The two greatest secrets of investing...

The two greatest secrets of investing... The importance of asset allocation... Why valuation is critical to every investor... How to use trailing stop losses with big dividend payers... What I'm doing with my own money... In the mailbag, success is the best revenge...

In prelude to today's Digest... What you're about to read is critical for you to understand. This document will explain the greatest weakness of individual investors and give you the two greatest secrets of professional investors. These two ideas will enable you to make money in any market, year after year – without ever taking a loss. These ideas are extremely simple, and anyone can easily use them. But before you begin to read this essay, I have to acknowledge two things about this information...

First, you'll remember how many times I've told you trying to teach our subscribers anything is a fool's errand. Let me explain... Based on my experience (my own learning, training dozens of analysts, etc.), I don't believe in teaching. I don't think it's possible to teach anything. Or, as I tell people, there is no teaching, only learning. What I mean is... until you are emotionally prepared to learn, nothing about your cognitive position will change. And this is doubly true when it comes to learning new behaviors, especially when those behaviors are tied to something that is as emotionally charged as money. As you read today's Digest, know that I don't expect you to change your investment strategy. I already know you won't.

So why bother writing things like this? Because sooner or later (hopefully sooner), some of you will make the decision to learn. At some point in the future... maybe after you've looked back over 10 years of investing only to find you haven't made anything (or worse, you've lost money)... maybe after you've suffered your third catastrophic loss in six months... you'll realize your actions aren't rational. You'll discover what you've been doing isn't giving you the results you desire. At that point, you'll want to learn how to do better. That's when you'll go online and search for this essay. That's when you'll be ready to read it. That's when you'll learn what I'm going to explain below...

I'll offer one more warning about this information. When you read this, your most likely reaction will be to say to yourself: I can't do this. You see, if you follow the secrets I'm about to explain, you will become a truly great investor – among the best in the world. But we all know that only a small percentage of the world's investors can do substantially better than the market as a whole. Everyone can't be a successful outlier. Investing isn't like Lake Woebegone... not every investor can be above average.

How do the markets weed out the weak from the strong? Simple: The markets challenge your emotions. What's difficult about investing isn't getting the right facts. What's difficult is learning how to put them to work. Thus, when you read this essay today, your emotions are going to tell you, "This isn't for me"... or "I don't have time for this"... or, most likely, "This won't be as much fun as what I'm doing right now."

Again, you must be wondering... if I don't believe in teaching and I don't believe most of you will ever put these secrets into action... why then do I continue to write these Friday Digests? Do I get some kind of perverse thrill from tilting at windmills?

No, I don't. My partner Bill Bonner told me something about 15 years ago that's always stuck with me. He likes to say, "We can't guarantee our success. All we can do are the right things to deserve it."

I believe I have an obligation to try to make our subscribers better investors. I also believe I have a constant obligation to give you the information I would want, if our roles were reversed. If I was the subscriber and you were the publisher, I'd want you to tell me about these secrets. I'd want you to try your best to give me the information I need to be successful.

And so... I will keep giving you this kind of information. I'll keep pushing you to make these kinds of changes to your strategies. And I know... at least for some people... It will make a vast difference in their financial lives. I hope that's you. I hope today's message is the one that "breaks through" and shakes you in just the right way.

So... what are these two big secrets?

The first secret will probably shock you, given our business model of selling investment research. But here it is:

On the whole, individual stock selection doesn't really matter. What really matters, over the long term, is asset allocation decisions. It's not what stocks you buy. It's when you buy stocks versus when you buy bonds, gold, cash, real estate, etc. that matters.

Several academic studies demonstrate why portfolio allocation (how much of which type of assets you own) is far more important in determining your results than simply which stocks or bonds you buy. The first (Brinson) was published in 1986. And Ibbotson and Kaplan published the best study (in my opinion) in 2000. The latter looked at 94 U.S. mutual funds and several asset classes. The researchers concluded the differences in asset allocation among the funds explained virtually 100% of the variance in their returns. Differences in stock picks made virtually no difference whatsoever to total portfolio returns.

You can look these studies up and read them if you'd like. But the takeaway from these studies is simple: Asset allocation is far more important to your total portfolio return than stock picking. That's why most professional investors (like the top hedge-fund managers) allow analysts to do the stock picking, while they focus almost exclusively on the core allocation decisions.

On the other hand, most individual investors don't spend any time or effort on managing asset allocation. They're typically fully invested in stocks all the time. Most individual investors don't even know how to buy bonds (which is a critical component of asset allocation), and they do a terrible job at position sizing, another critical component. We're going to come back to asset allocation in one minute and I'll explain how to do it... But first, you need to understand the second big secret...

