Doc's note: Is your portfolio ready to take on whatever the market throws at it? Most investors don't know the steps to take to create a fully prepared portfolio. In today's issue, Extreme Value editor Dan Ferris details five basic strategies to help you make sure you're ready for any market...
I came up with my "prepare, don't predict" investment mantra for a simple reason: Forecasts are often wrong.
That's as true for experts as it is for everyday investors.
Time spent forecasting the stock market's performance is time that could be better spent screening stocks for new bargains... enjoying a cup of tea... or watching an episode of your favorite TV show.
Today, I'll discuss how to manage your portfolio in the face of uncertainty. Instead of relying on predictions, you can be ready for anything in the markets this year...
Rather than waste time predicting specific outcomes and betting on them (thus increasing your risk), you should prepare your portfolio for a wide range of potential outcomes and fill it with assets that can withstand various shocks.
This isn't easy, but we consistently recommend some basic strategies for doing it...
1. Don't overpay for equities.
Even a great business can be a terrible investment if you pay too much. This will prepare you for the outcome of expensive stocks underperforming over the long term.
2. Never be afraid to buy a great business trading at a bargain price.
It doesn't matter if the stock market is cheap, expensive, or somewhere in between. A bargain is always out there somewhere. Sure, they get harder to find when many stocks are expensive (like today). But they still exist.
Doing this will prepare you for the outcome we expect to take place over the long term: Things will get better for most people, and businesses that help bring that about will prosper.
3. Don't be afraid to hold cash until you find a bargain.
There's nothing like the peace of mind you get from having plenty of extra cash on hand. There's also nothing like the returns you'll get from deploying that cash when you finally find a good business trading at a cheap price... and then hold it for the long term, watching your money compound at arm's length from the taxman.
This will prepare you for an outcome that happens every now and then, one that most people are never prepared for: a big drop in equity prices. It's rare, but when it happens to you and you have plenty of cash to buy great stocks at cheap prices, you'll feel a lot better than if you have no cash to spend.
4. If you can handle some inevitable losses, don't be afraid to short stocks whenever it makes sense for you to do so.
You'll lose often doing this. Betting against a business is risky. But selling short can make you money when almost nothing else does. And those are the moments you'll want to have extra cash on hand to take advantage of the many bargains that pop up when stock prices fall.
If you can't stomach taking small losses, you should avoid selling short and be satisfied with holding plenty of cash. Like holding cash, shorting stocks also prepares you for drops in equity prices – but it's only for more advanced investors.
5. If you have a long-term, value-oriented perspective, avoid using debt to buy stocks.
If you rely on debt, when the equity value in your account falls, your broker will call you up and demand you either deposit more cash or sell some stocks (the dreaded "margin call"). It will feel awful to be forced to do this right when you should be scouting out new bargains.
It's hard to sleep when you have big debts looming over your head. Staying away from leverage will prepare you for many nights of satisfying, regenerative sleep, as your equity portfolio performs solely on the basis of your stock investments and not on the amount of debt you hold.
These five tips are a good place to start. If you put yourself in the "prepare, don't predict" mindset, I bet you'll come up with some ways to prepare for a wide range of possible outcomes we haven't covered.