be increased by up to a third. The ability to cash in anytime at cost or better gives purchasers in years of low interest rates, the protection of declining principal value. In the case of high interest rates, they can switch into higher coupon issues, or even sell off and hold cash.

What Is a Coupon? A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity.

Bonds that deserve investor consideration

US savings bonds, series E and H

Copy of Comparison of Bonds

NameCorporation BondsState / Munipical BondsUS Series HUS Series EOther US Bonds
Also called "revenue bonds" because they're often obligations from a state/subdivion dependent for interest payments on receipts from a toll road, bridge, building lease.
Covers a wide variety of coupon rates and maturity dates. But they're all guaranteed in terms of interest and principal.
Interest (Yield)
Shorter term issues yieled less than longer term issues.
Varies with quality and maturity. Shorter maturity = lower return.
4.29% for first year, and then 5.1% for next 9 years
Series E bond interest is not paid out, but is added to their redemption value. They're sold at 75% of their face value and mature 5 years 10 months after purchase. Held to maturity this works out at 5%, compounded semi-annually. Redeemed earlier, the first year yield moves up from 4.01% to an average of 5.2% in the next 4 years.
In many cases, the yield is above than the oligated rate, an example is the transport department
Historic performance
Early 1972, those of highest quality (Moody's AAA corporate bond index) yielded 7.19% for a 25 year maturity. "Lower-medium" grade (BAA) return 8.23% for long maturities.
Late 1971, S&P's municipal bond index average AA, 20 years maturity, yielded 5.78%. Vineland, N.J bonds rated AA for A, yielded 3% on a 1 year maturity, rising to 1995 and 1996.
In late 1971, long term issues (10yrs+) showed an average yield of 6.09%, intermediate (3-5yrs) 6.35% and short term 6.03%.
Both federal and state tax.
Free of federal income tax and in the state of their issue.
Interest from bonds is subject to Federal income tax (annually when interest accrues or when the bond is disposed of) but except from state income tax.
👈 Same
Could get some older issues at discounts, because accepted for estate taxes at the same value (1 tax dollar = 1 bond dollar).
Cashing out
Cash anytime, at cost.
Any time, at their current redemption value. Can exchange these for Series H, with some tax advantages.
Lost, destroyed, stolen?
Replaced without cost
👈 Same
Purchase limitations
Yes, but there are liberal provisions for co-ownership with family members. Essentially means you could probably buy as much as you can afford
👈 Same
Renewal/ extension
Right to extend bonds at maturity (means you continue to accumulate annual values and higher rates 😲)
Not all are safe! An AAA rating from Moody's or S&P means safe.
Very safe
Very safe
Very safe


There are many bond options.

Those in the high income tax gain a better yield from good tax-free issues (vs taxed).

By sacrificing bond quality, you can obtain a higher return than the higher quality issues. But you're open to many risks: bad developments, price declines, company default. Long experience shows that an ordinary ise better to stay away from these. Emphasis on ordinary: bargain opportunities occur, but they need special study & skill to exploit.

Savings vs Bonds

At the time of writing (😂) the interest rate on savings was higher than the return of a first-grade bond. So do that if you can.

Call Provisions

What Is a Call Provision? A call provision is a stipulation on the contract for a bond—or other fixed-income instruments—that allows the issuer to repurchase and retire the debt security.

A call provision can be unfair - the price fluctates a lot, then the company takes advantage of the call provision and buys it back at an time negative to you. A form of protection that has arisen is preventing redemption for 10 years or more after issuance.

Graham advises long term investors to obtain this protection. It's better to buy a low coupon bond at a discount vs a high coupon bond which is callable.

Straight (non-convertible) preferred stocks

The owner of a preferred stock is entitled to a fixed dividend, and no more, which must be paid before any common dividend.

A typical preferred shareholder feels the safety of stocks on common stock dividends.

But a preferred stock carries no share in the company's profits beyond the fixed dividend.

Thus, the preferred holder lacks the legal claim of a bond holder and the profit potential of a common sharedholder.

The weaknesses of preferred stocks are especially apparent in times of depression. The time to buy preferred stocks is when its price is depressed by temporary adversity. So buy then, at a bargain, or not at all.

Security Forms

There are other forms of issues beyond stock and bonds.

Income bonds are ones in which interest does not have to be paid unless it is earned by the company.

Graham believes these issues get not nearly enough usage as they should. It seems best for the investor that:

1. they have the unconditional right to receive interest payments, when they are received by the company

2. and a right to other forms of protectino other than bankruptcy proceedings if interest is not earned and paid

Their advantage includes:

  • deductability of interest paid from the company's taxable income (effectively cutting the cost of capital in half)

2003 Book Commentary by Jason Zweig

The nature of your portfolio (aggressive vs defensive) is less about the investments you own and more about the kind of investor you are. Remember, there are 2 ways to be an intelligent investor:

  • "actively", or in an "enterprising" manner: constantly researching, selecting, monitoring a dynamic mix of financial instruments
  • "passively" or in a "defensive" manner: creating a low-effort, permanent portfolio that runs on automatically (less excitement)

The former is intellectually taxing, the latter emotionally demanding. Which type of investor are you? Of course a mix is allowed.

Both approaches are intelligent and successful, but only you will know which is right, when you're making your picks and managing your costs and emotions. It's a reminder that the risk isn't just in the economy, or the company, but within ourselves.

