Why You Shouldn’t Be Afraid to Buy Stocks Now, Part II
On Friday I made the case that everyone who is interested in achieving great wealth or protecting what they have should invest in stocks.
Not because stocks have generated a certain return over a certain period of time. Not because the outlook for the economy is fabulous. (It’s not.) And not because I have any inkling what the stock market is going to do next. (I don’t … and neither does anyone else.)
You should own stocks because great fortunes are usually the result of business ownership. (And the fortunes generated in real estate often involved massive amounts of leverage that seemed safe only when investors believed real estate appreciation is a one-way street. Not many do anymore.)
The simplest way to gain a piece of a great business is not to found one but to take an ownership stake through the stock market.
It’s not only easy… it’s fair. If I buy shares of Microsoft (Nasdaq: MSFT), for example, my return will be the same as the world’s richest man, Bill Gates. Sure, he may own a few more shares than I do, but our annual percentage gains will be the same.
Every stock market investor needs to be smart about it, however. In particular, you need to follow three proven principles that form the foundation of Investment U and The Oxford Club’s investment strategies:
- Asset Allocation
- Trailing Stops
Let’s take a quick look at each.
Asset Allocation is a phrase that makes the average investor’s eyes glaze over. Yet it is your single most important investment decision. It refers to how you divide your portfolio up among non-correlated assets: stocks, bonds, cash, metals, inflation-adjusted Treasuries and so on. Diversifying a portion of your risk capital outside of equities reduces your portfolio risk and volatility. History shows that businesses (stocks) outperform everything else over the long haul, but few people have the stomach to stay fully invested in prolonged bear markets. Benjamin Graham, Warren Buffett’s mentor, said no one should ever have more than 75% of his portfolio or less than 25% in stocks. It’s a good rule of thumb.
Trailing Stops. Anyone can plunk for a few shares. But the secret of investing is knowing when to get out. Unfortunately, no one rings a bell at the stop. But running a 25% trailing stop behind your individual stock positions allows you to both protect your principal and your profits. We’ve written on this topic frequently. For more information, click here.
Position-Sizing. You should not invest more than 4% of your stock portfolio in any one stock, at least initially. If it climbs, it may eventually become a much bigger portion of your portfolio but that’s ok. After all, you’re going to be running a 25% trailing stop to protect your profits, too. But look at the other side. If a stock goes against you and you take the maximum loss (25%) in the maximum position size (4%), your stock portfolio is going to be worth just one percent less. And if stocks are only, say, 60% of your asset allocation (as The Oxford Club recommends), the maximum loss in your maximum position size in your maximum stock allocation means your portfolio is only down six-tenths of one percent.
Many investors need the high returns that only stock can provide but can’t handle the risk. The solution? Asset allocate properly, run trailing stops and watch your position sizes.
It sure beats the heck out of sitting on the sidelines… and wishing you were earning higher returns.
Editor’s Note: This article is the finale in a two-part essay from Alex. To read the first part of his essay and find out why you should look at stocks more as ownership and investment in quality businesses, click here.