Why avoiding risk is the secret to investment success…

From Porter Stansberry, founder, Stansberry Research: You might not have thought of it that way, but that’s exactly what I’ve been doing.

Just read almost any of the newsletters I (Porter) have written since 2001. You’ll immediately see that my Investment Advisory is primarily about mitigating investment risk. We do this by focusing our recommendations on safe, capital-efficient companies. Alongside this core portfolio, we add a few non-correlated hedge-like investments (such as Fannie and Freddie, which have soared lately). And we even hedge against the market directly with a small number of short-sell recommendations that ideally will "zig" when the rest of our portfolio "zags."

Long-term studies of our results prove this approach has created the best risk-adjusted returns of any letter we publish. (That’s the highest returns with the least amount of volatility.)

But today, I’m recommending the riskiest thing you can do with your money in the markets…

There’s an enormous apparent dichotomy here. But… once you really understand this strategy, you’re going to see that there’s no divergence at all. At times, doing things that seem risky (like shorting a stock) are actually the best ways to reduce your portfolio’s risk exposure. Regardless whether you follow me with this particular strategy, I want to make sure you understand why I’m advocating that you take significant steps to hedge your portfolio today.

The biggest pitfall for most investors is the tendency to misjudge risk tolerance…

Most subscribers who think they can handle lots of volatility really can’t. But if you’re reading this and you’re thinking, “That’s not me. I’m a conservative investor. I don’t take big risks with my portfolio,” I’d bet you’re wrong. Almost every investor I talk to about risk also underestimates the volatility of his or her own portfolio.

Not you, though… right? Well, maybe. Think about your own investment experiences. What happened in your account from October 2008 through March 2009? Most people who would have sworn they were conservative investors ended up watching their life savings collapse by 50% or more. Most of them decided they weren’t “buy and hold” investors after all. (They ended up being “buy and fold” investors.) Holding too much risk inevitably trips up most investors.

Risk doesn’t equal reward…

I also know from empirical studies of investment results that contrary to what just about every finance department in the country will teach you about finance, risk simply doesn’t equal reward.

Lots of good research out there suggests that a strategy of buying well-financed, low-volatility stocks can beat the market by a wide margin. (If you like original sources, here’s a great example.)

Plenty of real-life examples guide our thinking in this area, too. Investing legend Warren Buffett is a classic example. He made nearly 25% a year in the market between 1954 and 2000 by focusing on the least risky businesses to own, like insurer GEICO, beverage giant Coca-Cola (KO), and credit-card issuer American Express (AXP).

It was a brilliant strategy. And it worked, primarily, because he avoided taking risks. He even sold almost all of his stocks in 1969 because he thought the market was too expensive. He didn’t buy back in until 1974. Do you think you could avoid making any equity investments for five years just because you thought the market was too risky?

What’s about to happen in the markets will be worse than anything you’ve experienced as an investor…

How do we know? Because of the credit cycle.

The market doesn’t react well to the risk of bankruptcy, because in bankruptcy, the value of a company’s equity goes to zero. You probably remember the bear market of 2001-2002. Most people assume that bear market was caused by the terrorist attacks of September 11, 2001. But it wasn’t. It was the corporate credit cycle. Defaults reached a peak in 2002, when 1% of investment-grade “BBB” debt defaulted and more than 10% of all junk bonds defaulted. The growing risk of these defaults led stocks to start to decline in 2000 and 2001.

During the boom of 2003-2008, the primary driver of growth in the credit markets was mortgages. As always happens, as the boom aged, the quality of the credit being underwritten declined. And as always happens, defaults soon began to rise. In 2007, an incredible number of subprime mortgages defaulted, practically shutting down the mortgage markets and greatly impairing the market for corporate credit, too. By 2008, these tightening credit conditions led to a rise in corporate defaults and bankruptcies… and you know what happened next.

From 2010 through early 2016, we’ve experienced the biggest increase to credit in history. Sovereign debt has soared in size (U.S. Treasurys). Student loans have essentially doubled. Car loans – in particular, subprime car loans— have boomed, too. These are all areas that responded directly to government incentives—this was a government-directed credit boom. And finally, because the Federal Reserve manipulated interest rates so low, corporations have borrowed more money, and more of that money was “junk” (low-quality credit) than ever before.

The timing of the credit cycle is a lot easier to predict than most things related to stocks and earnings…

The reason is obvious: Debts come due at a fixed date. We know the “maturity wall” and how much money will have to be repaid or refinanced.

