The Easy Way to Vastly Improve Your Results
Editor's note: For the rest of this week, we're doing something special... Over the next several days, we're sharing some of Porter's all-time-best Friday Digests. Whether you're a longtime subscriber or brand-new to Stansberry Research, these classic, educational essays are guaranteed to make you a better investor.
In today's essay – originally published in December 2013 – Porter explains the first (and most important) step on the road to investment success...
The Easy Way to Vastly Improve Your Results
The simple reason most people will never acquire a significant amount of wealth is because most people lack the discipline to save money. It's really that simple. Think about how much money you earned last year after taxes. Think about how much you saved. Was it enough for you to meet your financial goals?
My recommendation is that you always save half of what you earn. That's what I've done my entire life. Now, understand, I count a lot of things as "savings." Real estate purchases, for example aren't really investments at all. They're a form of savings.
In this way, saving half of what you earn isn't impossible. I know, because I've done it... even early in my career when I was working as an entry-level analyst making $34,000 annually. I lived on a friend's sofa for two years. I drove a 20-year-old Honda Accord. Now... none of these things may be attractive to you... but the point is, saving money can be done if you make it your top goal.
If you don't, it's unlikely that you'll ever possess a significant amount of wealth. That's not what we write about in our sales letters. But it's a real, hard-core fact: Without capital, it's impossible to make good investments.
Here's a good rule of thumb... Get completely out of debt (except, perhaps, for your primary mortgage) and save at least $50,000 in cash before you consider investing in securities (stocks and bonds). I can imagine the howls I'll get for putting this simple rule out there. People will complain that I'm only interested in serving "rich" investors. That's nonsense... We sell the highest-quality investment research you can buy for as little as $5 per month. We care, passionately, about serving small investors and helping them develop an edge over Wall Street.
Nevertheless, this is the advice I will give my sons, so it's the advice I will give you. The principle behind this idea is very important to understand: Until you've mastered the discipline of saving money, you have no realistic chance of developing the discipline to manage capital. For another, far more famous perspective on this idea, try reading The Richest Man in Babylon by George Clason.
Now, here's the bad news... Even if you develop the discipline to save a lot of capital, you are unlikely to be successful as an investor. At least, that's what studies of actual individual investor results tell us.
The investment-management firm BlackRock conducted one of the largest, most thorough studies. Over a 20-year period, from 1992 through 2011, the average individual investor earned 2.1% per year before taxes. Stocks went up 7.8% annually during the same period. Those same kinds of numbers – around 2% annually – are also what mutual-fund consultancy Dalbar has found in its research.
In my experience, the No. 1 reason why most individual investors fail to achieve positive results (never mind beating the market's average return) is because they're totally unprepared to manage risk. So let me tell you as clearly as I possibly can: 90% of your success or failure as an investor will have nothing to do with your investment selections. Almost all of your returns will be dictated by asset allocation – how much of your portfolio you assign to categories like stocks, bonds, cash, and commodities – and how you manage risk.
Until you begin to rigorously allow your winners to run and always cut your losers, it will be nearly impossible for you to be successful. Consider your results for the last year and ask yourself how much better off you'd be today if you had simply cut your losses based on trailing stops and allowed your winners to run (rather than selling to book a quick profit).
If you haven't yet, I'd urge you to try using TradeStops. This is the easiest way I know for you to improve your investment results. It's a Web-based service that will track all of your trailing stops for you (so you don't have to enter them with your broker) and so much more. You'll never miss a stop again. Now... do you have the discipline to follow the strategy?
By the way, I recognize that trailing-stop losses aren't the only way to manage risk. If you prefer to invest in very conservative companies with strong balance sheets that have essentially no chance of going bankrupt, you might be better off with a "buy and hold no matter what" strategy.
But please understand… folks who use this approach need to have strong accounting skills, know how to value a security, and have excellent business judgment. They also have to have an iron will... because most people end up practicing "buy and fold" instead of "buy and hold"… that is, they lose their nerve in a downturn and sell at the worst moment.
If you're using this approach, I'd still recommend disciplined risk management. Keep your initial position sizes small, so that no matter what happens, you can't suffer a catastrophic loss. My largest initial position sizes are no more than 3% of my net worth. If something surprises me and goes wrong, it won't change what I eat for breakfast, nor will it ruin my investment returns for more than a quarter or two.
Unless you've been successful as an investor in securities for at least 10 years, I'd consider using trailing stops to be mandatory. Think of them like training wheels that are going to keep you from having any catastrophic wrecks.
Now... here's the last part to becoming more successful as an investor. Do your best to learn how to value a security.
Think of a business you know well and look up the annual report (form 10-K) it filed with the Securities and Exchange Commission.
Read it carefully – especially the notes at the end. Look at the financial statements. Figure out how the numbers correspond to the business activities. Once you've done this for two or three businesses, you'll be able to figure out how just about any business in the world works (except insurance companies, whose annual reports are ridiculously complex).
Once you've figured out how to look up the numbers, a final rule of thumb is to never pay more than 10 years' worth of cash profits, after all capital investments have been taken out. Understand, this is merely a guideline... But I'm certain that if you haven't been successful as an investor, the two most likely reasons for your underperformance are: 1) You suffered catastrophic losses, and 2) You've purchased too many expensive securities.
It's very difficult to do well in stocks over time if you're buying them at expensive valuations. On the other hand, it's nearly impossible to lose money in stocks if you'll buy high-quality businesses at reasonable prices – especially if you're disciplined about managing risk.
Regards,
Porter Stansberry