THE FIRST EDITION OF The Intelligent Investor was published in 1949. It was written by Benjamin Graham, the most respected money manager of his era. The Intelligent Investor is regarded as the best book of its kind—comprehensive, analytical, perceptive, and forthright—a book for the ages.

Although Benjamin Graham is best known for his focus on the kind of value investing represented by the category of stocks he described as “bargain issues,” he cautioned, “the aggressive investor must have a considerable knowledge of security values—enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise . . . armed with mental weapons that distinguish him from the trading public. It follows from this reasoning that the majority of security owners should elect the defensive classification.”

Investors should be satisfied with the reasonably good return obtainable from a defensive portfolio.

Why? Because “[the majority of investors] do not have the time, or the determination, or the mental equipment to embark upon such investing as a quasi-business. They should therefore be satisfied with the reasonably good return obtainable from a defensive portfolio, and they should stoutly resist the recurrent temptation to increase this return by deviating into other paths.”

The first index mutual fund was not formed until 1974, a quarter-century after The Intelligent Investor was published in 1949. But Graham was presciently describing the essence of that precedent-setting fund. (Coincidently, it was also in 1949 that an article in Fortune magazine introduced me to the mutual fund industry, inspiring me to write my 1951 Princeton senior thesis on mutual funds. There, I first hinted at the index fund idea: “[Mutual funds] can make no claim to superiority over the market averages.”)

For the defensive investor who required assistance, Graham originally recommended professional investment advisers who rely on “normal investment experience for their results . . . and who make no claim to being brilliant [but] pride themselves on being careful, conservative, and competent . . . whose chief value to their clients is in shielding them from costly mistakes.”

Graham cautioned investors not to expect too much from stock-exchange houses, arguing that “the Wall Street business fraternity . . . is still feeling its way toward the high standards and standing of a profession.” (A half-century later, the quest remains far from complete.)

Wall Street—“a Falstaffian joke.”

He also noted, profoundly if obviously, that Wall Street is “in business to make commissions, and that the way to succeed in business is to give customers what they want, trying hard to make money in a field where they are condemned almost by mathematical law to lose.” Later on, in 1976, Graham described his opinion of Wall Street as “highly unfavorable . . . a Falstaffian joke that frequently degenerates into a madhouse . . . a huge laundry in which institutions take in large blocks of each other’s washing.” (Shades of the ideas of two of the top managers of university endowment funds, Jack Meyer, formerly of Harvard, and David Swensen of Yale, both of whom we heard from earlier.)

In that first edition of The Intelligent Investor, Graham commended the use by investors of leading investment funds as an alternative to creating their own portfolios. Graham described the well-established mutual funds of his era as “competently managed, making fewer mistakes than the typical small investor,” carrying a reasonable expense, and performing a sound function by acquiring and holding an adequately diversified list of common stocks.

The truth about mutual fund managers.

Graham was bluntly realistic about what fund managers might accomplish. He illustrated this point in his book with data showing that from 1937 through 1947, when the Standard & Poor’s 500 Index provided a total return of 57 percent, the average mutual fund produced a total return of 54 percent, excluding the oppressive impact of sales loads. (The more things change, the more they remain the same.)

Graham’s conclusion: “The figures are not very impressive in either direction . . . on the whole, the managerial ability of invested funds has been just about able to absorb the expense burden and the drag of uninvested cash.” In 1949, however, fund expenses and turnover costs were, remarkably, far lower than in the modern fund industry. That change helps explain why, as fund returns were overwhelmed by these costs in recent decades, the figures were impressive in a negative rather than a positive direction.

“Unsoundly managed funds can produce spectacular but largely illusionary profits for a while, followed inevitably by calamitous losses.”

By 1965, Graham’s confidence that funds would produce the market’s return, less costs, was shaken. “Unsoundly managed funds,” he noted in the 1973 edition of The Intelligent Investor, “can produce spectacular but largely illusionary profits for a while, followed inevitably by calamitous losses.” He was describing the so-called performance funds of the mid-1960s Go-Go era, in which a “new breed that had a spectacular knack for coming up with winners . . . [funds managed by] bright, energetic, young people who promised to perform miracles with other people’s money . . . [but] who have inevitably brought losses to their public in the end.”

Graham could have as easily been presciently describing the hundreds of risky “new economy” mutual funds formed during the great technology-stock-driven bull market of the late 1990s, and the utter collapse in their asset values, far worse than the 50 percent market crash that followed. (See Exhibit 7.2 in Chapter 7.)

