Why most investors should never buy stocks...

Why most investors should never buy stocks... Yes, that's right... What to do instead... Reviews of the Alliance meeting... Still more on Social Security... Plus, our first mailbag death threat...

Here's something you've never read before in an investment advisory: Most people shouldn't buy stocks. Not ever.

As longtime readers know by now, I personally write the Digest on Fridays... and I normally take the opportunity to show you something about finance that I believe is valuable, but you probably won't read anywhere else. Today's message is particularly important. I'd like to show you why you're extremely unlikely to succeed as an individual investor buying stocks.

As a purveyor of financial newsletters, which are mostly purchased by individual investors, the worst thing that could ever happen to my business would be the widespread realization that stocks, by and large, are a sucker's bet. So why on Earth would I write an essay explaining why this is so? It doesn't make sense unless you understand my sincere desire to help people become better investors. I am committed to my promise to always tell you what I would like to know if our roles were reversed. That's what these Friday Digests are really all about.

However... today's message comes with a big caveat. Doing well in stocks isn't impossible for individual investors. It's only extremely unlikely. Let me show you how I know. And more important, let me show you why. Once you know why most people don't make money in stocks, you'll have a vastly better chance of being successful.

So... how do I know most people shouldn't ever buy stocks? Look at the average outcomes of real individual investors. Give your accountant a call. Ask him how many of his clients who actively buy and sell individual stocks make money in most years. Accountants are the only folks who really know if their clients make money in stocks or not, because investors don't talk about their losses. The guys in your weekly poker game talk about their good trades... not the bad ones. And as real investors know, it only takes one big loss to wipe out an entire year of gains.

Your accountant will probably tell you what my accountant tells me: Porter, you're my only client who actually makes money in stocks. All my other clients get killed.

The second way I know that most people don't make money in stocks is by looking at mutual-fund results. Dalbar is a consultancy that studies actual investor returns in mutual funds. It found that individual investors consistently buy popular mutual funds that have already experienced great results, while ignoring funds that haven't done as well. Thus, they end up buying funds full of expensive stocks, while ignoring the funds that own cheap, out-of-favor stocks. This greatly reduces average investment returns.

From 1990-2010, stocks (as measured by the S&P 500) did very well. They averaged 9.14% per year. But actual investors in mutual funds only earned 3.27% on average. That barely outpaces inflation. They would have done far, far better in bonds… or even in T-bills.

One more thing tells me that most investors get killed in stocks – my own trading. Take a look at this chart. It's the Nasdaq stock market from the fall of 1994 until today – a 17-year chart. I picked this timeframe because it covers the period I've personally been actively investing. I picked the Nasdaq because that's where most stocks that individuals like to buy are traded.

There are two obvious peaks (2000 and 2006) and two obvious bottoms (2002 and 2008). I know from studying mutual fund inflow data that individual investors were piling into stocks all during 1999 and 2000. I know they were bailing out in the fall of 2002. They got killed. I know individuals were buying mutual funds heavily again in 2006. And I know they sold in record amounts at the bottom in the fall of 2008. Again, they got killed.

"Easy to see in retrospect," you may say if you're skeptical. Yes, it is. But I saw these tops and bottoms in real time and wrote about what was happening. You can look at the archives and see what I wrote at the time. Read my newsletter from November 2000… you'll see that I predicted the bear market that developed in 2001-2002. Read my newsletter from October 2002… you'll see that I was able to call the bottom in stocks almost to the day. Likewise, if you read my letter from February 2007, you'll see that I called the top just six months before stocks actually peaked. In November 2008, the headline of my letter was "This Is It" – as in, "this is your best opportunity to buy stocks in a generation."

Finally... if you read my letter from last month, you'll see that I was even able to predict this mini-rally we're experiencing right now. How did I know? Easy. I watch mutual fund inflows/and outflows…

In my trading and market timing, I make money by doing the opposite of what I know most individual investors are doing with their money. That's how I know they're getting killed. But... why? Why do so many individual investors make spectacularly bad investment decisions? Why do they consistently buy at the top and sell at the bottom?

