4. General Portfolio Policy

It is a widely accepted principle of investing that those who cannot abide risks must accept a relatively low rate of return on their invested funds, and from this comes the notion that a conservative investor should be motivated primarily by the level of risk in an investment.

The author takes a different perspective: the rate of return sought should be dependent on the level of effort the investor is willing and able to apply to his task. The passive investor accepts a minimum concern not only out of a desire for safety, but also from his intention to devote minimal attention to his investments.

An investor who is willing to apply intelligence and skill, and devote time to managing his investments, can earn a better return without taking on a significant amount of additional risk.

The Basic Problem of Bond-Stock Allocation

The portfolio policy of the defensive investor is an allocation of high-grade bonds and high-grade common stocks - and as a common guiding rule, he should have not less than 25% nor more than 75% of his fund in stocks.

This implies a natural equilibrium of a 50/50 split between stocks and bonds, but this is adjusted to manage the risk and return inherent in both forms of investment - shifting more to bonds then the stock market is predicted to provide a lower level of return and/or a higher level of risk.

Such "copybook maxims" are easy to enunciate and difficult to follow, because they are contrary to the very elements of human psychology that produce variances in the stock market (given that the value of stocks is well above their earnings, the majority of their value arises from fear or confidence in the marketplace). Hence the average investor, in balancing his investments between stocks and bonds, is prone to act emotionally and inaccurately as the market fluctuates.

The division of investment and speculative activity has be characterized thus: the investors are a shrewd and experienced core group who sell to the hapless speculators at high prices and buy back from them at depressed levels. Unfortunately, there is no evidence that experienced professional investors operate in a manner that is considerable more sagacious than the gambling speculators: they either hold their investments long-term and pay little heed to the market, or engage in activity that is plainly speculative.

Given this, the author is led to suggest what may appear to be an oversimplified 50/50 formula - that is, to maintain as nearly as practicable an equal division between bond and stock holdings, varying the proportion by only 5% to account for fluctuations. Some small adjustment if favor of stocks is advisable under certain market conditions, but the defensive investor should refrain from being drawn more and more into speculative investments as a result of fluctuations in the market, which are ultimately unpredictable.

Furthermore, a 50/50 split provides an even allocation of risk between bonds and stocks, whose risks of underperformance counterbalance one another (when stocks rise, bonds fall, and vice-versa).

Adopting such a formula is simple enough, but maintaining it can be difficult - there is always the fear of being too conservative or too aggressive, which will lead an investor to deviate from an even split.

The Bond Component

The choice of bond investment relies on two main questions: whether to purchase taxable or tax-exempt, and whether to purchase short- or long-term maturities.

The question of taxation is simple arithmetic: adjust the proceeds of a taxable bond by the rate of taxation to determine its comparison to a tax exempt bond - e.g., a taxable bond that pays 8% is reduced to 6% to a bearer whose tax rate is 25%.

The question of maturities depends on the expectations on the predicted change in interest rates available on bonds in the marketplace. Where interest rates are expected to increase, the investor would be better served by a short-term bond whose principal will be returned sooner, and can be invested at a higher rate. When returns are expected to decrease, the investor is motivated to buy a longer-term bond to lock in the present rate.

For a period of many years, U.S. savings bonds were the only sensible bond purchases: they paid the most advantageous interest rate and had other privileges such as the option for early redemption. While this is not necessarily true in the present day, they still have some merits, and likely remain the easiest and best choice for an individual of modest means (portfolio value of less than $10,000).

US Savings Bonds, Series E and H

Series E and H bonds are both subject to federal income tax, but exempt from state taxes. There is no other investment that provides as much assurance of the principal and interest payments with a right to redeem them at any time.

Series E bonds are sold at a discount from their face value and can be redeemed at full value when they mature, at which time taxes are collected. The bearer can opt to hold them after maturity to continue accruing interest. A series E bond can be redeemed or sold at a current redemption value, representing the interest they have accrued to date.

