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Why You can Throw Traditional Diversification in the Trash

admin on 09 23, 2010

Since I was in my college finance classes, the one thing that has been drilled into my head about investing is to diversify.  The traditional method of diversification is dead as we know it.   Here is the reason why: correlation.  Correlation is a measure of how well two assets move compared to each other.  In normal times, only a portion of a stocks daily movement was attributable to the overall market.  Most of the daily moves came from the stock, sector, industry news. Today, stocks are driven by what the overall market is doing compared to good company news.

Traditional diversification was what our grandparents used (if they put money in the market at all.)  This entailed buying companies with different market caps and sprinkling in fixed income.  The older you were the more conservative you should become with a higher fixed income percentage.  The sad part is that our older generations have spent their savings and can no longer rely on their pensions, and social security.  Read the Plundering of Social Security.  This very low maintenance approach worked for a long time as long as people believed in the theory of  just putting your money in a retirement account and expecting 8-10% returns. We know that we can not get 8-10% with traditional buy and hold.   Every stock is moving with the market these days in a highly correlated move.  To put it simply:there are too many risks.  Everyone should be afraid of the domino effect. I don’t want to get into the details of why our economy is not out of the woods yet.  But if we were, then why is the Fed talking about another round of quantitative easing? Where are the jobs, housing sales, automobiles sales, reduction in foreclosures?

So the question you must ask yourself is do I believe that my current asset allocation, a.k.a diversification, will save me from another 50% drop in the market?  Well if it didn’t do it the first time, will it do it now?

Do you think that a stock like PCLN will continue to double every 3 months?

Investors have thrown traditional valuations in the trash.  We see decent companies with “ok” earnings gap on earnings announcement.  We are getting back to stock movement insanity of 1999.   Investors are getting that “can’t stop the bull” feeling again.  This is a great time for investors.  They are starting to get back to break evens in their portfolios.  Now is a great time to evaluate your portfolio to see if it matches your outlook. Consult your broker, I am sure he will say it is doing well and stay the long term course…(like your grandparents portfolio!)

Here are a few wrinkles that I think you should add to your portfolio that your broker will not mention:

Stock replacement: This is where you sell the stocks that you are in and replace them with an in the money option.  This will free up a ton of money and give you a built in stop.

Premium Collection: Depending on your outlook, you can sell options against your portfolio to collect premium against your existing portfolio.  You can also add in delta neutral premium collection strategies.

Sector Diversification/Rotation: Analyze the stocks and their sectors, are you in the right stock? Can you rotate into a better candidate that has not made a move?  Can you take profits and diversify in that sector if you still like it?

Taxes: Time to start planning.  Where can you take profits and losses to offset each other.  Collar positions that you are concerned with.

Portfolio Protection: This can get a little tricky but very doable.  I suggest beta weighting your portfolio risk.  This is basically understanding what your stocks will move in correlation to a market move.  If the market goes down 10%, what will my overall portfolio do?  This is critical to not giving your profits back.

For those of you who want more information on protection your portfolio, I created a quick video on collars for protecting your stocks.  I also create a course on stock and portfolio protection for those of you who truly want to learn how to protect yourself for the rest of your life.  How much are you risking in the market right now?  How much would you pay to protect your portfolio right now?  Not only can you offset potential losses, you can make money if you want to.

The course covers: beta weighting your stock and portfolio risk, using option strategies to protect that risk, which options to buy and sell based on your assumptions, and which ETFs that you can use.  We also discuss inverse ETFs.  We talk about putting these hedges on and taking them off. We also discuss alternative cheaper ways to protect your portfolio.

The course gives you a beta weighting worksheet, video tutorial and video case study of an actual portfolio.

If you want more information please click here.

Now is the time to evaluate your portfolio.

Even if you don’t want the course, check out the video!

No email required!