From Porter Stansberry in the S&A Digest:
We have to start this Friday Digest with a very unpleasant truth. Most of you reading this note will not make money with your investments this year… or next year. Most of you, in all likelihood, will never make money in the stock market.
The statement above will shock some of you. It might make some of you angry. Or it might fill some of you with strong doubts about our credibility. I wrote it for two reasons.
First, it's simply true. We know from Dalbar… a Boston-based consultancy that studies actual mutual-fund returns. We know from the investment-management firm BlackRock, whose study is shown here…
We also know from discussions with dozens of certified public accountants that almost all their clients lose money in their personal brokerage accounts.
The second reason I'm putting my business relationship with you at risk to tell you an unpleasant truth is because I'm convinced the only chance you've got to become a successful investor is to start by acknowledging that reality. Once you know that individual investors generally fare poorly in stocks, you can begin to examine why…
Let's start with the most obvious reason: The financial industry does not exist because it enriches its clients; the clients provide all of the wealth required to maintain the financial industry.
Another common way of explaining this is to ask, "Where are the customers' yachts?"
The profits that power the branding and the marketing of mutual-fund companies and big investment banks came out of the pockets of their clients. Think about that. Think about it carefully the next time you consider following any financial institution's advice about what to do with your savings. Investment banks exist to raise capital for corporate clients. They do not exist to give you a good stock tip or put you in a safe bond. If you need a refresher course on the way Wall Street really works, read the famous book Liar's Poker
The other main reason people, on average, tend to fare so poorly in stocks is that very, very few individual investors know anything about how to value a security – a stock, or a bond. Let me give you a vital tip: If you don't know more about the value of something than the person who is selling it to you, the chances of you profiting from the transaction are extremely close to zero.
We've written volumes about how to value stocks and bonds. But… the writing is boring. It requires careful thought and attention. Most people, it seems, would rather trust some lines on a chart… Yes, sometimes these guides will work. But if you believe charts can compensate for a complete lack of basic financial skills… you will soon go broke in the stock market. That, my friends, is a fact. If you don't know how to value the business you're about to invest in, don't make the investment.
Finally… the last nail in the coffin of the failed individual investor is a complete lack of risk management. Here's the conversation you never, ever want to have with me.
The failed investor starts out with, "Porter… I'm wondering what you think of XYZ shares today."
"I don't think of XYZ at all," I respond. "We stopped out of that stock about 18 months ago. We had it all wrong. Its new widget didn't work… (or it wasn't FDA-approved… or the CEO is a fool and he tried to buy a bigger company…) I can't remember what happened… and it doesn't matter in any case because when we hit our trailing stop, we're out. Period."
"Well… yeah… I know… I know… but I really liked that stock and as it went down, I thought it was too cheap to go any lower, so I bought more. A lot more. Now it's down another 70%… what do you think I should do?"
"I think you should learn to follow trailing stops."
Catastrophic losses happen for the same reason, every time. They don't happen because an investment idea didn't work out. Even great investors are only going to be right about stocks roughly 60% of the time. Catastrophic losses happen because people can't stand to take small losses. They allow them to grow into big losses.
There are two good ways to make sure this never happens to you. The first way is completely foolproof. Never invest more in any individual stock than you're OK losing. If it goes down 100%, it shouldn't matter to your financial well-being.
That means if you're investing a total portfolio of $100,000… you'll limit your position sizes to $2,000 (or maybe $5,000 at the most). Worst-case scenario, you lose 5% of your portfolio. That's not going to kill you. With some kinds of companies (risky biotechs and mining stocks, for example), this is the only kind of risk-management technique that really works because the shares are too volatile for trailing stops…
The other way to prevent catastrophic losses is to simply decide, in advance, when you will sell. It might be on the basis of negative price action (a trailing stop). Or it might be at a fixed price – you'll sell if shares drop to less than $10, for example. Or you can use charts to find points where you no longer want to risk owning the stock.
I don't really care what kind of risk management you use… so long as you use something. I can guarantee that if you don't have your risk strategy figured out, sooner or later, you will suffer a catastrophic loss… and it will completely wipe out all your previous gains. That's just what happens.
Now… I want to remind you of one more thing before we get too far along in 2013. Most people have a knack for making exactly the wrong decisions, at exactly the wrong time, when it comes to their money and investing. Here's how I described these emotional hurdles a few years ago…
Investing involves a strange and horrible paradox…
Most people don't actually want to make money with their investments.
It's true. If people really cared about their investment results, they'd be far more logical, skeptical, and cautious about their investment strategies. What happens instead is people like to gamble – on penny stocks or options. Or they like to do what's popular – even if it's crazy and sure to lose money, like buying Internet stocks at 100 times earnings in 1999 or rental houses in 2005 and 2006, after real estate prices had doubled. If it's a horrible investment idea, you can count on it being wildly popular…
Why do people insist on doing foolish things with their money? I have a few theories. They feel guilty about being rich. Or they like the thrill of gambling more than the pressures of wealth. But probably the biggest reason is most people simply don't really care about their money. If they did, they'd make a lot better decisions.
A lot of people are happy to sell you bad advice or provide you with financial services they know will eventually cause you harm. They're happy to cater to your instinct to gamble. They're happy to trade on your emotional weaknesses… and happy to sell you products and services that stoke your fears or excite your greed.
That's not the business I want to be in…
If you're a new subscriber, you might not know that I write these Friday Digests myself. This week, I'm writing to you from a beautiful waterfront cabin at a private hunting lodge just north of the Florida/Georgia state line. I'm here with The Atlas 400, which is a private wealth club. We're shooting quail and hunting boar. I shot a huge boar yesterday morning. Yes, I admit… I'm a lucky man. I've built a very good business.
But I didn't build this business to sucker investors into doing the wrong things with their money. Instead, since the beginning, I've worked hard to give you the information I'd want if our roles were reversed. This is the most important information I can possibly give you. You need to realize that most investors will fail. You need to understand why they fail and how they fail. They fail because they allow their emotions to overtake their reason. They fail because they don't have the most basic tools – they don't know how to value stocks. And they fail because they eventually suffer a catastrophic loss.
I truly hope you'll take this week's Friday Digest to heart. I hope you'll look back on the investment mistakes you've made and think about why they happened. It wasn't just because you bought the wrong stock. Find a way to eliminate these mistakes and you'll be on your way to becoming a more successful investor.
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