Series H bonds are sold for their face value and pay interest semi-annually, and taxes are collected as interest is paid out. The bond can be redeemed at par value (cost).

Other US Bonds

A myriad of bond issues exists, with varying interest rates, maturity dates, and terms. Some are issued in exigencies, others used to pay vendors, and all are reliable and safe investments.

It's noted that bonds exploit a loophole in the debt ceiling imposed on government borrowing by congress: a bond represents a "guarantee" by the government, which through some "hocus-pocus" are not considered to be part of the national debt.

State and Municipal Bonds

These issues by stage and city governments also enjoy exemption from the federal tax, as well as an exemption from local taxes in the state of issue. They are functionally equivalent to federal bonds, but investors are cautioned, in that state governments are more likely than the deferral government to suspend interest payments or even default on their debts in times of economic hardship.

Corporate Bonds

Issued by commercial enterprises, these bonds represent debt accrued by corporations, generally to fund long-term projects that require substantial capital. They pay a higher return rate than government bonds, on account of the risk that the issuer will default on repayment, and the interest is taxable.

Ad additional hazard of corporate bonds are call provisions, which reserve to the issuer certain privileges, such as redeeming the bonds for face value or converting them to common stock at the convenience of the issuer, and the disadvantage of the bearer. A great many swindles were conducted by issuers in the fine print, but bond-buying institutions learned from the experience and generally refuse to purchase such issues; the individual investor would be well advised to do the same.

This is entirely different from redemption provisions, which provide the same kinds of privileges to the bearer of a bond. Where the holder of a security is able, but not obligated, to redeem his bond early or convert it to common shares, he may choose to do so if it is advantageous, but is not required to do so if it is not.

High-Yielding Bonds

Experience has demonstrated that the "ordinary investor" would be well advised to avoid high-yield bonds. They represent better returns than more secure sources, but expose the owner to a level of risk that should be unacceptable to the defensive investor.

This is even true of government securities, which may offer higher interest rates but carry with them a higher degree of risk, as their repayment may be tied to the generation of income from specific ventures (such as bonds issued for housing development).

The author encourages the reader to consult Moody's or Standard and Poor's when selecting corporate, state, or municipal bonds to assess the level of risk - but in general, the greater the risk, the greater the interest rate will be offered to compensate investors for such risks.

Safety Deposits

An investor may at times obtain as good an interest rate from a safety deposit (CD) issued by a commercial or savings bank. In terms of risk, they are virtually as certain as federal bonds (their face value being insured by the federal government, the only risk is to interest) and should be considered accordingly.

Nonconvertible Preferred Stocks

Preferable stocks duffer from a dim reputation for the same reason as certain corporate bond issues - that is, the "find print" enabled the issuer to repurchase them or convert them to common shares when it was advantageous to the company, and disadvantageous to the investor. However, it is not always thus.

In general, a share of preferred stock functions in the same way as a bond, though they can be issued more flexibly and in smaller denominations that bonds: the preferred holder is entitled to receive interest on his shares, but they do not convert voting privileges.

They also lack the legal protection of bonds in the event of bankruptcy, and the payment of interest is not guaranteed (except that it must be paid before any dividend may be issued to the holders of common stock).

Therefore, the individual investor should consider preferred stocks issued only by financially sound corporations, and should avoid those that are convertible or redeemable at the issuer's sole discretion. Moreover, they should be "bought on a bargain basis or not at all," when they represent some special possibility of profit that makes them worthwhile to hold.

It's noted that preferred stocks have some appeal for corporate investors, in that dividends are taxed at a lower rather than other forms of income. This may make them an appealing vehicle for corporate investment, but is not relevant to the interests of the individual investor.

Security Forms

There are numerous other methods by which debt may be sold, aside of bonds and preferred stocks. The author goes into a bit of detail, but ultimately, such an unusual investment should be purchased in unusual situations, and then with the utmost of scrutiny - which is a bit much to ask of the casual investor.