Diversification in the portfolio: What it actually means and how to actually do it
No trades for me today. Holding steady for today.
Market volatility has spiked. The DJIA is down 1000 points from its all-time highs, which were set just about 20 trading days ago. The Russell 2000 is down more than 10% from its recent highs, putting it fully in correction territory.
You have to be careful when volatility spikes as it recently has. These 1% daily intraday swings in the stock markets are often indicative of a change in character, at least for the near-term. I’ve been writing for the last couple weeks that the path of least resistance for the broader stock markets is probably lower for now. The lower path of least resistance will likely remain in effect as long as these daily dislocations in the markets keep happening. If this recent downturn in the markets is a precursor to the ongoing Bubble-Blowing Bull Market we’ve nailed over the last four years, then the volatility is likely to increase in coming days, weeks and months as the market unwinds itself.
As you know though, my analysis continues to point towards yet more bubble-blowing bull market action in the quarters ahead. So with expectations of yet higher-highs in the stock markets ahead in the next year or two, at some point I’ll look to start being more aggressive in my buying. Indeed, just yesterday, I nibbled some more common stock in FB, GOOG, SNDK and AMBA. I’m likely to scale into some more First Solar common stock in my own portfolio next.
Ideally, we’d like to see the markets continue to spike and crash intraday and head another 5% or so lower in the next couple weeks. Then we’d want to see the markets start to balance out and baseline for a few days as it settles in and the weak-handed longs sell out of their stocks in fear. And if we’ve done it right in the next few weeks, we’ll have put some of the money we raised by trimming stocks at much higher levels back into our stocks slowly but surely.
That’s the most likely playbook for the near-term. Obviously, we’ll take the signals and make the trades as the come though.
Let’s talk about all the different ways you can diversify your portfolio to hedge some of the risks inherent in investing and trading.
1. By asset class – This is the type of diversification that’s most important for most people. You want to own some real estate, some stocks, some fixed income, some private start-up equity, some precious metals and so on to diversify your overall wealth across the economy and society rather than concentrating it all in one asset-class.
2. By industry – This is the type of diversification that’s important for each of your individual asset class portfolios. If you have real estate, to diversify, you’d have some land, some residential and some commercial. In your stock portfolio, to diversify you’d want to have several different sectors represented, such as tech, financial, consumer staples, industrial, etc.
3. By growth rate – This type of diversification happens when you buy high-growth stocks in one sector and balance them with turnaround stocks from the same sector. In the Revolution Investing model portfolio, you see this type of diversification as I own high-growth stocks, Facebook, Google, Amberalla, etc, balance out with a Sony and an Intel, which are turnarounds.
4. By long and short positioning – Most hedge fund managers, myself included when I ran my old fund, look to have a few “Paired Trades” where you try to buy a great stock and reduce your risk to industry/market downturns by shorting a similar stock that’s not great. You’ve seen me do that with buying Apple and pairing that long with a BBRY short. Or more recently, you’ve seen me short Samsung and Barnes & Nobles to hedge against our many high-growth tech stocks.
5. By time – Dollar cost averaging anyone? This type of diversification happens naturally when you employ the approach of scaling into tranches when you buy your stocks. Rather than just jumping in with a full position all at once and hoping the stock goes straight up forever, you can diversify your buying in a single stock by spreading your purchases out over time. Stocks go up and down and are volatile and spreading out your purchases in an individual position helps you take advantage of that reality.
6. By price – It’s not a bad thing to spread your purchases over time and price as you earn more money to invest. That said, you can get cut badly when you try to catch a falling knife of a company that’s struggling and/or having financial problems, so I don’t suggest simply adding to positions when they’re down without staying continually on top of the stock and the company underlying it.
Diversification means many things. Use all the diversifications tools that make sense for you.
