Thursday, July 10, 2008

Security Analysis: Chapter 7, Part II

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

Certain fixed-income securities have higher yields due to their higher risk levels. Conventionally, it is accepted that the higher yields approximately make up for the occasional loss to the principals of these securities, suggesting there is no difference between investing in high-yield vs low-yield securities. Graham and Dodd argue that in practice there is no such simple relationship between the yield and the risk of a security.

Rather, the differences in yields between securities occur as a result of many factors, including the issue's popularity, its public familiarity, and its marketability.

They further argue that even if there were such a relationship between risk and yield, the income-seeking investor is in no position to make such tradeoffs. The fact is that many high-risk securities tend to lose their principals in bunches (i.e. during recessions), which income-seeking investors are neither psychologically nor financially prepared for. High-yielding securities are for those seeking gains in principal as opposed to those seeking income, and therefore guidelines for such investments are described in a later chapter.

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