How does a defensive investor get started? The first decision is the stock, bond, cash ratio. Graham never mentions age, which is against conventional wisdom. Each age has a different personal context. Furthermore, emergencies (hah, covid!) affect everyone, so your need to pull out cash could range from 40 years to 40 minutes - everyone should keep some assets in cash (emergency fund!).

Graham's 25% minimum in bonds comes from having a cushion that gives you the courage to keep the rest of your money in stocks even when they sink.

The better way to go about it is to think about the fundamental circumstances of your life - the timings, when they'll change and how they'll affect your need for cash. Consider the risks:

  • are you single or married?
  • with dependents?
  • inheritance
  • career shocks
  • self-employment
  • investments to supplement income
  • how much can you afford to lose

Once you set target percentages, change. them only as your life circumstances change. Don't buy and sell stocks on price. Discipline replaces guesswork.

The key is to rebalance on a predictable, patient schedule, not so often you go crazy or out of target. He suggests every 6 months.

The beauty is a simple standard with clear determinants and questions. Have my life circumstances changed? Yes? Change the split and rebalance. No? rebalance to previous percentage. No need to guess the future.

Tests to pass to see if you're allowed to put 100% into stocks:

  • you have enough cash for a year, to support your family for more than one year
  • will be investing steadily for the next 20 years
  • survived the 2000 bear market
  • did not sell stocks during 2000 bear market
  • bought more stocks during 2000 bear market
  • have read chapter 8, and implemented a formal plan to control your own investing behaviour

Otherwise, GTFO, people who panic in the last bear market will panic again.

Income Investing

In modern times there is a third dimension to bonds: bonds or bond funds. (As a reminder: taxable or tax-free, short or long term were the first two).

Unless you're in the lowest tax bracket, buy tax free bonds.

When interest rates rise, bond prices fall - a short term bond falls far less than a long term bond.

When interest rates fall, bond prices rise - a long term bond outperform shorter ones.

Pick a intermediate-term bond (5-10 maturity) which are not as volatile to interest rates.

When it comes to bonds or bond funds, the latter offer cheap and easy diversification which isn't available to the average investor. Funds will also research, spread risk and filter out junk bonds - which were one of Graham's earlier worries.



Copy of Cash alternatives

NameRiskReturnMaturityInterest Rate ImpactTaxation ImplicationLiquidityComment
Treasury securities ("T-bills")
No risk. US can jack up taxes or print money to pay it off.
Quick! 4, 13, 26 weeks
Not much on the short term bills, much more on the long term debts
Generally free from state but not federal tax
Can readily find a buyer
Savings bonds
Inflation protected "I-bonds" offer attractive yields
Foreit 3 months of interest if you redeem in less than 5 years.
Not marketable, can't sell to another investor
"Set aside money", small denomintations (from $25)
Mortgage securities
Greater risk
Higher than US treasury
Underperform when IR falls, and bomb when IR rates rise
Fixed return on fixed annuities, and variable you'd expect variable.
Enable you to defer current taxes and capture income after you retire. Not advisable to those under the age of 50 who expect to be in a high tax bracket during retirement.
Watch out for brokers who sell these too expensively and the associated costs of ownership, e.g. "surrender charges". Look for rock bottom costs providers.
Perferred stock
Worst of both worlds investment. Less secure than bonds (2ndary claim to assets in bankruptcy). Less profit potential because companies will often buy back the shares when interest rates drop or credit rating improves. Also that company cannot deduct these dividend payments from its tax bill. Ask: why is this company paying a fat dividend, when they could issue a bond and get a tax break.
Common stock
Some leading stocks are outyielding treasury bonds
Even the most defensive investor should realise that selectively adding stock to a bond portfolio increases its income yield and potential return.

2020 Pete Commentary, Questions and Notes

What are the determinents of bond value? How do I assess them?

  • Bond prices are inversely related to the interest rate. Mechanism: say interest rates rise, that means the rate of return in comparison to the bond's coupon is higher. So I'd like to pay less for that bond - the price lowers. This is especially apparent in the period before a bond's redemption.
  • Bond prices are related to the ability of the issuer to pay. the interest and principal back (remember it's a loan) - aka their "credit quality". Check their past historical repayments of interest, tax and other obligated payments (it's a measure of how reliable they are)
  • Assess the soundness and market sentiment of the company and stock! Look at the debt service number.
  • The longer the expiration date the greater chance of default or interest rate risk. Thus the bond ought to return more because of that risk.
  • Whether it has a primary or secondary claim to collateral. A "senior note"
  • Watch the inflation rate - if it's higher, the purchasing power that future cash is lower

How are bonds performing now? Why?

The US 10 year treasury is at a low.


What's the more current advice?

Bonds are more of a safe haven, people will put money into high credit quality bonds during times of uncertainty - e.g. these corona times. With stock sell offs, people plunge money into bonds, and with the price up, the relative yield is lower. Interest rates are super low, so there isn't much impact of them going any lower, only going higher (which would reduce bond prices).

"Ray Dalio says investors would be 'pretty crazy to hold bonds' right now as central banks continue to print money".

In a period of stock decline, long term Treasurys are good.

As a UK citizen, how do I buy international/ US bonds?

Go Vanguard!

Other Resources:

7 Common Bond-Buying Mistakes, Investopedia

Notes on the Bank of England UK Yield Curves