Don't Say I Didn't Warn You
The basic framework of risk... Two things to get right before buying an asset... The only way to buy risky assets... You never have enough information... A simple example of 'sufficient' diversification... Don't say I didn't warn you...
What is risk?
It's a difficult question for many folks. But it's one that I (Dan Ferris) like to revisit frequently...
I want to make sure our readers know how to think about – and answer – this question.
Hopefully, they can use it to take a deeper look at their own portfolios (and Stansberry Research's solutions for balancing risk in them). Far too many investors take on more risk than they should... and that's a recipe for disaster when trouble floods into the markets.
Let's start with the basic framework...
Risk involves a range of possible outcomes. An asset with a wide range is considered "high risk." One with a narrow range is "low risk."
For example, most folks don't expect to make 100% in a year on a 10-year U.S. Treasury note yielding 1.5% (as they do today). Nor do they expect to lose any money.
On average, with this asset, you'll probably make a return of 1.5% per year for 10 years (before taxes and inflation). Then, you'll get your principal – the amount you loaned to the U.S. government through the Treasury note – returned to you at the end of that period.
The reasonable expectation is a narrow range of outcomes. It's a low-risk investment.
Now, consider an example at the other end of the risk spectrum – junior precious metals exploration and mining stocks. In the same 10-year period, you could lose everything... break even... make 100 times your money... or any one of myriad other outcomes.
Much wider range of outcomes... Much higher risk.
The benchmark S&P 500 Index is somewhere in the middle...
The index fell roughly 38% during its worst year (1931) and rose almost 54% during its best year (1954).
From best to worst, that's a wide range of outcomes. But most of the time, the range is more narrow... Roughly 80% of the time, the index drops less than 18% in bad years and gains less than 25% in good ones.
So while the price of a particular asset might change a lot... the range may not change much at all.
As you prepare to buy an asset, you must get two things right...
First, you need to figure out if you understand the full range of possible outcomes. And more important, you must realize where in that range the price sits at that point in time.
When an asset's valuation is high, the range of possible outcomes may still be wide. But at that point, more of the possible outcome is downside than when its valuation is low.
That brings me to an important rule to follow if you want to be a successful investor...
The only way to buy risky assets – those with wide ranges of possible outcomes, like the junior mining stocks I mentioned earlier – is to pay the dirt-cheapest prices. Nothing less will do.
An entire industry spends its time figuring out under what conditions the range of likely future returns is skewed either down or up at any point in time...
For example, Liz Ann Sonders – chief investment strategist at investment bank Charles Schwab (SCHW) – noted on Twitter yesterday that the CBOE Volatility Index ("VIX"), the market's so-called "fear gauge," closed at more than 20 on Wednesday. Historically, according to Sonders, crossing that threshold has led to a "wider distribution of future S&P 500 returns."
"Wider distribution of returns" means more risk. But it doesn't tell you where we are in the range of potential outcomes... In other words, what's likely to happen in the near term.
Remember, investing is an art that requires you to prepare for a range of future outcomes...
Since nobody knows the future, you never have enough information.
You're always making decisions with some level of uncertainty.
Insurance companies call this underwriting... They don't know which folks will have car accidents. But based on the data available, they know that red Porsches have more accidents than white Honda minivans in certain zip codes (probably in most).
That's one reason why it costs more for insurance on a red Porsche (or any red car, according to my agent) than a white minivan.
How can investors prepare for a range of outcomes?
Many prudent investors prepare by holding a sufficiently diversified portfolio at all times. Diversification is "sufficient" when you're holding assets that don't tend to move up and down together.
The old "Permanent Portfolio" is one of my favorite examples of diversification. The late great Harry Browne and Terry Coxon introduced the concept in their 1981 book, Inflation-Proofing Your Investments.
The basic idea behind the Permanent Portfolio is this...
First, Browne and Coxon said to split your portfolio evenly among four assets – stocks, long-term bonds, gold, and cash. Then, Browne and Coxon said you should rebalance your portfolio once each year by buying and selling these four assets to get back to the original four 25% allocations.
