Benjamin Graham: Stocks Ugly, Bonds Uglier

Correction: This article originally used 1981 interest rates to demonstrate the compound interest potential of a zero-coupon treasury bond. However, zero-coupon treasury bonds were not available until mid-1982 -- examples in the article have been updated accordingly.

NEW YORK (TheStreet) -- For all of the complex investment products in the world, a successful retail investor only needs two: a S&P 500 index fund and U.S. government bonds. These two investments together provide adequate diversification among equities as well as interest payments and principal guaranteed by the U.S. government.

In The Intelligent Investor, Benjamin Graham touted this approach as the best way for an Average Joe to succeed in the market (Graham's text pre-dated index funds but suggested holding a diverse basket of 10 to 30 large-cap stocks).

Warren Buffett, Graham's greatest student, has often recommended that aspiring investors start their research with Graham's book, specifically: Chapter 20: "Margin of Safety" as the Central Concept of Investment.

Graham's "Margin of Safety" principal can be used to confidently guide asset allocation decisions and is easily summarized in two simple points:

1. Never hold less than 25% in stocks, and
2. Judge the attractiveness of stocks vs. bonds by dividing the earnings yield of the stock by the yield of the bond.

To the first point, no investor should ever be fully divested of stocks -- bull markets can last for decades. Graham's second point is the financial equivalent of Einstein's Theory of Relativity (yet largely ignored by most investors).

The earnings yield of a stock is defined as the inverse of the price/earnings ratio (Example: A stock fund with a P/E of 15 has an earnings yield of 6.67%). When the earnings yield of a stock fund is two times as great as the yield of a 10-year Treasury bond, stocks should be considered the better buy. When the ratio is less than one time, investors should shun stocks in favor of bonds (or paying down a mortgage).

Had you followed this strategy for the last 100 years, you would have avoided the stock market crashes of 1929, 1973, 1987, 2000 and 2008 and made money over any 10-year stretch. (See chart below.) Data courtesy of Robert Shiller, Yale Department of Economics.

Interestingly, theoretical data suggests that investors should have avoided the stock market for the better part of the last 30 years -- one of the greatest bull markets in history. So how would an investor who completely avoided stocks have fared? Shockingly well. Had you purchased a $10,000, 30-year zero-coupon Treasury bond in June 1982, the bond would be worth a staggering $497,572 at maturity in 2012 (even more amazing considering that capital was never put at risk). Data courtesy of Robert Shiller, Yale Department of Economics.

Sadly, the opportunity to buy government-guaranteed bonds yielding 13.91% has passed, but investors can still use Graham's wisdom to prevail in any market conditions. At current 10-year interest rates of around 3% and the Dow Jones stuck at 10,000, the calculated margin of safety ratio sits at around 1.6, suggesting that stocks are no bargain, but bonds are to be avoided at today's rates.

In this author's opinion, an intelligent investor would be wise to hold ample amounts of cash.

-- Written by John DeFeo in New York CityFollow @johndefeo

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