Trailing stops allow you unlimited upside potential with strictly limited downside risk. And that - in an uncertain world - is as good as it gets.
This article published with permission from InvestmentU.com.
This is the final installment of Alexander Green’s four-part series outlining the biggest risk and the greatest reward that investors face today. Click here for Part 1, Part 2 and Part 3.
Today I’m going to reveal why you should invest in the great, innovative companies of the future despite the reckless extravagance of the U.S. government and most other Western democracies.
In my last column, I pointed out that the United States is still the world’s largest economy, that our per capita income ranks among the highest in the world, that our work force is young and educated compared to leading competitors, and that the country remains a magnet to immigrants around the world.
Buying stocks is not tantamount to saying you approve of the current administration, that you are optimistic about the national debt, or that you are unconcerned with our $122.5 trillion in unfunded entitlement liabilities. It only means you recognize that most wealthy Americans achieved their affluence not by inheritance or real estate speculation but by starting and managing profitable businesses.
Most of us don’t have the time, the investment capital or the experience necessary to found and run a successful business. But we can still own a piece of one through the quintessence of capitalism: the stock market.
Focus on the business
Forget about trend lines, short interest and put-to-call ratios for a moment and think about it.
With even a modest amount of money, you can accumulate a stake in the world’s most profitable businesses. And it’s easy. A click of the mouse — a seven-dollar commission — and you’re in. Another click — another seven bucks — and you’re out. (Compare that to your typical real estate closing.)
Plus, owning a fractional interest in a public company is a whole lot simpler than running a business. You don’t have to sign personal guarantees, hire or fire employees, grapple with an avalanche of federal mandates and regulations, pay lawyers and accountants, or even show up for work. How great is that?
Over long periods, common stocks have outperformed everything else: cash, bonds, commodities, precious metals, commercial and residential real estate, rare coins, even Chinese ceramics. The risk, of course, is that they won’t in the future. However, that’s true of every investment and the reason investment products are always sold with the same boilerplate: Past performance is no guarantee of future results.
Yet, as Mark Twain pointed out, history may not repeat itself but it rhymes. Owning moneymaking businesses will almost certainly be a winning strategy in the future, provided you diversify to reduce your risk…
Naysayers insist it won’t matter how broadly you diversify when time and arithmetic finally catch up with free-spending Uncle Sam. And I won’t argue the point. That’s why — in addition to diversifying broadly — it is absolutely essential that you run trailing stops behind your individual stock positions. This is what allows you to protect your profits and cut your losses.
Protecting yourself in an uncertain future
Remember, the stock market is a discounting mechanism, but it only discounts what can be reasonably inferred about the next six or eight months. Everything beyond that is sheer speculation.
We can’t know with certainty whether government borrowing will eventually cause a financial crisis or an inflationary spiral or a deflationary depression. Or, surprise, none of the above. (You should, after all, at least consider continued prosperity.)
A future bi-partisan Congressional committee — formed to provide essential political cover for incumbents — might offer up legislative proposals to rein in spending, create new taxes (like a value-added tax) or increase old ones, gradually raise the age of eligibility for Social Security, means test various benefits, or genuinely reform other entitlements. If so, perhaps the worst can be avoided.
But when it comes to protecting what you’ve spent a lifetime earning, saving and paying taxes on, you want the ultimate insurance that you are not going down with the ship (even if we’re talking about the Ship of State). That is why it is so important that you diversify outside the stock market and protect every stock position with a trailing stop.
Let’s do a quick review. The profligate spending in most Western democracies may or may not lead to a financial crisis. If it doesn’t, owning a diversified portfolio of profitable businesses will almost certainly be the best way to protect and enhance your long-term capital, as it has in most democratic times and capitalist places for the past 200 years or so.
If reckless public spending ultimately throws a wet blanket (or a flaming one) onto the economy — causing world stock markets to tank — your trailing stops will protect you. They allow you unlimited upside potential with strictly limited downside risk. And that — in an uncertain world — is as good as it gets.
You may be independently wealthy and able to live comfortably for a long time with a conservative portfolio that has no exposure to stocks — but perhaps a great deal of exposure to potential future inflation.
For everyone else, a diversified portfolio of high-quality stocks is almost certainly going to be a winning formula … even (and, perhaps, especially) in these uncertain times.
Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.