Some folks believe the best way to invest is to put their money to work based on their expectations about the future.
If they expect the economy will boom, they own stocks.
If they think inflation will stay low, they own bonds. (Or, if they think it won’t, they own gold.)
And if they believe the world is rapidly going to hell in a handbasket – a common perception among heavy consumers of cable news and social media – they hide out in cash.
However, there’s a problem with each of these “strategies.” It’s that – to a great extent – the future is unknowable.
The economy may be humming and then along comes a bolt out of the blue – think Saddam Hussein’s invasion of Kuwait, 9/11, the collapse of Bear Stearns or the spread of the coronavirus – that upsets the market and wrecks your best-laid investment plans.
Or you may listen to political commentators who insist that one party is working to build a fascist regime or the other side is leading us to a socialist hell.
Running your portfolio on the basis of strong political convictions is a nonstarter.
We have had rip-roaring bull markets and treacherous bear markets during both Republican and Democratic administrations, with and without supporting majorities in the House and Senate.
Yes, there are wingnuts in both parties and the media makes sure their crazy comments get plenty of column space and airtime.
But cooler heads generally prevail. Or, as the old saw tells us, the dogs bark but the caravan rolls on.
The problem with running your portfolio based on your outlook for the future is you could be mistaken (even if you’re not initially).
And the folks with the strongest convictions tend to pay the biggest price.
I regularly meet folks who tell me they have all their money in gold. Or are fully margined in stocks. Or have put a substantial percentage of their liquid net worth in cryptocurrencies.
These individuals suffer from a myopia that prevents them from asking, “What if I’m wrong?”
If you can accept two basic premises – that the future is unknowable and human beings are fallible – it’s clear what smart, disciplined investors should do.
Spread their bets.
In financial terms, it’s called asset allocation and diversification.
You asset allocate to spread your risk among different types of equities – growth and value stocks, large and small cap stocks, foreign and domestic stocks – as well as different types of fixed income investments, like high-grade bonds, high-yield bonds and inflation-adjusted Treasurys.
Personally, I would not diversify into long-term bonds right now.
Not because they won’t perform well in the months and years ahead. (Again, we can’t be sure.)
But there is only so much further that interest rates can fall.
And the slightly higher yield on long-term bonds doesn’t justify the potential downside risk if inflation and interest rates move substantially higher.
In addition to asset allocation, you can reduce your risk by diversifying within each asset class.
You should own dozens of stocks, not just a handful. And you should diversify your bond holdings as well.
You can reduce your risk further by not investing more than 4% of your portfolio in any individual stock. (That’s The Oxford Club’s position-sizing strategy.)
You can also run a 25% trailing stop behind your individual stock positions.
That way if you take the maximum loss (25%) on your maximum position size (4%), your stock portfolio will be worth only 1% less.
And if stocks make up less than 100% of your portfolio – as they should – your maximum loss is just a fraction of 1%.
That’s smart, disciplined investing.
When things go well – as they do most of the time – you’ll enjoy high returns.
And when things go off the rails – as they will occasionally – you’re protected by your asset allocation, your diversification, your position-sizing strategy and your trailing stops.
This way you earn profits during the good times and protect them during the bad.
Best of all, this strategy is available to anyone with the good sense and humility to ask one simple question: “What if I’m wrong?”