How to Diversify Your Portfolio Properly

Today we have a guest post from blogger Troy at Market History.  He runs a small hedge fund that invests in U.S. stocks.  Instead of buying individual stocks, they invest in leveraged ETF’s.  If you want to read his latest thoughts on the market, check out his blog!

We’ve all heard the standard reasons for “why you should diversify”.

 

  1. Diversification reduces risk in your portfolio because it spreads money among many smaller bets.

  2. Diversification prevents you from missing out on a big trend. For example, an investor who didn’t invest in gold between 2002-2008 would have missed out on some significant gains.

 

What most blogs and financial advisers don’t tell you is that there is a right way and a wrong way to diversify. If you do it wrong, you don’t reap any of the benefits! Here’s how to do it right.

You need to make sure the assets you’ve invested in are uncorrelated.

 

It’s one thing to buy multiple different assets because you think that specific asset classes / companies / industries will do well in the future. However, it’s wrong to blindly spread your bets among many different assets solely for the sake of diversification.

 

The whole purpose of diversification is to make sure that your risk is spread out and your investments are uncorrelated with each other. If the assets have a high degree of correlation, you have not diversified at all! If all of your assets go up and down in tandem, then what you’ve basically done is just invested in one asset.

 

For example, many people “diversify” their life savings among multiple stocks. But do they realize that this isn’t really diversification? Of course not. Since the dawn of the internet, the correlation between stocks has drastically gone up. 99% stocks go up in a bull market, and 99% of stocks go down in a bear market like 2008. What’s even worse is that correlation among stocks for the medium term has increased as well. For example, the 20% decline in the S&P 500 from May – August 2011 brought 95% of stocks down.

 

So if you truly want to diversify, do so between asset classes that have a very low correlation. For example,

 

  1. Gold and stocks have a very low long term correlation.

  2. Stocks and Treasury bonds have a low correlation.

  3. Be careful of stocks and real estate. The long term correlation is significant because both stocks and real estate prices react to long term economic fundamentals.

You need to be aware of long term trends

 

Investing blindly is not a good idea. Sure you can convince yourself that “I’m a long term investor”. However, many companies do go bankrupt over the decades, and certain investments such as real estate are flat over a 50 year time frame (when adjusted for inflation). Hence ignorance is not a virtue.

 

Here’s an example. If you had invested 50% in gold in 1980 and 50% in an index fund for the S&P 500, where would you be today? Your stock portion of the portfolio would be up 2100%, but the gold portion would be virtually flat! Thus, your portfolio would have significantly underperformed someone who just invested in stocks over the past 37 years.

 

You need to diversify into assets whose fundamentals are bullish in the long term (or at least for the next few years). The good thing about long term fundamentals is that they’re not hard to understand!

 

  1. Stocks follow the economy in the long term. Home sales is a great leading indicator for the economy. When home sales falls significantly, a recession is imminent (and hence a bear market in stocks is imminent). The U.S. Census Bureau publishes a monthly report on New Residential Sales.

  2. Gold and silver follow inflation in the long run. So if you had seen that inflation was coming down in 1981 and 1982, you would not have bought precious metals (and would have avoided a massive bear market!)

  3. Long term real estate is flat in the U.S. when adjusted for inflation. So if you saw that Robert Shiller’s housing index was massively overvalued in 2005 and 2006, you would have avoided buying real estate at the time.

What are the long term trends today?

 

The current economic expansion is becoming quite long the tooth. By comparison, only 2 other economic expansion in U.S. history have been longer. However, the good news is that economic expansions do not die of old age. They die of excess. With the U.S. economy still growing and many parts of the economy still below long term “normalcy” (e.g. housing construction is still very low), the U.S. economy will continue to grow in the next few years.

 

However, it is certain that we are approaching the final few years of this economic expansion. No economic expansion in American history has lasted 15 or 20 years. The final stage of an economic expansion is characterized by rising inflation because certain parts of the economy start to overheat. In an inflationary environment, physical assets such as gold, oil, and other commodities go up the most. Bonds go down because yields are driven up by higher inflation.

Mustard Seed Money

Welcome to the website. A mustard seed is a very small seed but astonishingly grows very large over time. My hope is that through your financial journey that your small investment in time, money and faith will grow beyond anything that you could ever imagine.



