Legendary investment thinker and father of value investing, Benjamin Graham, wrote in his classic books, Security Analysis and The Intelligent Investor, that investors should never ask whether or not they should invest in stocks, invest in bonds, invest in real estate, invest in mutual funds, buy shares of a certain company, or sell bonds in a certain issuer. Instead, they should train themselves to ask two questions: 1.) "On what terms?", and 2.) "At what price?".
In your investing life, those are two of the questions that matter most. Those are the two questions that can help you frame all of your investment decisions, putting things into perspective.
To understand why these ideas were revolutionary and helped many of Benjamin Graham's students go on to amass net worths of hundreds of millions, and in some cases billions of dollars (the most famous example being Warren Buffett), you have to break down the two concepts individually.
Investing Question #1: On What Terms?
The terms of any negotiation matter. What if you were offered a new car for $1 but the contract said that you couldn't drive it, lease it, or resell the parts? What if you were promised a 10,000% return on your money but you wouldn't get the payoff for 100 years? In the first case, the price is a bargain but the fact you can't drive or liquidate the car means it has no utility to you so even $1 is overpriced. In the second scenario, 100 years from now, you will be dead and your family tree likely in the dozens, or even hundreds, of members so you'd be a fool to enter into an agreement.
Here's a simple example of how terms matter in the investing world: There is a big difference between a zero coupon bond and a traditional bond. The first only credits you interest payments, which get added back to the bond value until redemption even though you have to pay taxes on the phantom income each year, whereas the second results in an interest check being sent or direct-deposited semi-annually to you for the money you loaned a company. The same business, the same investment safety, the same interest rate, and the same bond issue size all result in radically different outcomes for an investor because the terms of the deal are different. If you need money upon which to love, you'd starve to death owning a zero coupon bond.
Likewise, two identical companies with different management or share ownership structures may result in wildly divergent outcomes for stockholders. Many businesses today are controlled by dual-class voting structures that allow a founding family to maintain power of the Board of Directors. Sometimes this is good, sometimes this is bad. Other times, a good company sees most of the reward flow to excessive compensation for management, which lines its own pockets at the expense of the true owners of the business.
Investing Question #2: At What Price?
We've discussed many times in the past that price is paramount. To put it more bluntly, the price you pay for an investment is one of the most important determinants in the ultimate return you earn on your money. Imagine you are bidding on an apartment building that generates $100,000 in profit each year. If you pay $1,000,000, your return is 10%. If you pay $500,000, your return is 20%. The same building. The same tenants. The same county, state, and street address. Yet, the lower price will result in much faster wealth accumulation and a much higher standard of living for you and your family. The only difference is the price you paid!
Constantly, throughout the year, I'm bombarded with letters and messages asking, "Do you think Procter & Gamble is a good stock?" or, "Do you think I should buy McDonald's bonds right now?". I hate these questions because they are the wrong questions. The right question would be, "Do you think Procter & Gamble is a good stock at the current market price?" or "Do you think McDonald's bonds are a good investment at the current market price?"
The Effect on Your Net Worth of Asking These Two Questions Can Be Enormous
By training yourself to ask Benjamin Graham's dual questions, you can avoid a lot of missteps when it comes to your investment portfolio. You could avoid mutual fund sales loads and "gotcha" fees. You could walk away from high pressure salesmen who try to convince you to buy overpriced financial securities with terms that are favorable to them. You could stop yourself from doing something stupid, like paying 50x earnings (or a 2% earnings yield) for a mega-capitalization stock that has no hope of growing profit per share by 50% or more annually.
Originally published on About.com on December 31st, 2011 at 3:54 p.m., Central Standard Time
