The Two Most Important Concepts in Investing (And Why It Doesn't Matter Which Stocks You Buy)
Editor's note: In a raging bull market like the one we've seen for almost the past 10 years, it's easy to forget the most important fundamentals of good investing. After all, when everything is going up (except GE), it's not hard to do well in the markets.
But these "frothy" markets won't last forever. Sooner or later, investors who have made wise choices will be rewarded... And investors who have made foolish bets will be punished.
Today's Masters Series essay is adapted and updated from the February 25, 2011 Digest. In it, Porter explains the two most important concepts for successful long-term investing.
Do you know what they are?
The Two Most Important Concepts in Investing (And Why It Doesn't Matter Which Stocks You Buy)
By Porter Stansberry
There are two ideas – just two – that are absolutely crucial for successful investing.
If you understand these ideas fully and execute them well, you can make money in any market (bull or bear) without ever taking a loss.
And although these ideas are very simple, most investors don't know anything about them. This lack of basic investment knowledge is the main reason why – according to surveys of actual investor results – most folks barely make any money in the markets.
If you've struggled to make money with your investing or you've had trouble making money consistently, I'm 100% certain that learning these two concepts could transform your investing results forever.
And so, I truly hope you'll read what's below and think deeply about why these ideas work. But before you begin, I have to acknowledge the big hurdle to learning these ideas. It's not that these ideas are complex. They aren't. In fact, they're so simple, they're almost obvious.
The big hurdle lies within you.
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 you anything. Or, as I tell people, there is no teaching, there is only learning.
Teachers, don't be insulted. A great teacher can certainly make all the difference in a student's willingness to learn. When I say "there is no teaching, there is only learning," what I mean is that until you are emotionally prepared to learn, nothing about your cognitive position will change. You have to be willing to give up the ideas you've held as true if you're going to learn anything new. Most people simply can't.
That's 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 essay, 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 earned 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. Again, these concepts aren't hard to grasp. The math is simple enough for a sixth-grader to master. And yet, we know that most investors simply never figure out how to become successful. So how do the markets separate the weak from the strong? Simple: They 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 without letting your emotions get in the way. Thus, when you read today's essay, 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."
Just be prepared for that. Your emotions will lead you astray every time. Your "gut" is a terrible investor.
So you must be wondering... if I don't believe in teaching, and I don't believe most of you will ever be able to get past your emotional hurdles to implement these strategies, why did I even bother writing them down and sending them to you?
My longtime business partner Bill Bonner told me something more than 15 years ago, in the midst of a challenging period in my career. It has always stuck with me. "Porter," he said, "We can't guarantee 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 were 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 I'd want you to be patient with me. I'd want you to understand that learning sometimes requires pain and loss and suffering.
That's why I keep publishing this kind of information. That's why I'll keep pushing you to make these kinds of changes to your investing. 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 this message is the one that "breaks through" and shakes you in just the right way. I hope you can learn these concepts without the big losses and heartache that some people require.
But, I'll be here to help either way.
All right... So what are these two big investment secrets?
Here's the first one. It will probably shock you, given our business model of selling investment research that's focused on individual stocks...
Over a lifetime of investing, individual stock selection doesn't really matter. What really matters is asset-allocation decisions. It's not what stocks you buy. What matters is when you buy stocks versus when you buy bonds, gold, cash, real estate, etc.
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.
Think about it. If you owned stocks in 2008, you probably lost money. Yes, a few stocks didn't go down (not many). But it would have been impossible to be reasonably diversified in stocks and not suffer a significant drawdown in 2008/2009. Even investing legend Warren Buffett saw his portfolio decline by 50%.
Thus, in 2008/2009, the key to being successful was owning safe bonds and cash – assuming you weren't shorting the stock market.
Plenty of academic studies verify this common sense. The first by 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 that the differences in asset allocation among the funds explained almost 100% of the variance in their returns. Differences in stock picks made almost 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).
Think about it... The most important variable in your portfolio is asset allocation. But you've never been at a cocktail party and heard someone say, "Oh man, you won't believe it, but I just moved my corporate bond allocation from 15% to 30%. Can't believe the risk spread these days. I should make, I don't know, at least 7% this quarter on my bonds."
Trust me. What matters this year for your investments isn't what stocks you own. What matters is how much of your portfolio is in stocks versus bonds, cash, and gold.
So how do you allocate properly? How can you learn to be a better capital allocator? We'll get that in a second. First, though, I want to talk about the second most important concept for investors to understand: 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? Beats me. But it happens every day.
(Even more incredible is investors' willingness lately to buy digital tokens, or cryptocurrencies, that are impossible to value because they convey zero ownership and provide no income.)
Believe it or not, most of the people reading this essay probably believe a $20 stock is twice as valuable as a $10 stock. "Why shouldn't it be?" they would argue. "It's trading at twice the price."
It is nearly impossible to explain to novice investors that the nominal price of a stock – whether it's trading at $10 or $500 a share – has nothing to do with its value.
