The Education of Warren Buffett 13The f irst problem that Graham had to contend with was the lack of a
universal def inition for investment that would distinguish it from specu-
lation. Considering the complexities of the issue, Graham proposed his
own def inition. “An investment operation is one which, upon thorough
analysis, promises safety of principal and a satisfactory return. Operations
not meeting these requirements are speculative.”^2
What did he mean by “thorough analysis”? Just this: “the careful
study of available facts with the attempt to draw conclusions therefrom
based on established principles and sound logic.”^3
The next part of Graham’s def inition is critical: A true investment
must have two qualities—some degree of safety of principal and a satis-
factory rate of return. Safety, he cautions, is not absolute; unusual or
improbable occurrences can put even a safe bond into default. Rather,
investors should look for something that would be considered safe from
loss under reasonable conditions.
Satisfactory return—the second necessity—includes not only in-
come but also price appreciation. Graham notes that “satisfactory” is a
subjective term. Return can be any amount, however low, as long as the
investor acts with intelligence and adheres to the full def inition of
investment.
Had it not been for the bond market’s poor performance, Graham’s
def inition of investing might have been overlooked. But when, between
1929 and 1932, the Dow Jones Bond Average declined from 97.70 to
65.78, bonds could no longer be mindlessly labeled pure investments.
Like stocks, not only did bonds lose considerable value but many issuers
went bankrupt. What was needed, therefore, was a process that could
distinguish the investment characteristics of both stocks and bonds from
their speculative counterparts.
Graham reduced the concept of sound investing to a motto he
called the “margin of safety.” With this motto, he sought to unite all
securities, stocks, and bonds in a singular approach to investing.
In essence, a margin of safety exists when securities are selling—for
whatever reason—at less than their real value. The notion of buying
undervalued securities regardless of market levels was a novel idea in the
1930s and 1940s. Graham’s goal was to outline such a strategy.
In Graham’s view, establishing a margin-of-safety concept for bonds
was not too diff icult. It wasn’t necessary, he said, to accurately determine