The No. 1 reason is simple: They have no idea what they're doing. I would wager 90% of all individual investors don't understand even the most basic concepts of finance or accounting. Most don't even know that nominal share price (whether a stock is trading at $10 or $100) has nothing to do with its value. That's why we have to constantly explain terms like "market cap" and "enterprise value" – never mind that no one should ever buy a stock if they don't understand exactly what those two terms mean.

This lack of understanding implies that most individual investors have no capacity to judge the value of the stocks they're buying. It's like they're shopping for cars by looking at the gas mileage numbers instead of the sticker price. Imagine your neighbor bragging that he bought a car for "18 miles to the gallon." And imagine he didn't even understand why saying that makes no sense. Now you know how I feel when I talk to most individual investors. They literally have no clue.

(By the way... Market cap is the total number of shares outstanding multiplied by share price, which gives you the total value of all of the company's shares. This total market price – or "market cap" – is how you evaluate whether or not a stock is cheap or expensive, if it doesn't have outstanding debts. Enterprise value adjusts market cap by the company's total net debt. Enterprise value is the appropriate way to judge most company's actual market value, because it incorporates debt.)

If you don't know how to accurately value a security, you don't have a chance. None. And because most individual investors can't act on knowledge and logic, they act upon rumors and emotions – essentially blind guesses. It's no surprise they generally do exactly the wrong thing at exactly the wrong time.

Do you fall into this category? Here's a simple test. What's the best and most accurate way to value most operating businesses? What's the primary difference between net income and cash from operations? Who decides what a company's dividend payment will be? What are the primary differences between common stocks, preferred stocks, and corporate bonds?

If you can't answer these questions off the top of your head, you should never, ever buy a stock. Not ever. (Answers: discounted future cash flows, depreciation, the board of directors; common stock provides voting rights, but no fixed dividend… preferred stock offers a fixed dividend but no voting right… bonds have guaranteed principal, fixed coupons, and senior legal claim to corporate assets in the event of bankruptcy.)

These are the big mistakes most individual investors make when it comes to stocks…

• They don't know when to sell, so they sell at the bottom.
• They don't know how to value stocks, so they buy at the top
• They own stocks that are designed to fleece shareholders through constant dilution
• They suffer catastrophic losses because they don't diversify and only sell when a stock collapses – the so-called "buy and fold" approach
• They ignore income opportunities and thus don't enjoy compounding returns
• They buy mutual funds that are horribly managed and sell them during market panics.

Here's how to overcome all these mistakes. All investors should follow the rules below, unless experience or particular expertise allows you to break these rules successfully. For example, you might pay more for certain growth stocks, but only if you're in the industry or especially familiar with a given company's prospects.

Otherwise, follow these rules. When you break these rules, you generally suffer...

First and foremost, you only want to allocate heavily to stocks when they offer good value. (See my long essay about asset allocation). I believe stocks represent good value at or below roughly 10 years of cash earnings. Some stocks with great growth prospects might be worth a bit more. Some stocks that own valuable assets – like commodities in the ground or prime real estate – should be evaluated by replacement cost analysis, not cash earnings. But... generally speaking, 10 times cash earnings is a great place to start when judging value.

Next, you want to make sure that the stocks you're buying are reasonably capital-efficient. See the essay I wrote about that here, or see the most recent issue of my newsletter, where I published a list of 20 highly capital-efficient stocks. This helps make sure that as the company grows, it will have plenty of capital to return to its owners.

Speaking of which... make sure the companies you invest in are dedicated to returning capital to shareholders. Never buy a stock that doesn't pay a dividend, buy back shares, or both. Never, ever buy a stock that's constantly issuing new shares and diluting its shareholders, which is common. Apple, for example, has increased its share count by almost 50% over the last decade and has never paid a dividend. Common stock investors believe they own the company, but the management clearly believes otherwise. That won't have a happy ending.

Don't put all your eggs in one basket. I can't tell you how many times I've heard individual investors say, "What do you think about XYZ stock? I've got all of my savings in it." That's insane.