The second secret is how to properly value a security. In my experience, most individual investors have zero ability to calculate even the most basic measures of value in either a stock or a bond. How can you buy a stock or a bond without knowing how to value it? And yet, that is what most individual investors do every single time they buy a stock.

Believe it or not, most of the people reading this essay probably believe a $20 stock is twice as valuable as a $10 stock. It is nearly impossible to explain to them that the nominal price of a stock has nothing to do with its value. The value of a stock can only be determined if you know the cash earnings that underlie its shares and multiple other things about the balance sheet and the outlook on the corporation it represents. Rather than study any of those things, most individual investors prefer to focus on changes in nominal prices. That explains why individual investors are typically much more interested in nominal price trading systems than professional investors (though there are certainly many exceptions to this rule).

Whether you prefer to focus on nominal price changes or not, you have no excuse for failing to understand how to value a security. To learn how, try reading our two most dedicated value-based analysts Dan Ferris and Mike Williams. They dedicate most of their advisories (Extreme Value and True Income, respectively) explaining the intrinsic value of their recommendations.

Dan's letter has become one of the most respected in the world because of his ability to accurately decipher the true value of even complicated holding companies like Altius Minerals and Sprott Resources. If you look at our Top 10 list (our top 10 best-performing open positions) or our Hall of Fame, you'll find repeated examples of Dan's approach.

Likewise, with each new recommendation in True Income, almost all the text is dedicated to explaining liquidation value of the bond that's being covered and the future value of the coupon payments, given the bond's current price.

If you use both these secrets together (asset allocation and proper valuation), you can become a vastly better investor. Here's a real-life example from my newsletter, Stansberry's Investment Advisory. In December 2008, I was urging readers to buy as much gold bullion as they could reasonably afford. I understood what would happen to commodity prices in the face of the Fed's decision to bail out the banks. I also suspected quantitative easing was coming.

But because I am also always looking for value, I noticed a rare anomaly. Gold stocks (the big gold producers) had been hammered in the 2008 bear market. As a result, there were huge discrepancies between what the stocks should have been worth based on the price of gold and the value of their production and current share prices. This difference between their share prices and the value of their production had never been greater. Thus, if you wanted to allocate assets to gold, the best way back then was with gold stocks because of the tremendous value they offered. And so I told my readers: "You should immediately buy gold stocks. In fact, I'm convinced you'll never have a chance to buy gold stocks this cheaply again."

If you look back, you'll see the price of gold was around $850. It's gone up a lot – like I knew it would – about 64%. But the gold producers ETF I recommended in that letter (GDX) is up a lot more – about 107%. The additional gain we've earned was the result of knowing it was time to buy gold... and knowing what form of gold to buy, because of our focus on value.

So if you want to do a better job on asset allocation and you're ready to learn more about valuing securities... where should you start? We don't write much about asset allocation because we need renewal income to stay in business. Even mentioning the words "asset allocation" causes people to cancel. They don't want to hear it.

The other reason we don't often talk about it is a lot of asset-allocation decisions depend on your personal position in life. Are you worth $10 million and your brokerage account is merely how you like to play poker? Then these ideas don't apply. Or perhaps you're a 30-year-old investor with a good career, who has another 30 years of relatively high income ahead of you. Again, these rules might not apply. We don't (and can't) provide individual advice, so you'll have to figure out how to manage your own asset allocation.

But I can show you a model...

Let's assume you're a 55-year-old with $100,000 in your portfolio. (That's about average for our readership. You'll have to make adjustments based on your personal differences from this model.)

In order to build a "neutral" starting point, we also have to ignore value considerations (for now). At 55 years old, if you're in good health, your life expectancy is roughly 85. You will work full time for another 10 years. Ideally, you'll be able to save $50,000 per year for the next decade. Given your relatively small nest egg, you need plenty of capital gains. But given your age, you simply cannot afford to lose anything – not even a penny.

Also, you should note, this plan requires you to save a large amount of money every year. That's life. Folks who want to become rich, but don't know how to save are hopeless. Don't be one of them.

Given this example, if you're able to earn 12% a year (after taxes) on your portfolio, you'll end up with a nest egg of $1.13 million by the time you reach 65. You won't be "rich." But you should have plenty of money to fund a comfortable 20-year retirement. Earning 12% a year isn't impossible. In fact, it's easy. And you don't have to take any risks to accomplish it. Let me show you how...

Here's my suggested neutral allocation...