The rationale for this asset mix is simple and straightforward...
Stocks do well during good times. Long-term bonds do well during times of deflation. Gold does well during periods of inflation. And cash holds its value during recessions.
From 1974 to 2011, the Permanent Portfolio compounded at 9.4% per year.
Even better, folks following this strategy never suffered gut-wrenching declines... The portfolio's worst year occurred in 1981, when it fell 4%. Stocks outperformed the portfolio many years, but they also crashed a few times in that span. The Permanent Portfolio never did.
That's a small range of outcomes.
Now, I'm not recommending that you should blindly follow the Permanent Portfolio today (though I suspect you could do a lot worse over the long haul). It's just a simple example of "sufficient" diversification.
But I'm starting to wonder how the Permanent Portfolio will do over the next few years...
The U.S. stock market currently trades in excess of two times sales, according to Bloomberg data. That's heady territory... It has reached that mark only one other time in history – the dot-com era.
And of course, regular Digest readers know how I feel about bonds today...
The world currently has $14 trillion in negative-yielding sovereign debt and $1 trillion in negative-yielding corporate debt. And the U.S. 30-year Treasury bond yields just 2% – abysmally tiny compensation for a 30-year loan.
Gold is never cheap or expensive on an absolute basis... As long as stocks and bonds remain expensive, I believe gold is cheap. And even though cash yields diddly squat today, we can trust it to just sit there and not do anything. That's the whole point of holding it.
For the bond and equity portions of your portfolio, I bet you'll do a lot better following Stansberry Portfolio Solutions products – The Capital Portfolio, The Income Portfolio, The Defensive Portfolio, and The Total Portfolio.
Headed by Austin Root, these fully allocated portfolios provide a more up-to-date – and lately, more profitable – example of diversification...
These portfolios contain between 20 and 40 of the highest-conviction ideas from our universe of Stansberry Research publications. Austin and the investment committee – Porter, Steve Sjuggerud, and Dr. David "Doc" Eifrig – work together to develop one-and-done model portfolios that will provide a clear, diversified path to outperformance.
In the latest issue, published earlier this week, Austin reiterated to subscribers that all four portfolios are still meeting or exceeding their goals so far this year. They're all outperforming their comparative benchmarks on year-to-date and annualized bases.
For example, through the end of September, The Total Portfolio was up more than 24% this year (about 33% annualized). Meanwhile, the S&P 500 was only up around 20% in the same span (about 27% annualized).
But still, some folks can't recommend owning stocks of any flavor these days...
Yesterday, I briefly mentioned this week's episode of our Stansberry Investor Hour podcast. It includes an interview with David Levine, founder of investment firm Odin River.
David is extremely intelligent... He earned law and MBA degrees from Harvard. And he has worked for some of our era's investment legends – like John Paulson, who made billions of dollars by shorting the housing bubble... Mitch Julis' Canyon Capital fund... and real estate legend Tom Barrack's investment-management firm, Colony Capital.
I first learned about David through his must-read Twitter feed – where he refers to himself as a "Paranoid Bull."
David's bullishness is more on humanity than the stock market... He believes our quality of life will continue to get better, due largely to technological progress.
I tend to agree, for the most part... I'm extremely optimistic that our quality of life and longevity will continue to increase.
Of course, nothing happens in a straight line... Progress is always messy.
So I had to push back a little on the technology angle...
I asked David about the backlash against social media giants Facebook (FB) and Twitter (TWTR), as well as our overall obsession with screens (laptops, phones, tablets, TVs). A lot of people say using this stuff is really bad for you...
David replied that it would be like saying cars were bad in the early 20th century because the Model T was a crappy car. We're early in figuring everything with technology out. But overall, life is improving for many people and will continue to do so.
I thought it was a good answer.
When it comes to the overall stock and bond markets, David is as bearish as I am...
A typical Paranoid Bull tweet reads, "The Unwind from a decade of excessive manipulation and intervention will take a second. Patience, kiddos." (That's sarcasm, in case you couldn't tell.)