You want to spread your investments over a reasonable number of positions, because doing so greatly reduces your risk. We construct our S&A model portfolios using 16 different positions. There are four value stocks, four growth stocks, four income securities and four "macro" plays. We've had great success with this approach and I'd strongly recommend it to individual investors. It's enough concentration so you can have meaningful positions and enough diversification that you won't lose too much if you immediately get stopped out of something.

Always cut your losses. Whether you use trailing stop losses, fixed stop losses, or some technically based stop loss – whatever suits you. But always know when you're going to sell in the event that stocks go down. Using such discipline will slightly reduce your returns from year to year, as sometimes the stocks you sell end up rebounding. But such discipline is the only way to guarantee you won't suffer a catastrophic loss.

(Note: You should adjust your stop losses for cash dividends and share buybacks, which allow you to stay in companies that are returning capital even through bear markets. This can be tricky, as there are no firm rules for doing this... But my rule of thumb is, if I'm earning 10% a year from the shares via dividends, I'm much more reluctant to sell.)

Now... finally... the most important concept. What do you do when there aren't many (or any) high-quality companies trading at a good price? Make investments that allow you to generate income, so your cash pile grows. You want to build cash while you wait for a buying opportunity. It's really that simple. So how do you build a cash pile? There are two important concepts to learn.

First, you should get to know corporate bonds. I've written about corporate bonds many, many times in the past. (See this essay for example.) The key to corporate bonds is buying bonds that offer you at least a 10% annual return via coupon payments and that offer plenty of protection in the event of a default.

This analysis isn't always easy to do, but here's a good rule of thumb. The average recovery in corporate bond defaults is $0.45 on the dollar. The closer to $0.45 you get, the less risk you're taking. If you're buying a diversified basket of bonds for less than $0.75 on the dollar on average, you've got a good chance of making a lot of money without losing any. Most of your bonds won't default. Instead, they will pay off at par ($1), giving you a 33% capital return in addition to yields that will average 10%-15%. Those gains will more than offset whatever losses your portfolio experiences because bonds don't typically go to zero like stocks.

If the average individual investor understood the bond market, he would never buy a stock ever again. If he understood that bonds are less risky, offer higher annual payouts, and frequently generate stock-like capital gains… He'd see there's simply no reason to accept the higher risk of the stock market.

Let me repeat myself: It's easy to put together a diversified portfolio of bonds that will pay you double-digit returns on average without producing an annual loss. For most investors, that's a far better return than they will get in stocks – without any real risk at all. That's why I urge our subscribers to read True Income, which is the only high-quality, independent investment advisory available about the bond market. Frankly... if you're not buying corporate bonds, you shouldn't consider yourself a real investor.

The other smart and easy way to generate income when there aren't lots of safe and cheap stocks is to use options. I recognize that most of you will not trade options. Just like most of you will probably never buy bonds. That's fine with me. You have to do what you're comfortable with... and do what you understand. But know this: You can make 5%-10% a month, nearly risk-free, in the options markets. You do this by selling options, not buying them.

Buying options is incredibly risky. It's a strategy that should be used mostly by professional investors to hedge against losses – insurance, essentially. Buying options is a cost of doing business for professional fund managers. Selling them those options is an easy way for us to generate large amounts of safe income.

How safe is selling options? Doc Eifrig, who has been showing the readers of Retirement Trader how to use options to generate safe income for the last several months has now closed out of 41 recommended trades. Every single one – 100% – of these trades were profitable.

I have written about the power of selling options several times before. The key to success is to sell put options only against stocks that you'd like to own at a price you're certain is safe and cheap. If you do, you can make 50% or more per year, without taking any real risk. This is hard to believe if you've never done it… But it's true.

And whether or not the option is exercised against you and you actually end up buying the stock, you always get to keep the premium you were paid in exchange for the option. Thus, your results will be either a lucrative income steam or a vastly lower entry price on a stock you wanted to own in any case.

