Image: Benjamin Graham © AP Photo

Warren Buffett is widely considered one of the greatest investors of all time, but if you were to ask him who he thinks is the greatest investor, he would probably mention his teacher, Benjamin Graham. Graham, an investor and investing mentor, is generally considered the father of security analysis and value investing.

Graham's ideas and methods of investing are well documented in his books "Security Analysis" (1934) and "The Intelligent Investor" (1949). These texts are often considered required reading for investors, but they aren't easy reads. Here we'll condense Graham's main investing principles and give you a head start on understanding his winning philosophy.

Principle No. 1: Invest with a margin of safety

Margin of safety is the principle of buying a security at a significant discount to its intrinsic value. Adhering to this principle not only provides high-return opportunities but also minimizes downside risk. In simple terms, Graham's goal was to buy a dollar's worth of assets for 50 cents. He did this very, very well.

To Graham, these assets may have been valuable because of their stable earning power or because of their liquid cash value. It wasn't uncommon for Graham to invest in stocks where the liquid assets on the balance sheet (net of all debt) were worth more than the market value of the company.

This means that Graham was effectively buying businesses for nothing.

This concept is very important, as value investing can provide substantial profits once the market re-evaluates the stock and ups its price to fair value. It also provides protection on the downside if things don't work out as planned and the business falters. The safety net of buying an underlying business for less than it is worth was the central theme of Graham's success. Carefully chosen undervalued stocks seldom declined further, Graham found.

Principle No. 2: Expect volatility, and profit from it

Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as opportunities to find bargains. Graham illustrated this with the analogy of "Mr. Market," the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote, the price at which he would either buy out an investor or sell his share of the business.

Sometimes, he will be excited about the prospects for the business and quote a high price. Other times, he is depressed about the business's prospects and quotes a low price.

Because the stock market has these same emotions, the lesson here is that you shouldn't let Mr. Market's views dictate your own emotions or, worse, lead you in your investment decisions. Instead, you should form your own estimates of the business's value, based on a sound and rational examination of the facts.

Furthermore, you should buy only when the price offered makes sense and sell when the price becomes too high.

Put another way, the market will fluctuate -- sometimes wildly -- but rather than fear volatility, you can use it to your advantage to get bargains or to sell out when your holdings become overvalued.

Graham also suggested dollar-cost averaging as a strategy to mitigate the negative effects of market volatility. Dollar-cost averaging is achieved by buying equal dollar amounts of stock or other investments at regular intervals.

The strategy takes advantage of dips in the asset's price, and means that an investor doesn't have to be concerned about buying his or her entire position at the top of the market. Dollar-cost averaging is ideal for passive investors; it relieves them of the responsibility of choosing when and at what price to buy their positions.

Graham also recommended that investors distribute their portfolios evenly between stocks and bonds as a way of preserving capital in market downturns, when income from bond holdings helps preserve capital.

Remember, Graham's philosophy was, first and foremost, to preserve capital and then to try to make it grow. He suggested having 25% to 75% of a portfolio in bonds, depending on prevailing market conditions.

This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e. speculating).

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Principle No. 3: Know what kind of investor you are

Graham advised investors to know themselves. To illustrate, he made clear distinctions among various groups operating in the stock market.

Graham referred to "enterprising investors" and "defensive investors." Those in the first group make a serious commitment in time and energy to become good investors and equate the quality and amount of hands-on research with the expected return. If this isn't your cup of tea, then be content to get passive (possibly lower) returns but with much less time and work.

Graham turned the notion of "risk equals return" on its head. For him, the more work you put into your investments, the higher your return should be.

If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative. Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the of the of the Dow Jones Industrial Average ($INDU) in equal amounts.

Both Graham and Buffett said that getting even an average return -- for example, equaling the return of the Standard & Poor's 500 Index ($INX) -- is more of an accomplishment than it might seem. The fallacy that many people buy into, according to Graham, is that if it's so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.

In modern terms, defensive investors would own index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to pick those areas ahead of time.

In doing so, an investor is virtually guaranteed the market's return and avoids doing worse than average by just letting the stock market's overall results dictate long-term returns. According to Graham, beating the market is much easier said than done.

Not everyone in the stock market is an investor. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: An investor looks at a stock as part of a business and stockholders as the owners of the business, while the speculator views stocks as expensive pieces of paper that hold no intrinsic value. For the speculator, value is determined solely by what someone will pay for the asset.

To paraphrase Graham, there is intelligent speculating as well as intelligent investing -- just be sure you understand which you are good at.

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