1. Put at least 50% of your assets in fixed income. That should include 30%-40% in corporate bonds bought at a wide discount from par, where the yield to maturity is at least 10%. This should include 10%-20% in cash and cash-like holdings, where your annual yield will be at least 10%. (I wrote last week about how to get double-digit annual returns from cash and cash-like holdings.)

The overwhelming majority of our readers will never allocate this much of their savings to fixed income, no matter what I tell them or how many years in a row we demonstrate how easy it is to make stock-like returns with bonds. To review, please read the Report Card this year where I cover the performance of Mike Williams' True Income.

Mike continues to average huge returns (more than 33% last year), with a "win rate" greater than 90%. He does this year after year after year. How? He's buying securities with the legal obligation to repay you $100 for usually less than $70. It's difficult for companies to avoid paying out these huge returns. That's a much, much better position to be in than most stock investors will ever see. And yet, no matter how many times we explain this to subscribers, it doesn't seem to matter. They're simply not interested.

Learning to invest in and value corporate bonds is the single most important thing we could ever teach you. That's why True Income costs $2,500. But believe me, learning this information at any college would cost you a heck of a lot more. Plus, with us, I can just about guarantee you'll earn back that tuition quickly.

And I can also promise you one more thing: You might decide today that you don't need to read True Income. You may feel bonds aren't right for you right now. But sooner or later, you're going to change your mind. And the sooner you do, the better off you will be.

Mike Williams has been generating huge returns on his bond portfolio... But I'm not planning on this to continue forever. Assuming you've got a discounted bond/cash portfolio that is producing 10% a year in income, it's not a big stretch to assume your total returns will average 14%-16%, including capital gains. If you're earning 16% a year (roughly half what Mike earned subscribers last year) on half your portfolio, then your total portfolio return is already 8%. You're 75% of the way toward your goal.

2. Place no more than 30% of your assets in the stocks of regular operating companies. This part of your allocation should focus on dividend-paying "World Dominator" stocks – the kind of high-quality companies recommended in several of our letters. Ideally, these will be companies you will hold onto for decades because they continually raise their dividend payments.

To hold these stocks safely for a long, long time, you'll need to understand how to adjust your trailing stop losses to account for dividend payments. It's easy to do. Consider my recommendation of Exelon. Right at the bottom of the market in October 2002, I recommended Exelon as the highest-quality electric utility on the market. I predicted it would continue to raise its dividend and become a great long-term investment. We bought in the low $20 range almost 10 years ago. After raising its dividend several times, the stock now pays $2.10 per year. Based on our purchase price, we're making almost 10% a year in dividends alone. So even though the stock has fallen from $90 to $40, it doesn't much matter to us.

So rather than use a trailing stop loss (which might force us to sell purely based on a stock price that went up far too high and then fell back to normal), we use a simple stop loss on these positions, adjusted for the dividends we've been paid. We bought Exelon in the low $20s. It's paid us $13 in dividends so far. So our original capital at risk here is only about $10. The stock price would have to fall to $10 before we'd be forced out by our capital conservation rules. It's critical to understand that once a dividend-paying stock is yielding 10% or better, the normal trailing stop rules don't apply.

Here are your value rules when it comes to buying stocks in this 30% allocation, blue-chip category:

1) Don't pay more than 10 times cash earnings for operating companies.

2) Don't pay more than book value for asset-based companies.

3) Get at least 5% a year in dividends or share buybacks, on average. And always favor cash-dividend payers.

Assuming you build these positions over time, you'll be earning at least 5% a year in dividends. If you only buy when there's value in these kinds of stocks, your 10-year average total return should be around 15% annually, which is what Dan Ferris has achieved in Extreme Value (without using any trailing stops). If you focus only on the safest values and use trailing stops, your returns are likely to be substantially higher – closer to 30% annually, as our trailing stop loss study proves. But to be conservative, let's use the smaller figure. If you're able to earn 15% annually on high-quality value stocks with 30% of your portfolio, that's another 4.5% of the total portfolio return you'll need to accomplish your goal.

OK… Now we've used up 80% of our capital between fixed-income investments and high-quality value stocks. We anticipate earning around 15% a year with each category, with the knowledge the total return in the equity portfolio is likely to be much higher. It's extremely unlikely we'll ever lose money in either of these two categories if we're disciplined about when we buy these kinds of securities and use trailing stop losses on the equities.