Out of all of the things I've taught subscribers over the years, how to generate income with options is the most powerful technique. We've shown thousands of investors why selling puts is always superior to simply buying stocks. Once you really understand how this works, you will simply never buy a stock again. You will always sell puts instead. I just got a note this morning from a subscriber about his experience selling puts through the last crisis period…

Here's the thought I'd like to leave you with... The No. 1 reason most individual investors fail is because they don't know how to value securities. As a result, they never know when or what to buy. If you want to be successful as an investor, you need to learn these basics, which we teach in all of our letters (and particularly in mine.)

To increase your odds of success even more, you need to learn how to minimize your risks and maximize your income.

If you ever come to our Alliance meeting or meet a longtime Stansberry & Associates subscriber anywhere, the feedback I hope you'll get is: "I'm glad I read S&A because they taught me a lot about value, they taught me how to manage risk, and they taught me how to generate income safely."

If we've done those things for you, please... take a minute and send us a note. We'd greatly appreciate it. We know real success as an investor takes a lot more than a hot stock tip. And while we do our best to give you those, too... we hope you'll find a lot more than just that in our work.

In the mailbag… the first death threat I've gotten in some time. Ah, my fellow Americans. Dedicated to truth, justice... and the freedom to plunder their neighbors. Send your comments here: feedback@stansberryresearch.com.

"You are an asshole. I've told my daughters that the only way out is to kill everyone over 60, including the power boys. You are an asshole. By killing all over 60, the young would have a chance to build a new system. You are an asshole. The old system that you have thrived in is totally corrupt. You are an asshole. The young must build a system where productive value added work is rewarded and speculative skimming is treason. You are an asshole. I will add now that all speculative skimmers be added to the 60 and up no matter their age. You are an asshole. I would gladly break your neck with my bare hands you little prick. May God have mercy on you, asshole." – Paid-up subscriber William Russell

"I join the reasonable voices of ex-subscribers George Earheart, Ed Chapman, and Jerry Lowry in expressing my disappointment (disgust) at hearing you describe Social Security recipients as being some kind of rabble on the 'public dole.' I participated as a system payer for several years. It was indeed a forced participation, with lost opportunity cost in those dollars extracted from me by the U.S. government.

"But working an honest job for a paycheck and being a law-abiding taxpayer is not a crime, neither does it necessarily make one a fool. I would not have insulted you by suggesting that 'financial consultants' that never get their hands dirty and make a living by manipulating the fruit of other peoples' labor are a band of lazy scammers. Gentlemen shouldn't engage in thoughtless over generalized inflammatory accusation of that nature.

"When I do reach Social Security eligibility age, I will certainly sign up for my benefits (or what, if any, remain of them) guilt free. I suggest that you really stepped in it this time, Mr. Stansberry. Your records will indicate that my subscription is reaching expiration – I will not be renewing. This Social Security topic and your intransigence on it is a deal-breaker for me. I hope that this can be a learning experience for you ('market' forces at work and such)." – Ex-paid-up subscriber, Charles Leach

"I assume you will not print this response to the Social Security debate, not because it is belated, but because you will be shamed to admit your arrogant misled position. Your base your argument on a totally inaccurate statement from the Social Security Administration that the average recipient of SSA benefits will grossly exeed their 'donations.' It has been a week or so, and I cannot recall the exact figure you quoted the SSA, but my memory says that the average benefit will be approximately $800K over a lifetime. My wife and I are currently drawing SSA benefits of roughly $22K/year total, aveage $11K each. For us to reach, individually, $800K in our lifetimes, we would have to each live almost 73 years! Since we started drawing SSA benefits at age 62, in order to collect nearly $800,000 we would have to live to the ripe old age of 135! I think you have been duped by the SSA!!" – Paid-up subscriber Ron S.

Porter comment: We could have printed hundreds of such e-mails. Most of our subscribers were deeply offended that we would accuse them of benefiting unfairly or unethically from Social Security. Some people (not many) raised what they thought were clever technical loopholes, like the real value of their contributions (as opposed to the inflated dollars they're receiving now). Others argued that our facts were wrong… that they weren't receiving more than they paid in. But most people simply are angry because I've suggested that they shouldn't be entitled to the benefits they're receiving because they're participating in a racket. They don't seem interested in the facts, only in making sure I know they would like to kill me for bringing them up. And of course, many, many people canceled their subscriptions in response.

