Two simple things you can change to double your investment returns...

Two simple things you can change to double your investment returns... Why being popular is so dangerous for investors... Position sizing is like riding a motorcycle...

In today's Friday Digest... a few ideas I think you'll have a hard time believing...

What if I told you that merely changing how much money to put in each stock position could radically improve the performance of your portfolio? In other words, changing how you buy stocks could be even more important than deciding what you buy.

Or, what if I told you that merely segmenting the stock market by one simple measure and then only buying stocks from that segment of the market can profoundly increase your returns? Once again, this involves merely changing how you buy stocks. It doesn't matter which stocks you buy from this market segment, and you always have hundreds of choices.

For a fundamental analyst like me, these ideas are extremely hard to believe. As you'll see, I haven't given up my skepticism. But I've begun to change my investment behavior based on what I've learned recently about these so-called quantitative strategies. I hope you'll take a minute and think deeply about these ideas. Whether you adopt these strategies or not, I'm 100% certain that the principles these strategies are based on are extremely important to all investors.

But before we get to the numbers, let me share a story...

It was about 9 p.m. David Galland – managing director at publishing firm Casey Research – and I had been driving around the Andes Mountains in Salta, Argentina. These roads are some of the most dangerous in the entire world. We were exhausted and hungry. When we finally made it back to our hotel, we went straight to the concierge and asked where to find the best restaurant in town. We hadn't been there before, so we had no idea what was good or where to find it.

The concierge, a tall, elegant Latin man who spoke Spanish with a wonderfully slurred Argentinean accent, told us to look around the block from the hotel where there were many places to eat. But which restaurant was best? I've never forgotten his answer. He simply said: "You are men of the world, no? You will make the right choice."

Around the corner, we found half a dozen restaurants. Even though Salta is only a few hundred miles from the equator, the altitude makes it cold at night. So all of the cafes had their doors and windows closed. All but one...

One place was brightly lit. You could see its gorgeous interior from the street because all around the building there were huge picture windows. A fire raged in a huge fireplace, surrounded by a comfortable lounge area. There was a big, open, central kitchen with several grills and ovens. The place was the size of half a block.

And it was packed. People were laughing and a few tables were singing. A guy in the back played guitar. This was obviously – far and away – the most popular place in town. The dinner that followed was one of the most enjoyable of my entire life: The food, the energy in the room, the sounds of delight, of singing, of laughter, of a rich and happy community enjoying a Friday night...

The concierge knew we wouldn't have any trouble figuring out which restaurant was the best. It was clearly the most popular. Human beings have an instinct for following the crowd. That instinct is probably helpful in an evolutionary way. If you're lost and you find two trails, which would you follow to find your way home? The one that's open and well-used, or the one that's covered with spider webs and fallen trees? You'd pick the path that's well-traveled.

If you see a sector of the stock market that's clearly popular... one that has lots of people trading in it... one enjoying a lot of momentum that drives stocks up 5% or 10% a week... one receiving plenty of press – where reporters speculate on who the CEO might be dating or which company might be bought out next, etc... Is this the sector you should follow?

When you find a company that's the stock market's equivalent of that restaurant in Salta – the one with all of the people sitting around having a great time – is that the kind of business you should buy, too? That's what your instincts will tell you if you're a socialized human being. And that's what most investors do.

About 15 years ago, I made a study of the Motley Fool message boards. Many people today don't remember that our dear competitors at "The Fool" started off in life as a simple message-board website. It was free. And it was popular with novice investors.

This was during the big tech boom of the late 1990s. Many suckers – er, I mean... inexperienced investors – believed they could go to the Motley Fool website and get valuable insights from other novices about which tech stocks were sure to take off next. The Motley Fool staff (at the time) raged against "greedy" research companies, like mine, that had the audacity to charge money for valuable insights. Information, these young people said, "wanted to be free."

In any case... the message boards were free, and they were certainly popular. And message boards are strongly influenced by the "network effect." Message boards with more activity attract more activity. Thus, those active boards become more valuable to the community.

As a result, even though the Motley Fool website was hosting thousands of different message boards (organized either by topic or the name of a particular company), more than 80% of the posts could be found on only a few of the boards. The big boards with the most activity covered the stocks being touted by members of the Motley Fool staff.

If you were investing back then, you will remember the names – Iomega, Advanced Micro Devices (which was going to put Intel out of the business), MicroStrategy, and AOL were a few of the most popular boards from 1996 to 2002.

Back then, you could click a button and see all of the different message boards at the Motley Fool ranked by the number of posts they contained. I began recording which boards were the most popular, based on which had the most posts at the end of each year. What do you think happened to top 10 most popular stocks at the Motley Fool over the next 12 months? They almost all collapsed.

