Managing Your Money Part 3: Diversification

by Craig Moser on May 25, 2017

Most people are familiar with the term “portfolio diversification.”  It’s generally known you shouldn’t invest all of your money in one stock, bond, or other investment vehicle.  However, my view of modern portfolio diversification has a different twist on the old “buy and hope” strategy.  To help explain my view, I need to quickly recap my two previous blogs in this series.

Past “Managing Your Money” blogs were to help design your portfolios.  Key points centered around setting your benchmark to provide returns during most calendar years while striving to minimize loss during those nasty bear markets.  Most of the time, you just need to be in the markets.  You only need to defend and react when loss goes beyond normal ranges.

We also discussed incorporating some form of risk management strategy into your portfolio.  The idea is certainly simple enough; attempt to reduce market exposure when risk factors are high.  Easy, right? After all, there are a gazillion different market indicators available on the internet to help slice and dice markets.  History is loaded with markets that saw high risk factors for very long periods of time.  This type of situation can make you feel foolish as stocks charge higher in the face of sky high valuations, a developing crisis, an unfriendly Fed, an external event, etc.  For example, do you remember what happened during 1999?

Back then, stock market valuations were at never-before seen levels (like today).  It was a new era.  Analysts made up new indicators because traditional metrics were clearly wrong.  This time it really was different!

And yet, stocks kept moving higher for months.  In fact, the S&P 500 didn’t actually start to decline in earnest until the spring of 2000.  Then we saw a three-year decline.

So, if you tried to manage the risk of insanely high valuations that were present in 1999, you may have looked and felt foolish.  Sure, the broad market indices struggled, but the NASDAQ kept ripping.  Risk? What risk?

What’s The Point

The point is if you take action to avoid a “potential” storm, you must recognize that you may be wrong!  The storm can take much longer than anticipated before arriving.  The storm may not be as bad as you expected.  Or, even worse, the storm may not come at all.

And then what happens to your portfolio if you prepare for a storm that doesn’t materialize as you expected? Severe underperformance, that’s what.  Hey, what have you done for me lately?

You can’t forget we have a two-pronged goal here, a dual mandate.  Yes, you want to manage risk or “lose less” when the bears come to call.  But, you also want to be around the benchmark during most calendar years.  And believe it or not, THIS is the hardest part.

From the dual mandate perspective, being early is the same as being just plain wrong.  Poor timing for an extended period of time likely means you won’t be around the benchmark that year.  Sure, you may eventually be right.  But it’s vital to realize that you aren’t trying to be right.  You’re are trying to get it right – year after year.  If you get too cautious too early, you run the risk of failing the first mandate.   You can be right much longer than you can afford it.

One of the really big, really important lessons I’ve learned is that there is no one single methodology. There isn’t a single strategy or manager that consistently achieves this dual mandate alone.  In short, all managers and all strategies get it wrong from time to time.  In short, everything works some of the time.

Portfolio Diversification

This is where diversification comes in.  But not the traditional approach that financial advisors have been promoting for eons.  Also known as the old buy and hold (hope) strategy, some believe you should ride through the down drafts in the market and stay put.  I disagree.

In today’s modern markets, I believe you need to go beyond diversification by asset class and find a way to modulate exposure.  This allows you to take more risk when times are good and less risk when times are bad.

Simply stated, I don’t believe these goals can be achieved via a single strategy or product.  From my perspective, you need to utilize a diversified mix of methodologies, strategies, and management styles – all in the same portfolio.

Unfortunately, finding the right mix of investing methodologies, strategies, and managers is no easy task.  Being around the benchmarks most years and losing less during big, bad bears is difficult.  But I have developed a way of coming close.

Start With the Core

Start by developing a healthy core to your portfolio.  For me, this means allocating between 25% and 40% to passive or strategic allocation strategies.  I prefer to use mutual funds and ETF’s to let the manager try and create some selection alpha and beta on an asset class to help be around the benchmark.

Layer-In a Tactical Overlay Approach

Next, I like to layer on what I call a tactical overlay approach.  This strategy starts with a risk-targeted asset allocation (for example: 40/60, 60/40, 80/20) and then focuses on overweighting and underweighting the primary asset classes relative to the overall environment.  For example, in good times, such a strategy should be overweight stocks and underweight bonds and cash.  Then when times get tough, bonds and cash are likely to be over-weighted while exposure to stocks is underweighted.

The idea here is to “be right most of the time”, without making a big bet and risk being really wrong.  This section of the portfolio can actually help achieve both mandates, albeit in a very slow-moving fashion.

Add Some Risk Management

From there, I try to incorporate a purely risk-managed strategy designed to raise high levels of cash in times of market strife.  This is added to help you “lose less” when the bears are mauling the stock market indices.

“Wax-On/ Wax-Off” Some Leverage (When Appropriate)

Next, I build in a super-charger.  Something designed to provide outperformance when times are good.  To me, this means the utilization of the third alpha factor – leverage.  (This is usually where moderate investors begin to gasp.)

Yes, using leverage is certainly a higher-risk endeavor.  If you use a times two leveraged mutual fund, you are going to get twice the return when it goes up.  However, if it goes down, it will go down twice as much.  You have to have a mathematical approach to tell you when the right numbers are there for this extra kick.

Just to be clear, I’m not talking about exposing the entire portfolio to a 2X levered long position.  I’m talking about exposing a portion of the portfolio to leverage (a level appropriate for the overall risk appetite of the investor).  I also believe you should do so ONLY when conditions are right.  As such, you need to identify a way to sprinkle in some aggressive behavior at the appropriate times.

Dial it in

From there, the remainder of the portfolio tends to be allocated to what I call “dealers choice.”  Some people want alternatives.  Others want individual stocks or bonds.  And still others want to play the global rotation game or dabble in emerging markets, gold, etc.

And this is where taking a consultative approach to portfolio design is preferred over the typical one size fits all, computerized approach.




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