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The principles of value investing

Multibillion-dollar casinos have been built in the desert because of the insatiable human desire to speculate.

However, when speculation is confused with investment, trouble inevitably follows.

The Internet bubble of the late 1990s is merely one example of the speculative frenzies that occasionally occur in financial markets.

In The Intelligent Investor, famous investor Benjamin Graham set forth the principles that form the foundation of value investing. Value investors seek to purchase assets at prices that are substantially below the assets' true, or intrinsic, value.

Benjamin Graham (L), and General R.E.Wood, an official of Sears, Roebuck and Co., as they appeared at the Senate Banking Committee's Stock Market investigation in 1955. (Getty)
Benjamin Graham (L), and General R.E.Wood, an official of Sears, Roebuck and Co., as they appeared at the Senate Banking Committee's Stock Market investigation in 1955. (Getty)

Graham's timeless principles provide a map that all value investors can follow to stock market success.

According to Graham, investing consists of three elements:

1. Thorough analysis

Stocks are not merely pieces of paper or electronic quotations on a computer screen, but partial ownership interests in real businesses.

Therefore, you must thoroughly analyze the underlying business and its prospects before purchasing a stock. Equally important—given the endless amount of data that flows from the stock market on a daily basis—is recognizing the information you must ignore or discard.

For example, the average price of a stock over the past 50 days may be important to so-called chartists or technical analysts, but does that have any effect on the safety or value of the underlying business?

As Graham wrote, you must study "the facts in light of established standards of safety and value."

2. Safety of principal

Warren Buffett is fond of saying that his two rules of investing are:

Rule #1: Don't lose money; and Rule #2: Don't forget Rule #1.

Buffett undoubtedly inherited his strong aversion to permanent capital loss from Graham.

To succeed over an investment lifetime, you do not have to find the next Microsoft (MSFT), but it is necessary that you avoid significant losses.

3. Adequate return

For Graham, an "adequate" or "satisfactory" return meant "any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence."

Many investors will find that the best way to own common stocks is through a low-cost mutual fund or ETF (exchange-traded fund) that tracks a broad market index such as the S&P 500.

Index funds allow investors to participate in the growth of American business, which has been very satisfactory over the last century. In addition, very few active managers have outperformed S&P 500 index funds over long periods of time.

Therefore, if you decide to construct your own portfolio of stocks or to purchase shares of an actively managed mutual fund, your investment return must exceed that of a low-cost index fund over the long term to be "adequate."

Otherwise, "reasonable intelligence" should dictate that you own an index fund.

Dive deeper: Benjamin Graham: Lessons from a legendary investor

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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