This Simple Portfolio Rule Can Help You Bag More Big Winners

jimmyToday, I’m going to tell you an unpleasant truth… The vast majority of investors won’t make much in their personal brokerage accounts this year… or next.

Now this might make you angry. But don’t take my word for it… it’s been proven by research year after year. For example, investment-management giant BlackRock found in a study that the average investor does poorly when compared to the growth of other asset classes like stocks, bonds and oil. Just how bad? Well, although the study is a few years old, it found that over a 20-year period, the the average investor earns just 2.1% — below even the rate of inflation.

I didn’t bring this up to poke fun. I want to point this out for an important reason. The sooner we acknowledge that the individual investor generally fares poorly in stocks, the sooner we can begin to examine why. And then, we can take action to avoid some of the common mistakes made by most investors.

What Most Investors Get Wrong

For starters, let’s acknowledge a not-so-secret truth about the average investor: very few know anything about how to value a security. Most of the research or tips individual investors get come from either a) Friends, family members or acquaintances or b) The talking heads on CNBC.

Take for example a conversation I had with my good friend, Roger. He knows I love the markets, so I knew he would inevitably ask the question… and he did: “So, do you have any good stock tips for me?”

Prior to joining StreetAuthority, I worked in the financial services industry as a financial advisor. I was accustomed to hearing these types of questions for years. I used to thoroughly enjoy this question. It was a great opportunity to showcase all of the research and due diligence I had done on evaluating companies.

But my excitement wasn’t always met with equal fervor. People like my friend Roger would hear my long-winded take on a stock and would typically respond with: “oh… now what was the name of that company?”

Roger symbolized what most individual investors want — the one hot stock pick that is going to make them rich… just handed on a silver platter without researching anything. This leads me to the next reason why most individual investors fare poorly in the stock market: The individual investor fails in risk management.

In other words, the average Joe tends to swing for the fences with every stock. All too often, investors become so fixated on chasing the “home run” that they risk turning possible success into big losses. They also miss the “no-brainer” returns that are often staring them in the face.

Now don’t get me wrong, it’s still OK to swing for the fences. But to do that, I recommend the following advice we’ve given readers for years…

The Pareto Principle

You see, from time to time over at my Capital Wealth Letter premium service, I make what I like to call “game-changer” picks. The goal: identify picks that have the kind of triple-digit potential every investor dreams about. But here’s the catch — we recommend going for triple-digit gainers with the “20% Solution” in mind.

This advice is based on a simple principle that was developed in the early 1900s called the Pareto Principle.

Its origins date back to 1906 in Italy. Economist Vilfredo Pareto observed that 80% of the wealth was controlled by 20% of the population. Pareto reportedly developed the principle after observing similar scenarios in everyday life, including the fact that 80% of the peas in his garden came from only 20% of the pea pods.

This principle has since been observed across a variety of disciplines. For example, studies have shown that 80% of a company’s profits often come from 20% of its customers. If you take a close look in your closet, you might find that you wear only 20% of your wardrobe 80% of the time. Because of this, many people, from management experts to fitness gurus, sometimes call this “the 80/20 rule.”

Applying this principle to investing, it follows that 80% of your returns will probably come from 20% of your holdings. That the essence of the “20% Solution” strategy.

Let me explain… Successful investors diversify based on their risk/return profile. Their idea of success is not to knock the cover off the ball every time, but to make consistently solid returns in line with their reasonable expectations. The 20% Solution increases your exposure to higher return stocks, but minimizes the risk.

How It Works

To better explain, let’s look at an example. Let’s say you put 80% of your assets into a low-cost index fund that mirrors the S&P 500’s performance.

Historically, the S&P 500 index has averaged around 10% a year, including dividends. So by investing 80% of your portfolio in an S&P 500 index fund, over time you could expect a return of around 8% per year.

With the other 20% of your assets, you could devote a couple of hours every week to finding stocks with the potential to generate returns in excess of the market average. This is what my “game-changer” picks over at Capital Wealth Letter are all about… If you’ve done the proper research, then many of these home-run stocks could do well.

Of course, there will always be investments that lose money. So let’s just say hypothetically that out of every four picks, you hit a “home run” with one and score a triple-digit gain. The others either do okay, go nowhere, or you lose a bit. But overall, this aggressive 20% of your portfolio nets a return of 25%. That would juice the overall average annual return of your portfolio to 13% per year in this example. That doesn’t sound like much, but over time the added boost from the aggressive 20% of the portfolio can make a world of difference.

Let’s look at the numbers. If you were to invest $25,000 in the S&P 500 and earned 10% annually, your investment would grow to $301,423 in 25 years. Not bad. But if you employ the 20% solution — investing 80% of your money in the S&P 500 index fund and 20% in aggressive stocks — and your average return would be 13% per year. That’s enough to turn a $25,000 investment into $633,596 over the same time period…

Closing Thoughts

Now, keep in mind that we’re making a few assumptions with this napkin math. It doesn’t take into account the kind of discipline you’ll need to use this strategy properly, for example. But the end result is clear. You would earn more than twice as much money in 25 years in this example, just by allocating some higher-risk investments to that 20% of your portfolio. That way the majority of your money is in safer, large S&P 500 stocks, but your overall portfolio returns are buoyed by the more aggressive stocks.

Also, I’m not explicitly saying this is what you should do. Everyone’s situation is different. But by keeping the 20% solution in mind, you can dramatically increase your returns and and have a good chance of beating the average investor.

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