Let's say that in two years' time, oil stocks become extremely cheap and represent a great buying opportunity. When we move to invest our capital in oil, we're not going to buy a startup company with an unproven business plan. We're going to invest alongside the world's best oil company operators. We're going to buy ownership stakes in the best oil assets. Life is too short to work with people with no track record, and no reputation.
When we invest in an industry, we invest only with proven operators with excellent reputations and excellent records of value creation. By investing only with proven operators and proven business models, we'll miss the occasional long shot that pays off big, but we'll also miss the 100 other long shots that fail.
Don't be focused on how much you can win, be focused on how much you can lose
I've often said there are five magic words to successful investing. They are: How much can I lose? Almost every novice investor focuses on making money. They focus exclusively on the potential upside of an investment. They're always thinking about the big gains they'll make in the next hot stock, the next big trade, or their uncle's new restaurant business.
They don't give a thought to how much they can lose if things don't work out as planned, if the best-case scenario doesn't play out. And the best-case scenario usually doesn't play out. Since the novice investor never plans for this situation, he gets killed.
When presented with a potential investment, the great investor reflexively asks early in the discussion, "How much can I lose?" The stories of Warren Buffett and Paul Tudor Jones can drive this point home. Warren Buffett is one of the greatest investors in history. He used his ability to analyze investments to build a huge fortune.
When asked what his secret is, he doesn't talk about the intricacies of balance sheets or cash flow analysis. The first thing he recommends to folks who want to make money in the market is to not lose money in the market. That's his first rule. Buffett is obsessed with finding out how much he could potentially lose on a stake. Once he's satisfied with that, he looks at what the upside is.
Buffett is your great investor. Now take Paul Tudor Jones, an incredible trader with a net worth in the billions. His interview in the classic book Market Wizards is one of the most important things any market participant can read. Jones's interview is filled with him saying how he's obsessed with not losing money ... with playing defense.
Tudor is a short-term trader. But he has the same core belief system as Buffett. Tudor says his most important rule of trading is to play great defense, not offense. Tudor always focuses on the risk involved in any move he makes in the market. Once he determines the risk, he then considers the upside.
Employ dynamic asset allocation
Don't stick to a rigid asset allocation system. Buy the best values in order to make the largest, safest gains. Talk to an investment advisor for more than five minutes and you're bound to hear the words "asset allocation." It's the part of your investment strategy that dictates how you divide your wealth into various assets, like stocks, real estate, cash, gold, and bonds.
Asset allocation is 100 times more important than knowing what stock or commodity to buy is, says CNBC. Keeping your wealth in a diversified mix of businesses, real estate, cash, gold, and other vehicles will prevent you from suffering a catastrophic loss in case one asset plummets in value.
For example, folks who had the bulk of their wealth in technology stocks in 2000 suffered huge losses as the tech sector fell more than 70% off its peak. Folks who had the bulk of their wealth in real estate in 2006 suffered huge losses as the housing market collapsed.
Conventional asset allocation often dictates that you subtract your age from 100 and convert that number into a percentage. That is the percentage of your investable wealth that should go into stocks. The rest should go into bonds. For example, if you're 60 years old, you should have 40% of your portfolio in stocks and 60% of it in bonds.
If you invest with conventional wisdom in mind, you'll get conventional results. But you can achieve two, three, five, or even 10 times the returns with something we call "dynamic asset allocation."
Dynamic asset allocation doesn't follow a set of rigid guidelines. It's a way of managing your wealth that focuses simply on buying bargains in stocks, bonds, real estate, natural resources, and currencies. Its overriding mandate is to buy great values, wherever and whenever they appear.
If you can't buy stocks at great values, don't buy stocks. If you can't buy real estate at great values, don't buy real estate. With dynamic asset allocation, you only act if there are great values available. You won't mindlessly buy assets no matter what their price just because some formula told you to.
Employing dynamic asset allocation takes more work than other strategies do. If you don't have the time or interest to work on it, you're probably best sticking with a simple asset allocation formula. But if you're willing to take control of your wealth, you can make much larger returns with dynamic asset allocation.
See a crisis as an opportunity not as a reason to panic
If there's one great difference between amateur investors and skilled professionals, it's that amateurs react to crisis by panicking. Professionals react to crisis by calmly looking to buy assets at fire sale prices.
Most people don't realize this, but a crisis situation is one of the few times you'll ever get to buy assets for bargain prices. A crisis creates panic. When people panic, they dump stocks and bonds and commodities with little regard to their real values. They just sell first and ask questions later.
This air of irrationality creates irrational asset prices, notes Forbes. If you can keep your head, you can take advantage of the irrationality and buy assets on the cheap. This leads to huge gains down the road.
That's why, when a great investor reads a headline like "Asian stock markets crash" or "Offshore drilling stocks plummet in wake of Gulf of Mexico oil spill," he immediately starts wondering if the crisis has created a buying opportunity.
For example, in 1998, Russia suffered a giant financial crisis. Back then, people thought Russia itself was going to implode. The government defaulted on its debt and the currency collapsed. The Russian stock market hit a low in late 1998. It looked as bleak as an investment could get.
Around this time, Russian stocks were extremely depressed and extremely cheap. Then, ten years later, the Russian stock market had gained over 6,000%. That's a six with 1,000 after it. You can make extraordinary returns buying after a crisis. The greatest trader ever, George Soros, has a good quote about this ... or at least it is attributed to him. He said, "The worse a situation becomes, the less it takes to turn it around, and the bigger the upside."
That's a great way to sum up crisis investing. When things are truly badâ€¦and assets are truly cheapâ€¦just a tiny bit of optimism can produce giant investment gains.