“The real money in investment will have to be made . . . not out of buying and selling but of owning and holding securities . . . [for their] dividends and benefitting from their long-term increase in value.”

Graham’s timeless lessons for the intelligent investor are as valid today as when he prescribed them in his first edition. Benjamin Graham’s timeless message:

The real money in investment will have to be made—as most of it has been made in the past—not out of buying and selling but of owning and holding securities, receiving interest and dividends and benefitting from their long-term increase in value.

Graham’s philosophy has been reflected over and over again in this book, best exemplified in the parable of the Gotrocks family in Chapter 1 and the distinction between the real market of corporate intrinsic value and the expectations market of ephemeral stock prices described in Chapter 2.

The Graham 1949 strategy—precursor to the 1976 index fund.

Owning and holding a diversified list of securities? Wouldn’t Graham recommend a fund that essentially buys the entire stock market and holds it forever, patiently receiving interest and dividends and increases in value? Doesn’t his admonition to “strictly adhere to standard, conservative, and even unimaginative forms of investment” eerily echo the concept of the stock market index fund? When he advises the defensive investor “to emphasize diversification more than individual selection,” has not Benjamin Graham come within inches of describing the modern-day stock index fund?

The failure of investment managers.

Late in his life, in an interview published in 1976, Graham candidly acknowledged the inevitable failure of individual investment managers to outpace the market. Coincidentally, the interview took place at almost the very moment in August 1976 when the public offering of the world’s first mutual index fund—First Index Investment Trust, now Vanguard 500 Index Fund—was taking place.

The interviewer asked Graham, “Can the average manager obtain better results than the Standard & Poor’s Index over the years?” Graham’s blunt response: “No.” Then he explained: “In effect that would mean that the stock market experts as a whole could beat themselves—a logical contradiction.”¹

“I see no reason why they [investors] should be content with results inferior to those of an indexed fund.”

Then he was asked whether investors should be content with earning the market’s return. Graham’s answer: “Yes.” All these years later, the central theme of this Little Book is enabling investors to earn their fair share of the stock market’s return. Only the low-cost traditional index fund can guarantee that outcome.

In the same interview, Benjamin Graham was asked about the objection made to the index fund—that different investors have different requirements. Again, he responded bluntly: “At bottom that is only a convenient cliché or alibi to justify the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results.”

The down-to-earth basics of portfolio policy.

The name Benjamin Graham is intimately connected, indeed almost synonymous, with “value investing” and the search for undervalued securities. But his classic book gives far more attention to the down-to-earth basics of portfolio policy—the straightforward, uncomplicated principles of diversification and rational long-term expectations, also overarching themes of this Little Book that you are now reading—than to solving the sphinx-like riddle of selecting superior stocks through careful security analysis.

Finding superior value was once a rewarding activity, but no longer.

Graham was well aware that the superior rewards he had personally reaped by using his valuation principles would be difficult to achieve in the future. In that 1976 interview, he made this remarkable concession, “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, but the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies. But in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

It is fair to say that, by Graham’s demanding standards, the overwhelming majority of today’s mutual funds, largely because of their high costs and speculative behavior, have failed to live up to their promise. As a result, the traditional index fund has now moved toward ascendancy in investor preferences.

Why? Both because of what it does—providing the broadest possible diversification—and because of what it doesn’t do—neither assessing high management fees nor engaging in high portfolio turnover. These paraphrases of Graham’s copybook maxims are an important part of his legacy to that vast majority of shareholders who, he believed, should follow the principles he outlined for the defensive investor.

“To achieve satisfactory investment results is easier than most people realize.”

It is Benjamin Graham’s common sense, intelligence, clear thinking, simplicity, and sense of financial history—along with his willingness to hold fast to the sound principles of long-term investing—that constitute his lasting legacy. He sums up his advice: “Fortunately for the typical investor, it is by no means necessary for his success that he bring the time-honored qualities . . . of courage, knowledge, judgment and experience . . . to bear upon his program—provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard, defensive investment. To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”

When it’s so easy—in fact unbelievably simple—to capture the stock market’s returns through an index fund, you don’t need to assume extra risks—nor the burden of excessive costs—to earn superior results. With Benjamin Graham’s long perspective, common sense, hard realism, and wise intellect, there is no doubt whatsoever in my mind that he would have applauded the index fund. Indeed, as you’ll read in Warren Buffett’s words that follow, that’s precisely what he did.