I urge you to check out our conversation. I enjoyed it a lot, and I hope you will, too. If you tune in, listen to what David said you should buy when I asked for a recommendation...
Bank accounts insured by the Federal Deposit Insurance Corporation.
Immediately, David acknowledged the risk of holding any fiat currency right now. But he still said it's as safe as it gets these days.
Remember, cash is the part of the old Permanent Portfolio that is designed to get you through a recession...
Or as we discussed yesterday, an epic financial crash that gores and tramples the stock and bond markets like a herd of 2,000-pound bison running in a panic at 40 miles per hour.
Of course, I would never recommend being entirely out of stocks. You'll always be able to find some values and opportunities in the markets. But I do think now is a great time to hang on to a little cash... just to be prepared for what could be lurking around the corner.
Don't say I didn't warn you.
New 52-week highs (as of 10/3/19): none.
Several folks weighed in on yesterday's Digest about bison, swans, WeWork, and more. Send your notes to feedback@stansberryresearch.com. As always, we can't provide individual investment advice, but we do read every letter.
"Hi Dan, I've been following you for a few years now and truly enjoy your work. Your essay on WeWork [yesterday was] priceless – many thanks!
"On another front I want to thank you for your recommendation of the Steve Jobs biography by Walter Isaacson. It's a terrific read.
"As you're interested in biographies and have a musical education I thought you might like one that I recently finished: Sam Phillips: The Man Who Invented Rock 'n' Roll by Peter Guralnick. It's very enjoyable and fascinating to read how all of the pieces came together in the little Sun Recording Studio in Memphis. With your background I think you'd enjoy it." – Paid-up subscriber Jim G.
"Dan, I loved the bison stories and also the put-downs of WeDon'tHaveAnyoneSmartEnoughToWriteABisonStory. Now let me tell you about MY bison story.
"About twenty years ago, in my mid-fifties, I was not married at the time and so was taking a solo vacation from work. I went on a road trip, part of which was through Yellowstone park. At one point, I was in a line of cars that was stopped by a line of bison crossing the road. It was quite a long line of the animals, and the cars were waiting for some time. Wouldn't you know it, some IDIOT jumps out of his car and runs up to the line of bison to snap a photo (with a flash!)... of a calf with its mother!!
"Sure enough, there was nearby a BIG Daddy Bison who looked a whole lot less than pleased. HE started looking around at the line of cars. Unfortunately, I was not in a car. This was a motorcycle trip. So, as I looked completely different from anyone else in the line, Mr. Daddy Bison starts staring directly at ME. Imagine how much effort I put into NOT looking directly at him and pretending to be a hole in space. (I had shut off the engine when I got caught in the line of cars, of course, because I didn't want the sound to attract attention. Even if the engine were running, however, there was no way I could have maneuvered out of the line and turned tail.) Eventually, Mr. Daddy Bison decided I wasn't the problem and just went on. I think it's possible that Mr. Daddy Bison's focus on me may have saved Mr. Idiot's tail, but if my bike had had a rocket launcher I may have been tempted to put one into Mr. Idiot.
"P.S. I have since ridden as far north as Dawson City, Yukon, and have encountered herds of moose, antelope, and mountain goats. I ALWAYS remember that wildlife is wild." – Paid-up subscriber PES
"I don't disagree about the caribou and the bison, but I would be careful about the fist fight with a swan. Several years ago, when I was stationed in Germany, we toured some of the old castles and on the grounds there were some swans that stood almost 6 feet tall! They also liked to approach tourist and snatch gold or other bright buttons off their clothes." – Paid-up subscriber Tom H.
"Dan – Don't mess with swans, they can easily take out an eye. I once had an encounter with a Canada goose which was a draw, but swans are much bigger, stronger and meaner. Give them a wide berth!" – Paid-up subscriber Ira C.
"I wish Dan would write something every day. He is the most talented writer you have on staff and I always laugh out loud as he turns something very serious into a comedy show." – Paid-up subscriber TD
Good investing,
Dan Ferris
Vancouver, Washington
October 4, 2019