Thus, using only 80% of our capital, we can achieve the 12% total returns we need to retire comfortably. That leaves us with 20% of our capital to speculate with… where we have a chance to achieve vastly higher returns…

Take this 20% and focus on the deeply cyclical areas of the market. Sectors like precious metals, real estate, energy, semiconductors, volatility (selling puts), etc. Use money from this area of your portfolio to buy one or two "moon shots" each year. Go ahead and buy that tiny gold mine Matt Badiali recommended. Take a flyer on one of Frank Curzio's secret tech companies. Trade Jeff Clark's options. Load up on my short sell recommendations.

Remember this: You'll need to let your winners ride a long way to overcome the losses you'll inevitably suffer as a speculator. And if you refuse to cut your losers short, you'll eventually lose everything in this category. Speculation is a far different animal than investing. Few people can do both well.

My advice? Until you've learned to be a successful investor, don't try to speculate. You'll be far more successful with your speculations once you fully understand the principles of sound investing.

So this is your basic allocation: 50% fixed-income/cash, 30% high-quality equities (with a focus on dividend payers), and 20% speculations, including short sells. How can an individual manage a portfolio like this? Actually, it's easy. Just don't allocate more than 5% in any one stock. And don't allocate more than 10% into any one bond or cash-like instrument.

So to build your value stock portfolio, you'll need six companies. That's it. Put 5% in each one, and you've got your 30% allocation. Then, with your 20% speculative portfolio, take four flyers at a time. Put 5% into each one. That's your 20% allocation. You trade them as necessary. So at any one time, you've only got 10 stock positions to keep track of. And you'll only have to buy five bonds/cash instruments. So in total, you should never have more than 15 positions.

I recommend keeping a file card on every position you initiate. Write down why you bought it and what you expect to earn. Write down what would make you sell it, including your trailing stop loss. Make sure you can describe the business model of every business you own to a friend, without looking at notes. Review your notes once a month. You'll have a very good understanding of what you own, why you own it, what the risks are and what you're supposed to earn. You'll be in charge. It's not that hard.

And here's the extra credit. If you've got 80% of your portfolio in high-quality bonds, stocks, and cash, you should be able to use those assets to guarantee the margin you need to sell puts profitably… This advice is only for experienced investors who understand how to sell puts. Anyone can do it, but you'll have to study the concept for a while and get a good broker who will work with you on your trading to make sure it's safe.

Here's how to do it. You take the 20% of your portfolio that's reserved for speculations and put it with your option broker. In return, he allows you to sell puts that cover 100% of your portfolio's value. In theory, this could result in you having to liquidate your existing portfolio and buy into the stocks you've sold puts on. But the reality is, if you're selling puts with strike prices that are out of the money, you almost never get "put" the stock. Instead, you can earn 5%-10% on your entire portfolio each quarter in put premiums. Sometimes these premiums will be much, much larger – as much as 20% per quarter. If you will learn to sell puts, you can greatly increase your total returns, without adding very much to the risks you're taking.

The key is – and this is critical – never sell a put on a stock you don't actually want to buy or at a price you're not happy to pay. The other key is, don't sell puts in a quiet market. You must wait for volatility to spike… for other investors to panic. I haven't recommended selling any puts since last June because the market has simply been too quiet. But you can bet these opportunities will eventually return. (They seem to be returning right now…)

When the put premiums become attractive again, you'll want to have a relationship with a broker in place and have the ability to leverage your portfolio. Dr. David Eifrig taught me everything I know about selling puts. He's now guiding our efforts directly in his new product, Retirement Trader. For anyone who truly wants to make extraordinary returns trading, learning to sell puts is my No. 1 suggestion.

(My No. 1 suggestion for investors who want to make truly stupendous returns is to study the corporate-bond market, using Mike Williams as your mentor.)

What about diversification? If you focus on buying values, you'll naturally end up diversified. Plus, owning 15 different positions is diversified enough to protect you, but still manageable for an individual.

How would I recommend adjusting this allocation today, given the situation in the markets and the risks to the U.S. dollar? Clearly, you won't find many good values. The rebound in stock prices since the spring of 2009 has almost completely eliminated any obvious buys. We're finding some here and there… but there is no real value in equities today. As a result, I've sold almost all my personal equity investments over the last several months.

What have I bought, instead? I've greatly increased – more than doubled – my exposure to real estate. I've been buying cheap apartment buildings in south Florida out of foreclosure. I've been buying unique, trophy real estate there, too. I think the middle of the market is still going to fall a lot… But the top end and the bottom end represent an outstanding value – one of the best opportunities of my life.

