Steve's note: On Monday, the benchmark S&P 500 Index fell about 4.1%. It was the worst one-day fall it had since 2011. Did it scare you?
As I've said lately, corrections happen – even in the "Melt Up." This is a time to stay calm. Stick to your stops. And if you're worried about the recent declines, it's also time to come back to an important lesson…
That's why today, we're republishing (and updating) a classic essay from my friend and colleague Porter Stansberry. In it, he explains the best way to control your fear… and how to avoid being a victim when the next bear market arrives.
Did you panic? Were you afraid?
Stocks got beat up on Monday. They fell 4.1% – their worst one-day fall since August 10, 2011.
Anytime investors are reminded that stocks can go down as well as up in value, our mailbag "lights up." Subscribers suddenly want to have constant contact with us. They need reassurance.
Friends… If that market action bothered you in any way, there's a huge problem with your portfolio.
Think honestly. When you first saw how the market was going to open (way down), what was your first reaction? Or, if you didn't see the open, what happened when you first saw the news? Or during the day when stocks just kept going down, lower and lower?
Be honest with yourself. If you felt even a twinge of fear, you've got a big problem. Let me explain why…
Monday was a 4.1% move lower. It wasn't a bump in the road. It was barely a ripple on the calmest lake the equity markets have ever seen.
Since 2015, stocks have been ripping higher, propelled by "rocket fuel" – central banks, sovereign wealth funds, corporate buybacks, and value-ignoring index-fund investors. There's hardly been a down day in nearly two years. This incredible rally has created record levels of investor complacency (aka investor stupidity).
It has also, almost surely, lulled many of our subscribers into portfolio allocation decisions that are far too aggressive.
On the golf course, virtually every amateur player overestimates how far he can hit the golf ball, usually by 20% or more.
Why? Because our best-ever shot becomes our expected outcome.
As we're sitting there on the tee box, we're thinking, "I crushed the ball the last time I played this hole. I'm sure I can do it again." Instead of making a conservative swing on the ball – a swing we can hit well nine out of 10 times – we end up taking the big cut… the move that almost never works.
Pro golfers don't make this mistake. They study the distance of every club in the bag, based on their most repeatable swing. They know their distances down to the precise yard. And they don't try to make swings they can't repeat virtually every single time.
Amateur investors make the same kind of mistake as amateur golfers.
They vastly overestimate the expected outcome of their investments. Think about this the next time you buy a stock. Write down what you're expecting to make (annualized) from the investment. Now go and look at what your actual annualized returns have been from similar investments.
The odds are you're overestimating your expected returns by at least 100% – meaning, you're expecting to make twice as much as history suggests you will.
You're probably doing the same thing right now in your portfolio: You're holding positions because you're sure they're going to soar.
Meanwhile, it's unlikely stocks will produce the sort of returns you're expecting…
With stocks trading at near-record valuations, with consumer debt crashing, and with extremely low interest rates, it's unlikely stocks will produce double-digit annualized returns in the time frame you're planning for. Very unlikely. Virtually impossible.
But every time you buy a stock, I'm sure you expect to make more than 20% over the next year. Or maybe even in the next quarter.
That's because, like an amateur golfer, you're thinking of that great "shot" you hit back in 2015 – that stock you bought two years ago that has soared with the market.
But that's not what's going to happen every time.
That 4.1% fall on Monday was a warning from the stock market "volcano."
It was just a minor rumble. A tiny taste of what will happen when there's another bear market, a decline that's five times worse. (A bear market is a decline of more than 20% on the major indexes.)
If you were worried about this minor dip, you'll be crushed – wiped out – by a bear market.
I know… you say you will just hold on "no matter what." But almost everyone who sets out to be a "buy and hold" investor ends up becoming a "buy and fold" investor. Just as you overestimate your expected returns, you're also overestimating your risk tolerance.