The value of a share of stock can only be determined if you know the total number of shares outstanding and the real underlying value of the business itself. You value the business by studying its cash-flow statement and balance sheet.
Interestingly, the financial statement that's almost worthless in valuing a business is the income statement. This is what's used to calculate "earnings." And of course, earnings seem to capture all of the financial headlines.
Meanwhile, we (and all of the talented investors we know) almost completely ignore earnings per share calculations. They're based on net income, a figure created by accountants. The "earnings" number is made up of all kinds of depreciation schedules and other assumptions that usually have zero connection to reality.
A guy who knows everything about a company's "earnings" usually knows nothing about the business. But rather than study any of the actual factors that influence a company's value, most individual investors prefer to focus on changes in nominal prices or "earnings" because those simple metrics are easy and painless to understand. It's like looking for a lost ring in the light. If it were in the light, you would've already found it. But it's a lot easier to look in the light than to find it in the darkness.
To be successful as an investor, you have to know how to build a portfolio. And you have to know how to value financial assets.
How would you rate your skills today? Be honest. Maybe that's why you're struggling. Or maybe that's why you've done well.
In either case, 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. (That's a joke... sort of.) The truth is, even mentioning the words "asset allocation" causes people to cancel. They don't want to hear it. It's the most boring subject in finance.
The other reason we don't often talk about asset allocation is because a lot of asset-allocation decisions depend on your personal situation. Are you worth $10 million and your brokerage account is merely how you like to gamble? Or are you a retired schoolteacher with a $250,000 portfolio who absolutely must survive on that money until you die? Obviously, the allocation of these portfolios is going to be a lot different, regardless of the impact on investment results.
We don't (and can't) provide individual advice to thousands and thousands of individuals, but we can offer you a model allocation and encourage you to work from there based on your own situation and goals.
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. If you're in good health, your life expectancy is roughly 85. You will work full-time for another 10 years or so. Ideally, you'll be able to save $50,000 per year for the next decade.
Given your relatively small nest egg, you'll need plenty of capital gains. But given your age, you simply cannot afford to lose anything – not a penny.
Also, you should note that 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 about $1.1 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 really not that hard at all. Let me show you how to do it safely. 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.
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.
Learning to value and invest in corporate bonds is the single most important thing I could ever teach you. 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.
Assuming you have a portfolio of discounted bonds and cash 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 on half your portfolio, then your total portfolio return is already 8%. You're two-thirds of the way toward your goal.
(Since the inception of our corporate-bond newsletter, Stansberry's Credit Opportunities, we have recommended 22 bonds. The average annualized return on these recommendations was 21%. Only two of these bonds were sold for a loss.)
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 on to for decades because they continually raise their dividend payments.
I've written frequently about how chocolatier Hershey (HSY) is exactly the right kind of stock you need to own to reliably build wealth.
Here are the rules when it comes to buying stocks in this 30% allocation, blue-chip category:
- Don't pay more than 10 times cash earnings for operating companies. You can use a reasonable time frame for your earnings number, like the average earnings over a three- or five-year period.
- Don't pay more than book value for asset-based companies.
- Get at least 5% a year in dividends or share buybacks, on average.
- Avoid operating companies with weak profit margins (operating margins of less than 10%) and high debt loads.
Assuming you build these positions over time, you'll be earning at least 5% a year in dividends. If you only buy when these stocks are reasonably valued, your 10-year average total return should be around 15% annually. 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 potentially larger gains in the equity portion.
(If you think our expected 15% returns from a safe equity portfolio aren't realistic, please look at the returns we made in Stansberry Portfolio Solutions last year. The Capital Portfolio was up more than 25% on an annualized basis. And The Total Portfolio, which was hedged, was up almost 18% on an annualized basis. These portfolio products allow us to "stack the deck" with only our best ideas... exactly how you should build your portfolio.)
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.
(Finding high-quality businesses that can be bought at safe prices is very difficult to do in today's market. But it won't be difficult forever. Remember... sometimes stocks go down. When this essay was originally written, finding high-quality companies trading at a reasonable price was easy.)
Thus, using only 80% of our capital, we can achieve the 12% total returns we need to retire comfortably. And we can do so with a high degree of confidence and safety. That leaves us with 20% of our capital to speculate with... where we have a chance to achieve vastly higher returns...
3. 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 "moonshots" each year.
Remember, 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 sales.
I recommend keeping an index 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 deep 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.
Regards,
Porter Stansberry
Editor's note: Thousands of readers tuned in to our special Stansberry Portfolio Solutions event on Wednesday. But if you couldn't make it, don't worry... For an extremely limited time, we're offering a free replay of the event. You'll hear Porter's latest thoughts on bitcoin... Dr. David "Doc" Eifrig's new bearish prediction... and why everyone is congratulating Steve Sjuggerud.
And this Thursday, February 1, we're revealing the latest iterations of The Capital Portfolio, The Income Portfolio, and The Total Portfolio. If you missed out on last year's gains – some of which beat the benchmark S&P 500 Index – now is your chance. Watch the replay of this incredible event right here.