My personal allocation looks extremely skewed – with probably half my net worth now in real estate. But… I'm only 38. I have a good income and a large net worth. I can afford to take a risk like this when I perceive a tremendous value. And real estate has never seen a collapse like this, not since the Great Depression. Also, you have to remember, I was allocating heavily to precious metals and equities in late 2008 and early 2009. Those assets now make up a substantial portion of my net worth because they've greatly increased in price. I don't have to buy them now because I bought them when they were a great value.

What if you're starting from scratch today? I would have at least 75% of my portfolio in cash and/or discounted corporate bonds. I don't perceive any value (broadly speaking) in equities today. I fear a correction is coming to gold and gold stocks. Gold has gone straight up for 10 years. At some point soon, the Federal Reserve will have to at least "jaw-bone" gold down or attempt to control it from soaring.

Thus… if I was just starting out today, I'd put 5% in gold and silver. It's not a great value today, but it's critical to own some because it's the best way to protect yourself from the U.S. dollar.

Then I'd have my 20% speculative portfolio working. There's never a bad time to speculate… It's really the only thing to do right now with new money.

Please click on the respective links to sign up for True Income and Extreme Value, our best letters for readers wanting to master investing. After reading both letters for one year, you will be a much better and much wealthier investor.

New 52-week highs (as of 2/24/11): Mirasol Resources (MRZ.V), DirecTV (DTV), Hershey (HSY), Abraxas Petroleum (AXAS), EV Energy Partners (EVEP), North American Energy Partners (NOA), Philip Morris International (PM).

In the mailbag today… the most timely and poignant letter we've ever received at the office. It's not easy to jar us out of our cynical, money-grubbing daily routine. But this letter did it. It was a great reminder of our core values. Don't miss it.

And please let me know what you thought about today's Digest. I continue to read every e-mail you send: feedback@stansberryresearch.com.

"I write a column for my hometown paper in Colorado. It was printed last month, but I will send to you the copy as submitted… Porter (if you actually read this), I know you, but you wouldn't likely remember me from a workshop in New Orleans. I am a member of the S&A Alliance.

"'In the newsletter True Income, Mike Williams refers to a plaque on the desk of his boss, Porter. It reads, "The best revenge is success." If you never make any bad decisions, never lose the confidence of others, have a great attitude at all times, and wish only the best for everyone, you may not need this plaque.

"'For the rest of us, there is a message. It takes 43 muscles to frown, and only 17 to smile. Similarly, it is more beneficial to pursue positives than feed on negatives. Our heads may nod yes, but our hearts know better – it's not so easy. But, a life rightly lived is a life that doesn't bear the pain of a grudge seeking negative revenge.

"'It is a special moment when a person stops living in defense of himself, stops getting even. He quits calculating and maneuvering; he just starts living. He doesn't stop listening, he just listens better. He doesn't throw away his education, he just finds what works for him and does it. He doesn't stop caring for others, he just finds his love is itself reward enough, acknowledged or not. He doesn't stop reaching, he just grows what he knows, and passionately seeks for more. He doesn't cut himself off from others, but he is delivered from a need to always seek their approval. He doesn't pretend he has no fear, he just learns to walk with inward peace.

"'I like the plaque on Porter's desk. For some people, revenge is a terrible thing, a thing of emotional turmoil, perhaps even a bad attitude; at its worst, hatred. No, that is not the Porter I know, and that is not what the plaque says to the wise and to the understanding. A life full of life is success enough.'" – Paid up subscriber Richard A. Nelson

Porter comment: I can't recall ever being so moved by a subscriber's letter. There's something that Richard didn't know about that plaque. It means something very special to me…

In early 1999, I was fired from my job as a financial researcher. I had no warning. My boss called me "the least entrepreneurial person he'd ever met." He asked me to leave the building. I was devastated, as anyone who has been fired understands.

In 2005, about six years after that event, I moved back into the same building from where I'd once been fired. It is now the headquarters of Stansberry & Associates Investment Research. My partners completed a $2 million renovation of the building, which returned it to its original, 1870s splendor. It is now one of the two or three finest restored mansions in Baltimore. The conference room where I'd once been sent packing is now part of my office suite.

We had a party to celebrate the grand opening of the building in late 2005. My parents surprised me by attending the party. They were proud I hadn't given up on my career in financial publishing. They didn't care so much about the success of my business… only that I hadn't quit or allowed the disappointment I felt from the way I'd been treated poison my ambitions. My dad gave me the plaque for my desk, "Success is the best revenge."

Whatever happened to the guy who fired me? That's a tale for another day and another person to tell. As for me, success is the best revenge.

Regards,

Porter Stansberry
Baltimore, Maryland
February 25, 2011