If you'd asked investors back in 2009 about their risk tolerance, they all would have said "none." They would have told you, "I'm tired of stocks. I only want safe investments. Just give me something that's safe…"
Today, you hear exactly the opposite. At conferences, I'm constantly seeing subscribers telling people, "I'm an accredited investor. I can handle the risks."
But they can't. Not really. Almost no one can.
Here's the best way to think about the risks you're taking…
If you're 100% invested (long stocks) it's only a matter of time before you suffer a 50% drawdown – at a minimum. Warren Buffett, the world's best long-only investor, has seen the value of his equity holdings drop by 50% three times in his career. And it has happened twice since 1999.
You probably aren't as good of an investor as Warren Buffett. It's likely that your results won't be as good as his have been… which means that if you are a long-only investor, you will (not might) suffer more than a 50% decline in the value of your equity portfolio.
If you're using trailing stops, you can greatly limit this volatility. In fact, if you merely use a trailing stop loss and reasonable position sizes, I can almost guarantee that your investment results will become dramatically better.
And there's another, even better way to limit the volatility of your portfolio.
Consider "hedging" your portfolio by adding small positions in investments that are designed to go up when the stock market goes down – like short sells and gold stocks. You should also consider a big allocation to short-term corporate bonds and mortgages. Or if you don't understand these kinds of investments, then simply hold cash.
In Stansberry Portfolio Solutions – a service I put together with my colleagues Steve and Doc Eifrig – we've used this general strategy with The Total Portfolio, a diversified and hedged portfolio.
Right now, we have about 7.5% of the portfolio in corporate bonds. This is allocated to fixed income via high-quality insurance stocks – which are really just big piles of bonds plus underwriting profits. (Last year, we allocated 10% of our portfolio directly in carefully selected high-yield corporate bonds.)
This is the kind of firm foundation we want in our portfolio. And to further reduce volatility, we've put another 20% of the portfolio in super-safe mortgages and cash.
Thus, nearly 30% of our portfolio is in cash and fixed income. It's like driving with a parachute tied to our car. It probably limits our top speed… But it keeps us from crashing. That doesn't mean we can't still produce good results, though. The Total Portfolio reported an 18% return last year.
But the real magic in what we're doing comes from the two things that you probably won't do. Ever.
When stocks fell on Monday, we had 3% of the portfolio allocated to short-sell positions and 3.5% allocated to precious metals stocks. This strategy doesn't reduce volatility, as these positions are enormously volatile. But they're also negatively correlated. So, when stocks go down, this part of the portfolio tends to go straight up.
On Monday, when the S&P 500 dropped 4.1%, our shorts went up 3%. And our precious metals stocks held their ground.
Since February 1, the S&P 500 is down 4.6%. But our Total Portfolio is only down about 3.2%.
That probably doesn't seem like a big difference to you. But proportionally, it's a huge difference. Our portfolio's decline was nearly a third less than the S&P 500's. What if the market's move down had been three times worse, like a correction or even a real bear market?
I'm certain you'd feel a lot better looking at a 10% portfolio decline than a 14% portfolio decline. And if you can reduce your risk without a corresponding decline in performance, why wouldn't you hedge your portfolio?
Again, if you look carefully at our Total Portfolio, you'll find a very conservative allocation mix, with almost 30% of the portfolio in very stable investments like mortgages, corporate bonds, or short-term credit facilities, and with an additional 6.5% of the portfolio completely hedged (short positions, gold stocks). This allocation allowed us to reduce our downside by more than 30%.
If Monday made you nervous… change your allocation. Act like a pro. Go for the "shot" you know you can hit. Stick with an allocation that lets you sleep at night and that fills you with confidence on bad days in the market.
Editor's note: Asset allocation is the best way to control your fear and survive the next panic in the markets. Even better, our Stansberry Portfolio Solutions service does all the hard work for you – with three hedged, diversified model portfolios to choose from, including The Total Portfolio.