The Greatest Investors in the World Already Know This Secret
Editor's note: Yesterday, we shared Porter's classic essay on the single most amazing thing he has ever learned about finance. He explained how one simple change to your portfolio – which has nothing to do with the stocks you buy or even the trailing stops you choose – can potentially double your long-term returns. Better yet, it can even be used with the stocks you already own.
But this strategy won't just help you make more money... it will also help you avoid big losses during periods of market volatility. In today's classic essay – which originally appeared in the Digest in February – Porter explains exactly how this works.
But first, a brief market update...
August tends to be one of the quietest months of the year for stocks. Trading volumes slow and volatility falls as Wall Street traders take their official summer vacations.
But this month has been quiet even for August...
Credit Suisse analysts report daily trading volumes fall an average of 8% in August compared with January levels. This year, daily trading volumes are 30% below January's level... more than three times lower than usual.
The benchmark S&P 500 Index has now gone 27 straight days without a 1% move. According to Ryan Detrick, senior market strategist at LPL Financial, this has only happened three other times in the past 20 years.
Likewise, market volatility has plummeted. The Volatility Index ("VIX") – the market's so-called "fear gauge" – fell to as low as 11 this month. That's its lowest level in more than two years, and just its second-lowest level since 2008. In other words, the market is essentially as complacent as it has been since the last financial crisis.
As always, there are no guarantees in the market – after all, last year's big summer panic began in late August when China devalued its currency – but there are reasons to believe the calm could continue.
According to Jeff Hirsch, editor of the Stock Trader's Almanac, August has a negative bias on average... meaning stocks tend to end the month lower than they began. But that's not the case in election years.
Since 1952, both the S&P 500 and the Dow Jones Industrial Average has averaged gains of about 1% in election-year Augusts. This suggests we're unlikely to see a repeat of last year's late August plunge.
But next month could be a different story. Periods of market calm are always followed by periods of fear and volatility, and September is among the weakest months on average. Hirsch notes that even in election years, the market tends to peak in September and fall through early October, before moving higher again into year-end. And there are plenty of catalysts coming up next month that could support a move lower in stocks...
Earnings are still poor. Financial data firm FactSet Research reports S&P 500 earnings fell 3.5% in the second quarter, with 91% of the index companies reporting so far. It's safe to say earnings fell again last quarter, marking the fifth straight quarter of declining earnings. This hasn't happened since 2009, at the end of the last financial crisis. But this time, it has happened while official figures say the economy is still growing.
Stocks aren't cheap. The S&P 500 is trading at more than 25 times earnings, which is well above its long-term average.
And company insiders are selling at the fastest rate since last April, just before markets peaked in May, according to INK Research.
The Federal Reserve will return from its own August "vacation" next month as well. The Fed's next policy meeting will be held September 20-21, and expectations are growing that the Fed could be looking to raise interest rates again.
In an interview on Tuesday, New York Fed President Bill Dudley told Fox Business Network that the markets are underestimating the odds of additional rate hikes, and said it was possible the Fed could raise rates again as early as September.
Atlanta Fed President Dennis Lockhart echoed that sentiment in a speech yesterday, noting that "if the meeting were today, I think the economic data stream would justify a serious discussion of a rate increase."
We continue to believe the Fed will eventually have no choice but to join the rest of the world's major economies and push rates lower again... but we wouldn't rule out anything in the near term.
And of course, this November's presidential election is quickly approaching, and it promises to be one of the most volatile and uncertain in recent memory.
In the meantime, we hope you're enjoying our recent educational Digest series... and encourage you to take a little time away from the markets during these final, quiet days of summer. They may not last much longer.
And now, we'll turn it back over to Porter...
The Greatest Investors in the World Already Know This Secret
If you're worried about the stock market today, you need to read today's Digest...
There are investors out there that are weathering this storm... They aren't experiencing the large losses and volatility most folks are battling on a daily basis... And they're able to sleep well at night knowing their portfolio is prepared for anything that may come.
The topic I will discuss today should make (and save) you more money than any other advice I can give you. But you have to read today's essay carefully. You have to think about this concept. And you have to promise yourself that you'll take the time to implement it.
I know hardly any of you will take this concept to heart... Fewer will actually take action – even though it's one of the simplest and easiest things you can do – and it will make you a fortune over your lifetime.
So why do I bother writing to you about things I know you won't do? Because, as I often state, my goal is to give you the information I'd want if our roles were reversed.
If you take nothing else away as a Stansberry Research reader, let it be this...
The greatest investors in the world already know this secret. It's so simple, but it can make you a better investor overnight. It will transform a losing portfolio into a winner. And it has nothing to do with the stocks you buy or trailing stops.
I'm talking about using risk-adjusted position sizing.
Have you ever looked at your portfolio and noticed most of your best-performing investments are in the lowest-risk names? Companies like Berkshire Hathaway (BRK-B), Microsoft (MSFT), and Apple (AAPL), for example.
Look at the best-performing open positions across all of our editors' portfolios...
Constellation Brands (STZ) – the owner of alcohol brands like Robert Mondavi and Corona – has returned nearly 700%. Tobacco giant Altria (MO) is in second place, followed by fast-food icon McDonald's (MCD).
Buying big, safe, slow-growing businesses has proven time and time again to provide the highest investment returns.
Yes, we all know "Warren Buffett-style investing" can make you rich. But what's the actual reason this investment style works? As I wrote in the October 16 Digest...
These stocks have a few standout quantitative traits aside from these qualitative basics that can help you identify them in advance. First, they pay good dividends and have a long history of growing those payouts over time. And second (and this is far less understood by most investors), their share prices aren't volatile. Their stock prices tend to move around a lot less than the market as a whole. That's because they have a stable cohort of investors who own the company – investors who are unlikely to sell.
