Benjamin Graham's 'Margin of Safety' theory suggests stocks are a mediocre buy, but bonds should be avoided at today's prices.

Correction: The original version of this article erroneously cited the present value of a 1981 Treasury bond as if interest was compounded at the issued rate (Treasury bonds pay simple interest). This example has been updated to use a zero-coupon Treasury bond (first available in mid-1982), that, when purchased at a discount, exhibits the characteristics of compound interest (in this case, yield to maturity).

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:

Never hold less than 25% in stocks, and

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 (later in life, Graham considered a ratio of 1.33 times acceptable). 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 been flashed a warning signal before most stock market panics. (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 been able to purchase $10,000 worth of 30-year zero-coupon Treasury bonds in June 1982 at a yield-to-maturity of 13.91% (please note, this is a hypothetical example based on historical interest rates), the bonds would be worth nearly $500,000 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 City

Follow @johndefeo