Investing Lessons From Benjamin Graham

A dictionary will tell you that investing involves putting money into assets with the intent of making a profit. But that's not the whole story. Speculating, for example, involves the very same process.

The legendary Dean of Wall Street, Benjamin Graham, differentiates the two approaches in his seminal work, Security Analysis, and in the process, he offers the best definition of investing I've come across. Graham says an investment is something that "upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative." [Emphasis added.] Given that definition, a lot of us who think we are investing may come to discover that we're engaging in what I would call intelligent speculation.

So let's briefly review Graham's three criteria for an investment.

Thorough analysis : Do your homework
Warren Buffett used to write down why he was making an investment. If what he wrote wasn't crystal clear, he either did more research, or he'd decide that he simply could not understand the business well enough to make an investment.

Imagine you're buying a house. You'll make sure it's in a nice, safe neighborhood with a good school system before you put down your money. Buffett puts that kind of prudent diligence into his stock research, and so should you. Really good investments are really hard to find. So when you find one that looks interesting, do your homework. Study the industry. Examine the competition. Find out everything that could possibly go wrong through boom and bust cycles.

Safety of principal: Never lose money
Buffett says he has two goals when making an investment. Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.

There are three types of stocks: the overvalued type, the fairly valued type, and the undervalued type. Your goal is to avoid the first, ignore the second, and buy the third. One way to keep attuned to that goal is to focus on value over price. Google (NASDAQ:GOOG), for example, is a fantastic business that is doing all the right things to ensure its long-term success. Yet when it traded last year at more than $700 a share, Google had an extremely rich earnings multiple. As the ensuing year proved, if Google had a bad quarter or year and you've bought in at $700, you don't have much safety of principal. But after the stock suddenly shot down to $300 during the recent panic, if you still think the economic characteristics of the business remain intact, then your investment thesis is entirely different. The one variable is the price. As Buffett once said, "Price is what you pay. Value is what you get."

Satisfactory return : Risk versus reward
Any time you commit capital to one business, you are forgoing the opportunity to commit that capital to any other business. But that's OK, because if you are rational, the investment you choose will be better than all other alternatives.

So what should you be looking for? Well, you can always invest in the market through index funds and earn, on average, about 10% a year without exerting any effort.

Whatever you do, you should at least expect a higher rate of return than U.S. Treasuries, commonly referred to as the risk-free rate, which currently stands at around 4%. I like to make investments that I think can exceed the market rate of return by 3% over the long run. John Bogle once stated that more than 85% of active money managers fail to beat the stock market by 3%, so making investments that can yield you 13%-15% a year is a great return, given your alternatives.

Meeting the Graham threshold
So how do you find good prospects for stocks Graham might approve of? Using Motley Fool CAPS, the Fool's free online investing community, you can run a simple screen to find some reasonably valued stocks that have earned the attention of Foolish investors.

Source: Yahoo! Finance, Motley Fool CAPS.

Of course, screen results alone aren't enough to conclude that these are truly Graham-quality stocks. Rather, these give you a place to start your own research.

You can rely on CAPS to give you plenty of good ideas whenever you want to look. Just be sure to keep Benjamin Graham's lessons in mind when you're ready to make your next investment.