TD Ameritrade is one of the most popular brokerage firms for individual investors. It has 6 million individual accounts. For many years, Ameritrade would publish the 10 most widely bought stocks across their accounts and the 10 most widely sold. My friend and colleague Steve Sjuggerud and I devised a successful trading strategy based on simply buying puts on the stocks that were being most aggressively bought by Ameritrade customers. Timing was tricky, but the strategy worked for a long time.

Ameritrade no longer publishes that data (at least, not that I can find). Instead, it now publishes a monthly review of its aggregate client activity. Here's what the review published in early January told us about what most individual investors bought in December...

Over the last 60 days (since the customer buying activity that's summarized above began) nearly all of these stocks have suffered unusually large falls. Transocean is down almost 10%. GoPro is down 26%. Even normally staid companies on this list – like AT&T and Verizon – have done poorly, especially compared with the market's 5%-plus return for the period.

Of course, being on the list doesn't guarantee a poor short-term future performance. Apple is up 5%, for instance. But in my experience, being on this list means poor short-term results are more likely than not. I've used these lists for many years to help time the entry points for speculative short positions. Experience has taught me that wildly popular stocks are far more likely to lose value than to appreciate, even during a raging bull market. The next monthly review of Ameritrade aggregate customer activity will be published on Monday. Check its website here.

A new study published in the Journal of Portfolio Management adds a large amount of quantitative analysis to my personal experiences. The authors of the study broke the market up into four categories based on each stock's trading volume. The study considered all stocks and all trading between 1972 and 2013. The size of the study gives it tremendous statistical certainty.

What the study found was a huge difference in average performance between the least popular stocks (the bottom 25% of trading volume) and the most popular stocks (the top 25% of trading volume). The performance difference, on average, was seven percentage points annually. That's an unbelievably large difference given the size of this study and its duration.

Imagine if you could add seven percentage points to your total return, on average, over 40 years of investing. If you're an average investor making 8% to 10% a year in stocks, this difference could increase your performance to a near-Buffett-like range of 15%-17% annually. In theory, all you'd have to do is simply avoid owning any stocks in the top three-quarters of popularity. And really, the big performance difference was found in simply avoiding the top 25% of the most popular stocks.

The authors didn't reveal what I'm sure was the most valuable aspect of their study. You see, in their 40-year study, the average annual return in the top quartile of popularity was still more than 8%. I'm certain that if you sliced the market up further – breaking it down into 10% segments, for example – you would find an even more meaningful performance improvement.

The point is, do whatever you must to avoid investing in the most popular stocks. You can bet we'll be working on indicators along these lines for our Stansberry Data and True Wealth Systems products.

Finally... a word of warning about the media. People buy magazines, newsletters, newspapers, and watch CNBC because they're interested in these same popular stocks – the ones you shouldn't own. Wall Street reports on these stocks and brokers rate them – almost always with "buys." Everyone is trying to profit from the glamour of these companies and the public's fascination with them.

Remember that as publishers, we aren't immune from these pressures. If we don't write about the stocks folks are interested in, we won't sell many subscriptions. That's the biggest conflict of interest we face in trying to serve our readers. You should understand why it occurs and take steps to make sure it doesn't harm your results. Believe me, I try my best to keep this influence out of our corporate culture, but it is impossible to stamp it out completely.

The impetus for writing this message today grew out of a discussion I had yesterday with Dr. Richard Smith. He is our partner in a business (www.tradestops.com) that aims to help newsletter subscribers improve their portfolio results by tracking trailing stop losses.

In addition to this work, Dr. Smith also conducts his own research into finding ways to improve upon our tried-and-true 25% trailing stop loss method. He has come up with some interesting ideas, including formulas that create a custom trailing stop loss level for each new recommendation and formulas that define mathematically when it is appropriate to buy back into a business you want to own for the long term. As Dr. Smith tells me, "Porter, we're improving upon your fundamental results by just adding a touch of science to your gut instincts."

The most impressive thing I've seen Dr. Smith figure out is a new improvement to our advice about position sizes. In general, we urge subscribers to never put more than 5% of their portfolios into any individual recommendation. For some reason, this advice seems nearly impossible for most people to follow – at first. After a few catastrophic losses, though, eventually everyone learns the lesson. Here's the rule to remember: Opportunity is infinite, but capital is finite. The only way to completely limit risk is to limit position size. And investors who do not limit risk will lose everything. It is only a matter of time.

One way I like to explain this is... Have you ever ridden a motorcycle? Did you put on a helmet? Did you ride during the day? Did you avoid drinking alcohol when you were riding? You did all these things to reduce the risks you face as a motorcycle rider.

You can reduce your risks as an investor by doing a lot of due diligence... knowing a lot about the business you're buying... making sure your stock is in an uptrend... emphasizing companies with great balance sheets that pay dividends, etc. All of these things will limit your risk.