I explained that academics measure this advantage by comparing the daily volatility of a company's share price with the volatility of the benchmark S&P 500 Index – which is composed of the 500 biggest publicly traded companies in the U.S. This is called "beta." As I noted...
Stocks with a volatility equal to the S&P 500's average are awarded a volatility score of 1. That is, the volatility of these stocks is perfectly correlated with the market as a whole. Stocks that move around more have higher betas. So a company that is 50% more volatile than the S&P 500 would have a beta of 1.5. A company that is two times more volatile than the S&P 500 would have a beta of 2, and so on.
In other words, these high-quality companies are more likely to have dedicated, long-term investors. They're not trading in and out of stocks. As a result, the share prices of these businesses move around less than that of the average publicly traded company.
I've long suspected buying this type of business would lead to outperformance in our readers' investment returns. But I wasn't able to prove it until I saw a presentation from Dr. Richard Smith at our annual conference last year in Las Vegas. From the stage, Richard explained...
We put together a group of 40 real-life portfolios – real buy and sell data from real investors. I asked my team to back-test all of our different stop-loss and position-sizing strategies against these real portfolios to see which of our tools made the biggest difference in performance... And I was amazed to see that there was one tool that improved investment performance more than anything else: volatility-based position sizing. If you only ever pay attention to one thing that I have to say, this is it – use volatility-based position sizing.
Don't let the term "volatility-based position sizing" scare you away... It's simply using the volatility of a stock to determine how much of it you should own relative to the size of your portfolio. Ideally, you'd have the same amount of risk in every stock you own.
The concept is simple, but implementing it is a bit tougher. That's why this type of strategy has long been largely exclusive to the world's best banks and hedge funds. Luckily, Richard – who studied math at Cal-Berkeley and went on to get his PhD – solved that problem for the individual investor. He built an algorithm that determines the volatility of your portfolio, and tells you how many shares to buy of a given stock (any stock) so your portfolio is "risk weighted," meaning each position carries the same amount of risk.
More simply... The program keeps you from loading up on risky stocks and helps you buy more high-quality, safe stocks like the ones we recommend. You can still swing for the fences with the "sexy stock du jour"... you just do so with much less risk.
Let me share the details of the study Richard conducted. From that Digest...
To back-test the strategy, Richard took the 40 investor portfolios and figured out how much of each stock these investors would have bought if they had built risk-weighted portfolios instead of using their actual allocations. Just making this one change – just changing the amounts of shares they bought – almost doubled the average returns of the portfolios he studied.
As I explained, Richard didn't change the stocks these investors bought, the purchase dates, or the sale dates. He only changed the relative amounts of each investment...
Just making that one change saw the average return go from 6.7% to 12%. No other form of portfolio management – not even smart trailing stops – made as big of an impact.
Why did causing investors to focus on volatility work so well? Because volatility (as measured by beta) is a great indicator of risk. Colleges still teach that in the financial markets, risk equals reward. That might even be true in a lab setting. But it's not true at all with real live human beings. Most investors who set out to practice "buy-and-hold" investing end up doing "buy-and-fold." That is, they end up selling at precisely the wrong time... when fear in the market is peaking.
The result of Richard's study is a new tool he created for his best clients at TradeStops. You link your existing portfolio with this software, press one button, and it shows you how risky your portfolio really is. Press another button and the software shows you how to balance risk across all of your existing positions – and exactly how many shares you should own of each stock.
Linking your portfolio to this software and pressing two buttons will be the easiest and most profitable thing you do in your investing career. There isn't a single other thing you could do – certainly nothing as easy – that will drastically improve your investment performance.
Nobody is perfect. We all swing for the fences from time to time. And sometimes it works – just look at Steve Sjuggerud's Seabridge Gold (SA) recommendation atop our Hall of Fame. But Richard's software will allow you to do so with much less risk. And it will vastly improve your long-term returns.
Here's an example of one portfolio Richard examined during his back-testing study...
No. 438. (The investor account names were hidden and each account was assigned a reference number.) This investor had $434,000 in his account. Over the period of the study, he lost 23.1% of his savings – just more than $100,000. That's a massive, horrific loss.
But using Richard's volatility tool to change the position sizes of his actual investments, his portfolio would have produced a total return of $59,494 (a gain of 13.7%). Note: This simulation did not change the stocks purchased or the timing of the buys and sells. It merely changed the position sizes by equalizing the amount of risk in each position.
What would you pay for access to a system that basically guarantees to vastly improve your investment results? Whatever the cost, you would make it up with your investment gains. People are already seeing great results from Richard's program...
"I love you guys, I feel a lot calmer about my stocks, I feel like you are an insurance company that helps me not lose my hard earned money. I feel much safer with you on my team, keep up the great work. You guys are mathematical geniuses." – Theresa H.
"I have been a subscriber to your service for several years and I am delighted with it. You keep on improving the software and as they say in the service 'you go above and beyond the call of duty.' Thanks!" – Tom C.
With Richard's TradeStops Premium, you just hit one button to know how many shares you should buy of any stock to equalize the risk in your portfolio. You can also use it across your existing portfolio to rebalance it with the proper risk.
This is just one part of a complete set of tools Richard has designed to give individual investors access to the same systems professional investors use – systems that drastically reduce your risk and improve investment performance.
If you invest in stocks, you should absolutely be using Richard's service. It's simple to implement. It will improve your investment results. And it could be the single most profitable decision you make. Click here to take advantage of a special risk-free offer.
Regards,
Porter Stansberry
Editor's note: To see for yourself how TradeStops Premium can simply and easily double your potential investment returns – without taking on more risk or changing any of the stocks you already own – click here now.