Straight Talk on Investment Diversification


There have been numerous articles in recent months saying diversification doesn't work and others reassuring investors that, yes, diversification still works.

As with many debates, the answer might be in the middle. Investors may need to come to grips with the idea that they still need to diversify, but there is an evolution both in the science of portfolio construction and the management of a diversified portfolio in stock-market cycles.

Tying the concepts I've been writing about for several years along with work done by others including RealMoney contributor Mebane Faber, we can explore how to account for the continued need to get a return on savings and acknowledge that buying and holding all the way down through a bear market is not comfortable for many people.

Starting at the asset-class level:

  • Domestic equities, 20%: iShares Russell 3000 Index Fund (IWV).
  • Foreign equities, 15%: SPDR ACWI ex-US ETF (CWI).
  • Commodities, 5%: PowerShares DB Commodity Tracking Fund (DBC).
  • Domestic bonds, 10%: iShares Barclays Aggregate Bond Fund (AGG).
  • Foreign bonds, 10%: SPDR Barclays International Treasury Bond ETF (BWX).
  • Inflation-protected, 10%: iShares Barclays TIP Bond Fund (TIP).
  • Absolute return, 15% (5% each): Nakoma Absolute Return (NARFX), Rydex Managed Futures (RYMFX), Dover Long Short Sector Fund (DLSAX).
  • Cash, 15%.

The above allocation is intended to be very conservative and capture most asset classes while not adhering to buy-and-hold. Over the last few years, I've written several articles about taking defensive action within the portfolio when the S&P 500 falls below its 200-day moving average, or DMA, and getting fully invested when it goes back above its 200-DMA. This approach can also work with individual holdings.

The basic idea is to pick a simple but effective proxy for the asset classes you believe are important, weighted suitably and own them when they are above their respective 200-DMAs and be out of them while they are below their respective 200-DMAs. Being out in this case means holding cash as opposed to buying something else -- this would defeat the purpose of the defensive action.

Currently, the above portfolio implementing the 200-DMA strategy would be 80% in cash as most of the funds went below their 200-DMAs at different points throughout the year. The current holdings would be AGG, which very recently went above its 200-DMA, as well as RYMFX and NARFX.

A portfolio buying all of those funds at the prescribed weights at the start of the year and holding them would be down 17.6% year to date. The portfolio would have been hurt the most by the 40% drop in IWV and the 45% decline in CWI. The same mix using the 200-DMA strategy would actually be up a slight 0.85% this year. In this case, IWV and CWI would have never been purchased, a 32% drop in DBC would have actually been a 12% gain (thanks to the 200-DMA being breached in September), but all three absolute return funds would have been worse off for the extra trading.

The "extra trading" in RYMFX, NARFX and DLSAX points to one of the flaws in the concept. There will be times when a fund (or market for that matter) goes above or below its 200-DMA only to go right back the other way a couple of days later, causing an extra trade and incurring a commission and possibly a tax implication with no real performance benefit.

The intention is to create diversification and avoid a large portion of the occasional steep decline without having to make managing your portfolio a full-time job. Being so light in equities will reduce the volatility but will lag badly the next time the market goes up a lot, as it did in 2003. Anyone seeking out a lower-impact investment strategy of any sort will also need to plan on saving more money in order for their financial plan to work. Saving more will be difficult but that is the tradeoff for a much smoother ride.

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