I want to make my ground level thoughts on investing very clear. I think using these ideas and the framework I lay out will help you not only cut your risk dramatically, but beat the stock market handily. Everything I say here is rooted in historical market studies, experience and math.

I will update this page from time to time. That doesn't mean the philosophy changed, it just means I found a better way to say it.

Summary

• Asset allocation drives 50-90% of volatility, risk and returns so focus on asset allocation by sector, industry and nation above all else, with a core position in ETFs
• Stocks must present an opportunity to significantly beat the market averages or are not worth the single stock risk
• When selecting stocks, because data is easy to get and analyse with computer algos, you must find under appreciated assets within a company to get an edge
• The vast majority of our trades are "position trades," that is, lasting quarters to years. We make almost no "swing trades" at Fundamental Trends investing

Correlated stock market risk

The stock market is extremely risky. This might seem like a self-evident cliché, but most people invest with little regard to the real risks. It is not hard to lose half of a diversified portfolio in short order.
Highly correlated stock market crashes happen one to three times per decade.

Including the 2022 bear market, there have now been 10 bear markets since 1980. And this is in the era of government deficit spending which began in the early 1980s and Federal Reserve monetary policy which began post 2008 financial crisis.

There are takeaways here:

• Government policy, no matter how well intentioned, can have unexpected side effects and consequences.
• Federal Reserve policy is "counter trend" in nature and we should be equally suspicious of stimulated economic expansions and induced recessions.
• Big correlated corrections are buying opportunities for high quality and high beta

Mild diversification is best

Cutting risk does not come from broad diversification.

"There should be adequate though not excessive diversification."

— Benjamin Graham, Chapter 5: The Defensive Investor and Common Stocks, The Intelligent Investor

Graham's quote tells us that we do need some diversification, however, it should not be excessive.

"If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk."

— Warren Buffett, Berkshire Hathaway: Letter to Shareholders (1993)

While we like to think of ourselves as "know-something" investors, the fact is that while we might know more than most investors, we are not perfect. Therefore, we do need some diversification to protect against what we do not know.

The diversification I look for comes in two flavors:

• We will buy ETFs to give ourselves diversification across the sectors, industries and nations that we think offer the best intermediate to long-term risk adjust returns.
• In general, we want to own 12-30 stocks. This jives with Buffett's 20 slot "punch card" for owning stocks. Owning fewer than a dozen stocks does not offer enough diversification. Owning more than 30 stocks is simply too many to know well enough to manage properly.

In their “Modern Portfolio Theory and Investment Analysis” book, Elton and Gruber, concluded that as you increase the number of stocks in your portfolio you significantly reduce the stock specific risks (unsystematic risks) with each added stock.

Diversifying with roughly 30 stocks gets rid of most systematic risk. Substantial risk is reduced even at 12 stocks. Hence, depending on your funds base and other investment holdings (real estate, private equity...) the proper range of stocks to own is 12 to 30.

Semi-diversified asset allocation

Studies have showed the asset allocation is the key driver of long-term risk, volatility and returns. Investing primarily in the best sectors, industries and nations will yield market beating results over time.

For our diversified asset allocation in the 2020s we want to stick with the "barbell" approach I have laid out:

In short, we want to be invested in the 4th Industrial Revolution (which includes many technology subsectors), Decarbonisation, Fintech including Blockchain, and the best consumer businesses. This is where the "big money," think trillions in government, sovereign wealth fund, family office, endowment, pension and other big money, is headed. We want to invest with, not against, the big money.

The 4th Industrial Revolution (4IR) is a fusion of advances in artificial intelligence (AI), robotics, the Internet of Things (IoT), genetic engineering, quantum computing and more.(Quoted from Salesforce)

Here, let's have a quick note on "crypto" and blockchain. There are legitimate use cases for both, even though I've said for a couple years now, "most crypto will go to zero." Blockchain is useful across multiple industries as it can validate transactions and contracts using its multi-confirmed ledgers.

The last men standing in crypto will be Bitcoin (BTC-USD) as a store of value, Ethereum (ETF-USD) as a backbone for digital contracts and a few others the financial industry are integrating right now into the banking system. Bank or America (BAC) is using Ripple (XRP-USD) and the SWIFT system, America's massive international payments system is using ChainLink (LINK-USD). Beyond that, not much other crypto will survive.

Single stock risk

Ownership of a stock carries the most risk and the most reward. I follow one very simple rule when it comes to owning a stock, that is, taking single stock risk:

I only own stocks that can beat the S&P 500 by a double digit percentage annually on average over time.

That does not mean that every stock I own will beat the S&P 500 by double digit percentages. But, by only owning stocks that we believe can offer great returns, we build in a margin of safety.

Too many people own stocks that don't even have the potential to beat the S&P 500 index by much. What's the point? We can own ETFs with better potential than the S&P 500, so why wouldn't we apply an even tougher standard to stocks given their higher risk.

This is an extremely important rule because individual companies run into problems all the time, even if they have great products, great business plans and great management.

All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don't work out — Peter Lynch

Perfection is impossible

Not all of our ETFs, stocks or other investments will perform well. Sometimes we will make a mistake. Other times the world changes somehow and our investments get stuck. That's life.

By having a good investment philosophy that controls risk and builds in potential upside, we have a chance to beat the stock market averages. I remember being told by different people, including coaches, that making good small decisions over time will yield big results in the long run. In my experience, that will be true.

Author

Kirk Spano 

CEO/CIO — Fundamental Trends

Kirk is an Accredited Investment Advisor and founder of Fundamental Trends and Bluemound Asset Management LLC. Kirk has been highly successful in helping DIY investors make sense of the investment world, and profit in stocks, ETFs and crypto.