Fortunately, I decided a long time ago that I wasn't interested in having the biggest financial publishing company in the world. No, I'd like to have the best financial publishing company in the world. And there's a big, big difference. To become the biggest, you accept advertising from every securities salesman in the world. You write a bunch of fluff. And you sell your subscribers down the same river of ignorance that they sailed in on. To be the best, you tell your subscribers the truth as you see it, even when you know they won't like it. Sometimes the truth is a bitter pill. And so it is with Social Security.

If you're angry at me for pointing out the unpleasant facts about Social Security, you're angry with me for being a dedicated and honest financial writer. You're angry with me for doing the very thing you've paid me to do. You're angry at me for serving you in a way you're too narrow-minded to even understand.

But... no matter what you decide about what I've written... it won't change any of the facts.

The analysis I cited was prepared by the Social Security Administration. It is accurate. It shows the unmistakable progression of a Ponzi scheme, where early "investors" receive windfall returns, while later "investors" receive greatly diminishing returns – until, finally, the system collapses.

For example, using average figures for a couple retired in 1960, your total Social Security and Medicare taxes paid were $18,000 (in constant, 2011 dollars). Total benefits received were $248,000 – a return of 1,277%. By 1980, those amounts were $104,000 contributed and $512,000 in benefits, a return of 378%. And by 2010, the returns had fallen considerably – now $352,000 in contributions were worth only $798,000 in benefits, a 226% return.

The "returns" would have long since turned negative, except for the fact that Social Security taxes have been increased 40 times since the program began. That was necessary because today only three workers must support each retiree (down from 16-to-1 in 1950). By 2030, the numbers will fall to two workers supporting each retiree. And unless the taxes are increased again – and by a huge amount – the entire system will collapse. What will the folks retiring in 2030 say about those who got their benefits today, while they were working hard to support them? And what do you think those workers will do in 2030, when faced with Social Security taxes that make up a majority of all of the taxes they must pay?

The whole thing will collapse – just as every Ponzi scheme must.

As everyone by now understands, the core problem is that Social Security was never the insurance scheme it was sold to the public as being. Instead, it is purely an intergenerational redistribution scheme, where current workers are taxed to support retired workers. That is, it is a government-administered Ponzi scheme that's destined to collapse.

If more people understood what Social Security really is and why it will ultimately collapse, we at least have a chance to reform the system without reneging on any of the promises that have been made to people 50 and older. I do not advocate limiting or reducing benefits for anyone who is currently receiving benefits. What I propose instead is that we develop a bona fide pension system, so future recipients will not be forced into robbing their grandkids.

You can argue (and many have) that they're not stealing anything because they contributed for years. And if those contributions could have been invested, they would have been worth a lot more than what they're likely to get back, etc. That's all fine and good. If it makes you feel better, that's fine with me... But it's all a lie. The money was never invested. It's a Ponzi scheme. That's the whole point.

You can pretend you would have gotten whatever interest rate you like... but guess what? The money was never invested. The money you paid into the system was paid out to the government (the general fund) and recipients. And as of last year, current tax revenue is being used to support shortfalls in Social Security and Medicare spending. Thus, like it or not, the line we published about being on the "dole" is absolutely correct.

How could we reform the system? It's not that hard. First, you allow anyone with 20 years until retirement to opt out of the system entirely. These people are allowed, instead, to make contributions to privately managed pension funds. As with Social Security, they would have to meet minimum contribution requirements, and the government would provide a guarantee for a future minimal rate of return. Everyone would voluntarily opt out of the existing program, because the minimum contributions would be smaller and the future returns vastly more attractive.

Additionally, some exchange value would be offered for previous contributions to the system – though not at a one-to-one ratio. For folks too close to retirement to effectively use the new system, the old system would remain in place, backed by tax revenues, not the artificial Ponzi scheme.

This, by the way, is exactly what happened in Chile in 1981. That's when its Social Security system, which had been in place since 1920, collapsed.