A substantial amount of this debt will default. We know that because default rates have already gone from almost 0% in 2014 to more than 5% this past August. As defaults grow, lenders become more cautious. That makes credit tighter and refinancing more and more expensive. Given the huge amount of debt that has been underwritten, and the incredibly low rates that prevailed at the time, not only will another credit-default cycle materialize in 2017 and 2018… but it’s even more likely that default rates will end up being higher than they have been in the past.

The most knowledgeable experts are expecting more than $1.5 trillion in defaults.

You have a few choices…

You can do nothing for a long time—maybe six months… maybe a year. Nothing might happen. Or you could just wait and see if default rates really do keep ticking higher. But whether you take action, these corporate debts are coming due.

No doubt, they will be difficult to refinance, especially as interest rates return to normal. Sooner or later, something—like Hertz (HTZ) falling out of bed… or Disney (DIS) losing a bunch of ESPN cable subscribers… or Ford (F) losing money because car sales plummet—is going to put the entire stock market on “tilt.” A new bear market will begin.

Your other option is to “lighten” your load. As we’ve been suggesting for a while, you can begin to raise cash when you hit trailing stops or take profits on positions where you have gains and you believe tightening credit conditions could lead to falling sales and profits. (A look at "The Dirty Thirty" might really help in this regard, as we’ve focused the list on companies that are most vulnerable to problems in the credit market.)

Or you can choose the option that’s the most likely to allow you to profit from these developments: You can actively hedge your portfolio. Trying to hedge against a specific industry’s troubles usually calls for shorting stocks.

For example, for a long time we’ve been selling short oil-sands producers and buying the best, most efficient U.S. shale firms because we believed shale production would continue to grow, while the lower prices of oil would eventually lead to losses and curtailed production at the oil-sands firms.

This kind of “paired” trading has been great for our portfolio and is a wonderful way to mitigate risk while still producing gains. However, that kind of trading isn’t as effective against broad market declines. In bear market, you’ll see even good stocks fall 30%-50%. How can you protect yourself from that?

You could short stocks…

We know that certain sectors of the market are encumbered by debt and suffering from falling asset prices. We’ve written about some of these sectors previously (autos, malls, and high-cost oil producers). But the main problem with shorting is it costs money to borrow shares (usually 4%-6% a year) and your returns are limited—you can only make 100% even if the company goes bankrupt.

In most market conditions, that’s enough to provide you with plenty of protection. But what about when you know a bear market is approaching? What about when you know which companies won’t be able to refinance? What about when you know the largest credit-default cycle in the history of our country—which just began in August—is going to intensify for the next 18 to 36 months, causing trillions in defaults and soaring bankruptcies?

The best way to reduce your risk…

Stansberry’s Big Trade, like all of the products I’ve developed over the years, is primarily designed to reduce your risk. That will surely earn me a chuckle and a “come on” from some subscribers.

But remember… last year at about this time, we launched Stansberry’s Credit Opportunities. We wanted to prove that, at certain times in the credit cycle, you could easily beat the stock market while investing in bonds! And it worked. All of our recommendations made money and the average annualized return was around 40%… far better than the overall market’s return.

Stansberry’s Credit Opportunities allowed our subscribers to make far higher returns with far less risk than investing in stocks. That was only possible because we knew which firms wouldn’t default. And as interest rates rose on corporate credits (and bond prices fell), we were able to tell you which were safe to buy. It’s the same database that’s powering Stansberry’s Big Trade… except rather than use the information to find companies that won’t default on their debts, we’re using the information to predict which firms will default. It’s the other side of the same coin.

Taking advantage of rising volatility…

You might recall that last fall, the Volatility Index (“VIX”) was elevated. Interest-rate spreads on risky corporate debt were “blowout”—many corporate bonds were trading at annual interest rates more than 10 percentage points more than similar sovereign bonds.

These conditions created an opportunity for us to buy “risk.” Sure, we knew the individual bonds we were buying weren’t actually risky at all, but the market perceived there to be a lot of risk, which allowed us to buy the assets at attractive prices and earn big profits as a result.

Today, though, the conditions are almost exactly the opposite. The VIX is near all-time lows. There’s no “spread” to speak of in the yields between lower-quality debt and higher-quality debt. And that means this year we want to hedge risk, not buy it. The best way to hedge risk is by buying put options. And I hope you’ll at least learn the best way to do so by joining us for our free live webinar on Wednesday night. (Save your seat here.)