But the only thing you can do to completely control risk is not to get on the motorcycle in the first place. Yes, it's true, most of the time you ride, you won't get hurt. But it's also statistically true that if you ride until you get hurt, you have an almost 100% chance of having a serious or fatal accident. If you continue to put 25% of your portfolio... 30% of your portfolio... or heaven forbid, 50% of your portfolio into single equity positions, it is only a matter of time before you suffer a huge, catastrophic loss. Don't do it.

But, you might say, all recommendations are not equal. Some are going to outperform others. Shouldn't I vary my positions sizes according to the quality of the opportunity? The answer to this question is yes – but only if you define "quality" as low risk. You should take bigger positions (though rarely more than 5%) on the recommendations that we make that are low risk. You should cut down on the size of positions you take in our higher-risk recommendations.

What we find from talking with our customers, though, is that most people do the opposite. Most people break their position size discipline when they get excited about a speculative opportunity. When you're tempted to do this, just remember: The No. 1 difference between professional investors who make money year after year and individual investors who consistently lose money is position sizing. Most professionals – even "gunslingers" at hedge funds – will not put more than 2% of their funds into any single equity position.

Dr. Smith has been studying the audited results of our newsletter portfolios, which track our recommendations going back 10 years (and in some cases even further than that). He has been studying techniques like "smart" trailing stop losses that account for each security's individual volatility. And he has been studying using the same ideas to determine optimum position sizes. What he has found is amazing...

What if you could equalize the risk in any given investment you make? Say you want to buy Johnson & Johnson (JNJ) – a triple-A-rated, top-quality, American blue-chip stock because you're sure it's safe and you want a steady dividend-payer. But... you're also interested in David Lashmet's high-upside portfolio in Stansberry Venture, with picks like biotech Esperion (ESPR), which has gone vertical ever since he recommended it. How could you equalize the risk in both positions?

The only way to completely control the risk in a stock like ESPR as compared with a stock like JNJ is to reduce your exposure to ESPR in relation to JNJ. And you can do that by studying how volatile the two stocks have been...

Let's say that you normally would invest $1,000 into each recommendation. You are putting the same amount of money into both JNJ and ESPR, but you are not taking the same amount of risk. ESPR is a much more volatile and riskier stock than JNJ.

In order to equalize the risk, using Dr. Smith's system, you would instead invest $2,254 in JNJ and only $527 in ESPR.

This approach equalizes your risk in both stocks. You invest more money in the less risky stock (JNJ) and less money in the riskier stock (ESPR).

Keep in mind, adjusting your position sizes won't protect you from any fundamental single stock risk. Any individual investment can still turn in a poor performance and decline in price. But by dynamically adjusting your position sizes and using Dr. Smith's "smart stops" (which also account for volatility), you can greatly reduce – almost eliminate – market-volatility risk. And that will allow you to be far more successful with your portfolio's returns, on average. Just check out these numbers, based on our actual recommendations in my Investment Advisory.

First, here's a chart that shows the actual results as recorded by our audited track record over the last decade. We've made something around 12% a year – not bad for a portfolio that's hedged with both long and short positions. The chart shows the net profit assuming you put $1,000 in each position.

But you could have done a lot better than we did using equally weighted positions. Using Dr. Smith's dynamic allocations (which are based on volatility, like the examples I showed you above) you would have done a lot better. Just by changing how you bought these recommendations – by adjusting your position sizes to reflect the stock's volatility – you could have improved your results by 33%.

That's buying the same stocks at the same times, and following the same advice that I gave to all subscribers. The only difference was, rather than putting the same amount of capital into every recommendation, you took the same amount of risk with every recommendation by adjusting your position sizes based on volatility. (Full disclosure – the precise way Dr. Smith adjusts for volatility is proprietary.)

When we ran the audited numbers from True Wealth (Steve Sjuggerud's monthly advisory) and put them through Dr. Smith's dynamic position-size simulation, we found an even bigger difference. Using dynamic position sizes instead of equal position sizes resulted in a 51% increase in total returns...

Dr. Smith has found other useful tools, too... like a quantitative way to increase returns by figuring out when to buy back into a stock that you've sold because it triggered a trailing stop loss. Keep in mind, he's using these tools on the same stocks we've recommended – but he's able to show better results. That's why I believe asset allocation and proper portfolio management are far more important than individual security selection. Some picks are good. Some are bad. It's how you manage them that makes the real difference to your results.