The longer we postpone this transformation from Ponzi retirement plan to actual pension funds, the more expensive the transition will be. And there's one other key benefit to understand. When people are allowed to actually save for their own retirements, rather than being forced into paying for the retirement of older generations, the internal savings rate of the country soars. Chile averages internal saving rates of more than 20% of GDP. If we did the same, our currency wouldn't be on the verge of collapse.

Having bona fide pension funds, instead of the nonsense we have now would be a huge economic advantage for our country. So... if you care about the future of America, tell your congressman you don't want to be a part of a Ponzi scheme anymore. Tell them to fix Social Security.

And stop shooting the messenger.

"I am writing to thank Porter and Stansberry Research for putting on another enlightening (and entertaining) Alliance meeting. As always, the location and hospitality were impeccable but ultimately what stands out are the quality and depth of the presentations. There were multiple ideas that were invaluable but may not have come off as effectively in writing. You have to be there to get the full flavor of the recommendations, particularly during the give and take of the panel discussion section. On a side note, the outtakes from the End of America Video were priceless and worth the plane trip right there..." – Paid up subscriber E.W.

Porter comment: Not everyone liked the outtakes video. See the next note...

"I wanted to thank you for hosting the Alliance Meeting. I very much enjoyed myself, especially the conversations I was able to have with the different contributors. It was very educational. My only complaint was the End of America outtake video. Porter has the right to use whatever vocabulary he chooses in the privacy of his own recording studio. But if his staff wishes to pull a joke on him by publishing his profane gaffs to the public, that should be by the consent of the public. I understand that an adult content warning was given but that should not have been done in the middle of a session when it is troublesome to leave our seats and make our way to the exits.

"It would have been much better to show it at the end of a break so those who wanted to laugh at Porters profanity could choose to enter the room. Dignity, decorum, courtesy and chivalry are not dead, at least they should not be. There were ladies in the room who should be respected more than to be subject to language reserved for a gutter. Additionally the profane use of Deity is objectionable to a significant portion of our population and should also have been avoided.

"Porter, your intellectual capability is evident in your work and your trading is evidence of your discipline over your emotions. Profanity is beneath you. I recommend a method I used when I was young. Any slip of the tongue should cause a contribution to a Jar. I am sure there are enough people around you that would be more than willing to help remind you. Much of the editorials you publish express frustration at people behaving badly financially. It is my experience that behavior in one aspect of your life tends to spill over to other aspects. Our society needs to be more morally based in general. The way to change the world is to change each home." – Paid up subscriber Gerald Pilj

Porter comment: We showed a short video that documented the making of our hugely successful End of America video. The video was filled with profanity as yours truly made gaffe after gaffe in the recording of the video. It was extremely funny to watch. And although we warned the audience... some people were inevitably disappointed. This just goes to show that you can't please everyone.

"After being a SA Alliance member for five years, I finally attended the Alliance Conference. What a wonderful conference. The Bacara Resort is a magnificent venue... The staff who greeted me could not have been more low key or nicer. I really felt welcome.

"Sometimes, at conferences there is a snootiness or country club type of feeling, but not here. Everyone including the speakers were approachable and loved to talk. Porter has really assembled a group of people who you would love to hang out with.

"Before I recap the meeting, I have to talk about Porter... I didn't know what to expect from Porter as some of his responses to letters seemed a bit harsh. As luck would have it, I was having lunch on the patio with 3 others, and out of nowhere, Porter and another gentleman asked if they could sit with us. Without missing a beat, Porter started asking about the conference and what we thought of it... I was amazed at how pleasant and genuinely interested Porter was. He truly has an enthusiasm that is infectious. He is so pleasant and inquisitive and frank. There is no pompousness or arrogance, or at least none I could see. The people at the table, all commented that he is very nice and not the person some may perceive him to be in his responses to client letters..." – Anonymous

Porter comment: My responses are frank... And I think that's rare in this age. Wrong or right, agree or disagree, you're paying me for my view. That's what I give you. When I'm wrong, I try to change my mind quickly. When I'm right, I do my best to never let anyone else change my mind. The only problem is... sometimes it's hard to know the difference.

Regards,

Porter Stansberry

Baltimore, Maryland

October 28, 2011