- Do you know what type of investor you are?
- True diversification
- How high risk stocks can actually be less risky
The stock market in the US is near an all-time record high.
The Aussie stock index is near a multi-year high.
Which way will the market go next?
Is a crash imminent? (It’s possible.)
Or will stocks go on to hit even higher highs? (That’s possible too.)
The point is, regardless of where stocks ultimately end up going, the market is at a key ‘risk inflection point’.
That’s an important thing to remember. Risk isn’t just about falling stock prices. You can apply risk to rising stock prices as well. And if we want to be completely truthful (and we do), there is risk in a sideways market too.
So, what, if anything, does any of this mean?
Well, this is the core of investing in today’s market. While we may have a personal view on where the market is heading next, we don’t know for a fact what will happen.
Because of that, how can you know if you should be bullish, bearish, or neutral?
It’s only with the benefit of hindsight that you can know for sure what would have been the best investment approach.
It’s for this reason that we recommend investors take what many in the mainstream financial advisory business would consider to be unconventional action. How so?
Most investment advisors will have a fairly ‘vanilla’ asset allocation approach. They’ll likely recommend that most investors have 60–80% of their investable assets in stocks (probably most of it in a selection of top 50 blue-chip stocks), 10–20% in cash, and 10–20% property trusts, hybrid securities, or fixed interest securities.
While that may not be the most egregious asset allocation strategy, we do have one problem with it. In fact, we have a major problem with it. It’s this: an investment advisor would likely claim that asset allocation approach represents good diversification.
But we would disagree. We would argue that aside from the cash, the rest of the portfolio, regardless of the stocks, trusts, hybrids, or fixed interest securities, will likely fall significantly in the event of a major market crash.
The stocks could fall 50% or more. The property trusts could fall 80% or more. The hybrid and fixed interest securities may just not trade at all, due to a potential lack of liquidity.
To our mind, that doesn’t seem like much of a diversified portfolio. Assuming a portfolio value of $100,000, a major crash could see the value of that portfolio fall to less than $60,000. Maybe less than $50,000, or worse.
It’s all because in most cases, Aussie portfolios aren’t diversified at all. Instead, they’re concentrated in similar assets, which will behave similarly in the event of a market crash. That’s not good. And unfortunately, most folks won’t realise that until after the crash happens.
Now, you may say, ‘But what if the market doesn’t crash? Won’t all these assets go up in value? If so, good.’
We can’t deny that possibility. We also can’t deny the potential for a quick-witted investor to perfectly pick the top of the market, and sell their stocks and other assets just before the market crash.
However, experience tells us that genuine quick-witted investors are few and far between. Most investors don’t tend to get out of the market while stock prices are scooting higher. They’re more likely to buy more and follow the crowd higher…and then follow the crowd lower!
So, with all this said, is there a better approach? An approach that has the potential to help investors make the most of a rising stock market, while at the same time not exposing a large part of their wealth in the event of a major market collapse?
We believe there is. And we believe we’ve found it, in possibly the most unlikely area of the market. We’ll explain exactly what we mean below…
Do you know what type of investor you are?
Investors think they know the type of investor that they are.
Ask any investor whether they’re a conservative investor or an aggressive investor, and it likely won’t take long for them to reply.
They’ll have a pretty good hunch of what they are.
However, our bet is that while many investors have a clear perception about the type of investor they think they are, the reality is that their investment decisions probably don’t match their perception.
We’re pretty sure this is true, due to the investment choices people make.
For instance, many investors will claim they’re conservative…only to then invest 80–90% of their investable wealth in half a dozen or so big, blue chip Aussie stocks.
The same big, blue chip Aussie stocks mind you, which fell 50% during the financial meltdown in 2008 and 2009…and which many of the same investors then sold at the bottom or near the bottom.
Now, you could say that all those investors needed to do was hold on, as stock prices have since bounced back. You could say that. But, that’s only with the benefit of hindsight. At the time, no-one could know for sure that stocks would bounce back.
Therefore, what if stocks don’t bounce back after the next market crash? It may have turned out to be a good idea to hold on in 2009, but that may not be the case in 2017, 2018, 2019, or whenever the next crash happens.
In that case, what’s an investor to do? You can’t just sit and do nothing, right?
Well, yes and no.
Without making this too complicated or too cryptic, what it really comes down to is having a real asset allocation strategy. And most importantly, an asset allocation strategy that doesn’t just involve buying and owning stocks.