If you don't have a good system for managing risk, you're not going to achieve good returns. I haven't seen a better system than Dr. Smith's TradeStops – which is why we decided to invest in his company. Dr. Richard Smith has a passion – like we do – for helping individual investors achieve dramatically better results with their investing. So please, before you buy another advisory service from me or anyone else, make sure you've got the proper tools you need to manage your risk effectively. There's no better or cheaper way to do so than with TradeStops. Click here to learn more.

New 52-week highs (as of 2/5/15): Apple (AAPL), Automatic Data Processing (ADP), Brookfield Asset Management (BAM), Brookfield Property Partners (BPY), CDK Global (CDK), Esperion Therapeutics (ESPR), Nuveen Quality Preferred Income Fund 2 (JPS), and Constellation Brands (STZ).

You may have seen a "meme" floating around the Internet recently claiming that Costa Rica expects to rely entirely on renewable energy by 2021. Porter and a subscriber had an entertaining back-and-forth about the validity of this meme through several e-mails. We're publishing that exchange below. Send your comments and thoughts on the topic or otherwise to feedback@stansberryresearch.com.

Paid-up subscriber Peter comment: Gee, Porter... seems the nation of Costa Rica – which, if I'm not mistaken, is the location of your new Doomsday retreat – will soon be powered exclusively by renewable energy (or as you would call it, the great hoax). Whatever will you do? Maybe build some diesel generators on the property? LOL.

Porter comment: Have you been there?

Subscriber comment: Have you actually used alternative energy sources, or just mock them from afar?

Porter comment: Believing things doesn't make them so...

Subscriber comment: Exactly my point, and the reason for my last question...

Porter comment: Well, I haven't spent much time in Costa Rica. (I own property in nearby Nicaragua.) So I don't know this from firsthand experience, but apparently the country's electrical grid is primarily (85%) powered by hydro and geothermal. A small amount is wind turbines and biomass. They have zero grid-based solar power.

That makes a lot of sense, given the country's small size and natural assets (lots of rain, steep hillsides, and volcanos). Also, given the country's relative poverty, I'm also not surprised to see that it has chosen (almost exclusively) the cheapest options available for grid power.

I can't see how any of these facts contradicts what I've written about photovoltaic (PV) solar power, though I have noticed a recent onslaught of online "reporting" about Costa Rica's renewable power sources being used (ironically) to advocate for PV solar. I find that type of writing and thinking to be typical of the solar crowd, which seems rather mindless to me. Thus my questions and my comments.

P.S. In Nicaragua, 100% of the homes I've seen have back-up diesel generators, not solar... the reason being the cost of the batteries.

Subscriber comment: Could've sworn you guys were doing a development in Costa Rica (Rancho Santana, or something?) If I was wrong about that, then the whole premise for my "dig" at you is invalid. I saw that meme, and immediately thought of you...

It's just that I'm getting rather tired of your constant putting down of anything "alternative" when it comes to energy. And what I think is "mindless" is that other (yes, smaller) countries can successfully get off fossil fuels, but we just can't take any meaningful steps in that direction. Maybe if the BILLIONS of subsidies and tax breaks that go to Big Oil went to alternative energy companies (or at least research), we could be more like Germany or other forward-thinking nations that have made the switch.

Alas, we have a government OWNED by huge corporations, and they (rather than our citizens) get to decide how our laws are written. Sad, really... Keep up the good work, Porter. I may abhor your Ayn Rand-style politics, but I appreciate the quality work you good folks do for subscribers. I only wish I had simply listened to Doc over the last several years; I'd be much better off today.

P.S. By the way, I thought about approaching you a few years ago about helping your fine company move in a more "multi-media" direction (I have about 30 years of live television experience under my belt), but you beat me to it. Good on you. My only suggestion now would be to buy an occasional 15-second spot on CNBC and FBN to let more people know you exist. But I imagine your analysts' occasional TV appearances have done that as well.

Porter comment: What makes you think Costa Rica is going to get off fossil fuels? The thing you read on the Internet? Ha, ha, ha... You know it's true because you read it on the Internet...

Again, this is my concern with many folks who are excited about alternative energy. They willfully avoid facts that don't match their agenda. Have you been to Costa Rica or Nicaragua? I ask because if you have traveled there, you would know that claim is absurd.

My wife and I lived in Nicaragua for some time after we were first married. It is a great country with lots of hard-working people... all of whom are striving to buy a car.

Look at the data. Costa Rica consumes more than 50,000 barrels of crude oil per day (equivalent) in the form (mostly) of diesel and gasoline. This consumption has been growing steadily since the early '80s, when the country began to develop economically. This isn't going to change any time soon. Thus... the whole meme you were excited about is just total BS. Unfortunately ... This is what I'm used to finding when I examine the claims of alternative energy fans. A lot of feel-good claims that are laughable.

P.S. Thanks for the kind words regarding our newsletters.

Regards,

Porter Stansberry
February 6, 2015