24 Comments

  1. I think that these are all great points to diversify your portfolio. However, I believe that the majority of the public are still struggling to learn the basic investment concepts. On some of my posts, when people hear of the stock market, they automatically associate it with high risk investments. It a shame that there are so many good resources out there but people are just ignoring it because they are unwilling to dig a bit deeper to educate themselves.
    Leo T. Ly @ isaved5k.com recently posted…Raising Financially Responsible KidsMy Profile

  2. Proper diversification is important, but everyone must keep in mind their investment horizon. Like for a minimum 15 years timeframe I see no problem with a portfolio that contains even 80-90%(diversified) stocks. I wouldn’t add gold for such a long timeframe. For a short period it might make sense though.
    It would be nice to read about the characteristics of leveraged ETFs and whether you use any different strategies than trading with normal ETFs.
    Roadrunner recently posted…ABN AMRO Grip App ReviewMy Profile

    • You cannot buy and hold leveraged ETFs forever. Some leveraged ETFs like upro match the underlying market (s&p 599) pretty we’ll these will fall 95% in a bear market!

      Other leveraged ETFs are poor, like uvxy (matches vix). These face erosion problems in the long term, so although vix may be flat uvxy will fall
      Troy recently posted…The U.S. economy is not on the verge of a recessionMy Profile

    • When you hold such a high concentration in any asset class, you run the risk of taking a big loss if/when it doesn’t perform well. You may also compound your loss by missing out on some pretty good trends while your investment is suffering.
      mike melissinos recently posted…“Why Are We Losing Money?”My Profile

  3. Troy- I agree diversification is key. I like what you are doing with the leveraged ETF’s and have started doing some more research of my own on the strategy behind them. Based on the above, would you stay long the S&P500 for the next few years then considering purchasing a gold or commodity based ETF to go along with the rising inflation, or would you just go short the S&P?
    Courtney @ Your Average Dough recently posted…10 Apps to Help You Save MoneyMy Profile

    • To make money investing, you need to be on the trend. Pairing that with the notion that you cannot predict the future, you might as well stick with the trend until it changes direction.

      If the SP500 continues up, I say stick with it. If it starts falling and moving averages turn downwards and prices break through 1-year lows or something, then you may consider selling out to protect yourself from a prolonged downtrend.

      With gold, and any other market for that matter, don’t buy it unless it’s trending up (e.g. moving avgs up, making 6-month or 1-year highs). Gold, in the 1980s, 90s and early 2000s moved sideways. It provided no value for a buy and holder for a 20-year period.

      The risk of making predictions can cost you big time – not just on your investment, but opportunity cost too. Say, you make the bullish gold call and buy some. Then it goes down or sideways for years while, in the meantime, you miss out on some great trends in oil, agriculture, stocks, etc.

      In my experience, clarifying a definition for “trend” and reacting and following trends works better than predicting.

  4. I’m not even sure id say gold follows inflation. After all gold was down for much of the 80s and 9s but inflation didn’t stop. I think better diversification would be internationals and bonds. Even there some correlation exists, but at least they are assets with an actual yield.
    FullTimeFinance recently posted…What Life Insurance Should I getMy Profile

    • Gold doesn’t fall inflation one to one. It follows rising inflation. Inflation and rates were either flat or falling in the 1980s and 1990s.

    • You may consider expanding your horizons even further and consider other commodities like oil, agriculture products like corn/wheat/sugar/cotton and currencies.

      When you confine your portfolio to a small number of markets, you increase your risk of missing out on some pretty good trends.
      mike melissinos recently posted…“Why Are We Losing Money?”My Profile

  5. Good points and thx for the reminder.

    Being only in stock is no good indeed in case of a crash. The world is so global, that all go down together.
    For me, gold is one alternative to have. I have been increasing my position a little over the past year.
    Amber tree recently posted…2 cars is frugalMy Profile

    • Gold doesn’t have to go up when stocks go down. Both markets produce nice uptrends from early 2000’s through 2010. Since that time, stocks continue upwards while gold falls ~30%.

      The safer play may be to cut your losses short and either allocating to something that’s still trending or staying out altogether.
      mike melissinos recently posted…“Why Are We Losing Money?”My Profile

  6. Good post. I remember not long ago when gold and silver were very hot. Of course the tendency was to buy high. Ebay coin sales were all over the place and the sellers made a killing. I think having a mix of stocks, physical commodities, and cash are good combo.
    Mr Defined Sight recently posted…Remove the Clutter and Find Some Cash!My Profile

  7. Good post on diversification. Agree with your statement that investors should not invest blindly! I agree with an earlier comment that your time horizon should shape your investment decisions and diversification strategy; There isn’t one right or wrong way to diversify and you have to find which methods work best for you.

    Great read!

    Bert
    Dividend Diplomats recently posted…Lanny’s Q1 2017 Goals UpdateMy Profile

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