Done properly, it should be a multi-asset strategy. What’s more, the strategy shouldn’t always be about trying to achieve the best return today from every asset you own.
That’s hard. Especially when you see news reports on the TV or online telling you about how well the stock market is doing. Seeing those news reports day after day can tempt you into making the wrong investment decisions.
You may look at your genuinely diversified portfolio, and see that it has only risen in value by, say, 2% over the past three months. Meanwhile, you see on the news that the stock market is up by, say, 8%.
It’s hard not to feel jealous or foolish when you’re in that position. However, I’m here to tell you that you shouldn’t feel jealous or foolish. Not when you’ve laid out a clear multi-asset and genuinely diversified investment allocation plan.
Instead of feeling jealous or foolish, you should just say to investors who have all their money in stocks, ‘Good luck.’ And that’s all.
So, what does a genuine asset allocation strategy look like? This is something I’ve written about for years. It’s how I divide my family’s investable wealth. For me, I’ve found this the best way to manage wealth. Before I followed this approach, I found it hard to justify making a particular investment decision.
That’s because I didn’t have a clear plan or idea about what asset to buy. Sometimes I’d buy a stock just because I wanted to buy a stock…rather than working out whether that fitted in with the plan. But now that I have a broad asset allocation strategy, I can look at a potential investment, and then figure out within seconds whether it’s something I should consider buying for the portfolio.
If it is, I’ll do more research on it, to assess it as an individual investment. If it doesn’t fit in with the current state of the asset allocation strategy, then I won’t even consider it. No time wasted.
To keep things simple, I group my assets into what I call ‘Safe Money’ and ‘Punting Money’. But that’s just my name for the two groups. You can come up with your own if you like.
Then, I consider the different types of investments I can make, and then group them under those headings. So, for me, ‘Safe Money’ includes:
- Dividend paying shares
You could include property in this classification, but not if it’s heavily mortgaged property. I’d only include mortgaged property in your ‘Safe Money’ allocation if you’re able to pay the mortgage from your own cash flow, without factoring in rental income. Naturally, you can include unencumbered property here too.
For ‘Punting Money’, I include:
- Growth stocks
- Small-cap and microcap stocks
Just a note on derivatives. If you’re using the type of cash-covered strategy recommended by my colleague, Matt Hibbard, you could include that in your ‘Safe Money’ allocation. Note, the term ‘Safe Money’ doesn’t mean that all investments in this category are safe. It’s a relative term, and it’s a descriptive term I use for these investments. As I say, you can use your own terms.
Now, once you’ve split your assets into these groups, you then need to figure out how much of your wealth you want in the ‘Safe Money’ group, and how much in the ‘Punting Money’ group. This will vary depending on your comfort level.
To give you an example. At a rough guess, I would say I have close to 90% of my family’s wealth in the ‘Safe Money’ allocation. You may be different.
Once you’ve decided the split (it can be a rough split, you can always change it later), you can then divide your assets further into the respective areas. You may choose to have 40% in cash, 20% in dividend stocks, 20% in gold, 10% in small-caps and microcaps, and 10% allocated to trading in blue-chip stocks.
Or you may go for a completely different allocation strategy. But whatever you choose, it’s up to you. Of one thing I can be certain: just the process of going through this exercise will open your eyes to how you currently allocate your assets.
You may find that, although you thought you were a conservative investor, you’re actually more aggressive than you thought.
The ultimate question then is what does this have to do with the subject we’ve referenced all week: tiny stocks?
That’s easy. By having a clear asset allocation strategy, you should now be able to figure out how much you can afford to allocate towards one of the most exciting and potentially rewarding sectors of the market, microcap stocks.
Furthermore, used the right way, microcap stocks can potentially provide you with a leveraged exposure to the market, to hopefully profit if the market goes up, while still leaving you with only a limited overall exposure to the market if it goes down.
Let me explain.
Let’s suppose you had a $100,000 investment portfolio. And let’s say you wanted to try to profit from your belief that stocks were going to go up. You could invest, say, $80,000 in a bunch of stocks, and keep $20,000 in the bank.
If your stocks and the market go up 10%, you will have made an $8,000 profit on your stocks, taking your overall portfolio value to more than $108,000 (assuming you’ve earned interest on your cash too).
However, sometimes investors get it wrong. Sometimes the stocks you pick, or even the market as a whole, goes down. If the market fell 10% rather than went up, that would mean your stock portfolio would fall to just $72,000. Add on the $20,000-plus interest from the money in your bank account, and your portfolio is down to the tune of nearly $8,000 — worth just $92,000. Not great.
Plus, what happens if the market falls further? What happens if stocks crash by 50% as they did in 2008 and 2009? Your stock portfolio may now only be worth $40,000. Add on the cash in your bank account, and your overall portfolio is worth only around $60,000.
That’s a big hit.
Now consider an alternative approach. Let’s say, rather than putting $80,000 into stocks, you only put $10,000 into stocks. The rest you kept as cash in the bank.
And let’s, for arguments sake, say you put all $10,000 of your stock investments into high risk microcap stock plays. What could happen?
Well, with microcap stocks, the aim isn’t to go for 10% gains. The whole purpose of microcap stocks is to go for 50%, 75%, even 100–200% gains or more. Hopefully, within the space of a year.
So let’s say in our scenario, with these being high risk, potentially high return plays, the average return on these stocks was 80% over the course of a year. From your $10,000 punt, you’ve made an $8,000 gain. Add the $90,000 cash in the bank, and your portfolio is now worth over $108,000.
However, what if you’re wrong? What if rather than gaining 80%, your microcap stocks, on average, fall 80%? In that instance, your stock portfolio is now worth a trifling $2,000. Add on the cash in the bank, and overall, your portfolio is worth $92,000. That’s not great.
But now think of the worst case. Let’s say the stock market crashed, and in the crash, every one of your tiny microcaps went bust, so your stock portfolio is now worth zero. But, if we add your cash savings of $90,000 plus interest, your overall portfolio is still worth more than $90,000.
That’s $30,000 more than the value of the first portfolio in the same scenario.
You see what I’m getting at? Of course, I’ve used extreme examples to illustrate a point. The market is never that simple or clear cut. The point I’m making is that it’s wrong to assume that a blue-chip portfolio is always safer than a portfolio of tiny and risky microcap stocks.
To take it further, what I’m also highlighting is how important it is for investors to think harder about how they invest. I hope you won’t take offence at this, but I’ll say it anyway: most investors are lazy.
They don’t want to think or make decisions. That’s why they frequently write to us, telling us to get to the point, to not write so much…to just give them a stock code and a buy or sell instruction.
I don’t know for sure, but I’m pretty certain that those type of investors will never make money on the market in the long term. Investing does require thought, and a little time.
This week, I’ve written to you all about microcap stocks, or as I call them, ‘tiny stocks’. Tiny stocks aren’t for everyone. I know that. But used the right way, they can offer terrific growth potential. Heck, folks don’t even have to follow the strategy I’ve highlighted above. I know there are some punters who insist on putting huge amounts of money into these ‘tiny stocks’.
I don’t recommend that at all. To me, that’s way too risky. But it’s a choice some investors make. For me, the beauty of ‘tiny stocks’ is the ability to get leverage to some great stories, and most of all, unlike many over forms of leverage, with ‘tiny stocks’ you know your maximum risk of loss up front.
With the ‘tiny stocks’ we’re talking about, you can’t lose any more than the money you invest, because a stock can’t go below zero. (Note, we’re talking about paying for these stocks in full with cash. These are not margined trades. These stocks have enough built in ‘leverage’ as it is.)
To sum up, there are some terrifically exciting (and risky) opportunities among ‘tiny stocks’.
It’s also the only area of the market I know of where it’s possible to make big double, and even triple-digit gains in a relatively short period of time. Look back at the list of daily big-moving stocks I’ve shown you this week. There isn’t a blue-chip stock among them.
They’re all tiny stocks. Many, if not most, of them are sub-10 cent stocks.
Now, in the interests of full risk disclosure, it’s important to remember that just as quickly as these stocks can shoot up, they can crash down too. But that’s why we suggest allocating just a small part of an investment portfolio to these stocks.
I call these types of stocks ‘Punting Money’. But you can use more colourful language if you like. You can call them ‘White Knuckle Ride’ stocks…or ‘Hail Mary’ stocks…or ‘Boom or Bust’ stocks. Call them whatever you like.
All I know is that this is a sector I love. I’ve loved it for going on two decades. And in my view there’s no more exciting, and potentially rewarding (and risky) place to put your money in the stock market. If you like the idea of potentially making big triple-digit gains, while understanding the risks, I can only encourage you to check out a special summit I held with colleague, Sam Volkering earlier this month.
I’m certain you’ll get a lot out of it. Details will be in your inbox tomorrow. Look out for it. It will show you how you could get in on the ‘tiny stock’ action (if you’re up for it) very soon indeed.