Learn to Trade the Markets : Part 4 (of 6) Diversification

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“…You can build an investment portfolio for a rainy day, but what of a monsoon? Or to put it in technical terms: how not to put all your eggs in one basket…”

 

In this fourth in a series of six articles, we look at how you can look to trade the Markets, be it full time, part time or occasionally.

Every one reading  these articles will be at a different level compared to the next man. Fundamentally the rules are the same. Over 80% of retail “punters” lose money. Hopefully, here, we will try and help you be in the 20% that doesn’t.

We will cover different strategies, ideas, entry and exit plans and try and get you to just think a little more before giving your hard earned cash away. There is no right and wrong way to make money in the markets. Find a strategy that works for you.

The markets have been around for centuries, they are not going anywhere so take your time with your research. There is a plethora of information around these days with the advent of social media and the internet, use it. Ensure you have an exit plan. Any fool can buy a share, the trick is selling higher than you bought. We hope you find some benefit in one or some of the articles. The fourth article here features another very important topic : Diversification

“…It simply isn’t possible to diversify short-term equity risk by spreading equity holdings: as the past year forcefully reminded us when there is a shock to the world market global equities fall together…”

 

The underlying theme of this series is the imperative to hold on to the capital that allows you to continue to trade.

The market will always present new opportunities if you are able to stay in long enough to take advantage. As Warren Buffet observed: ‘Rule number one: never lose money. Rule number two: never forget rule number one.’

We’ve looked at essential risk management principles like how to cut your losses when an investment isn’t working out, when to take gains when one is, and how much of your portfolio to stake on a single investment.

This week we consider diversification: how to allocate your investments across different sectors and assets to ensure your portfolio is sufficiently robust to withstand losses within a particular sector or asset class. Or to put it in technical terms: how not to put all your eggs in one basket.

Avoiding ‘diworsification’

 

Experienced traders with deep knowledge of the economics and habitual cycles of a particular market, and the hard-won discipline to cut their losses on unsuccessful investments, may be able to trade within a relatively narrow orbit, backing and shorting stocks within a certain sector, like oil and gas, mining, or tech.

But less experienced investors would do better to distribute their capital across unrelated sectors that work according to distinct economic logics and cycles, maximising the prospect that gains in one will compensate for losses in another. The key is try to avoid undue correlation – often termed ‘diworsification’: a portfolio comprising shares with relationships between your investments that make them prone to rise and fall together.

Those correlations can be hard to spot. A pair of seemingly unrelated investments often have subtle connections to each other. Indeed, most conventional portfolios run by professional fund managers tend not to be very well diversified.

Managers of pension funds and other big schemes face significant commercial and institutional pressures that push them towards narrow selections of ‘low risk’ big name stocks. Many funds track major indices or the global market quite closely, and though comprising many different shares are not truly diversified, tending to follow a cluster of global businesses that wax and wane together according to the fortunes of the world’s advanced economies and prevailing market sentiment.

A portfolio following companies like General Electric, Glaxo, Vodafone, Apple, Microsoft, Tesla, Exxon, Unilever and BP – world class companies operating within a range of sectors – might seem diversified. But when the global economy enters a downturn or markets are turbulent they tend to fall together.

The pattern has been repeated three times in the relatively recent past. During the tech crash at turn of the millenium, the financial crash, and the initial Covid-19 lockdowns, portfolios weighted towards these shares fell significantly. Considered individually each holding was as low risk as anything can be on the markets, a great company with a strong market position. But the portfolios themselves were brittle, less than the sum of their parts.

The private investor’s advantage

 

The private investor has the freedom to diversify more effectively than many commercial managers. The challenge is to avoid the temptation to end up with a set of investments, each attractive in their own right, whose fortunes are hang together.

For example, an investor with a particular interest in the energy and resources sector may well diversify within that sector – but not beyond it. When you immersed in a particular market, a clean energy stock can look radically different from an oil major, or a mining share. But they are actually quite closely related. In the end oil and renewables both offer the same service: power, demand for which moves according to economic cycles. A mining company in central Africa might seem a world away from a Californian electric vehicle company. But the car manufacturer needs the materials produced by the miner.

Of course there are periods when clean energy and fossil fuel stocks diverge, as last year when the oil price crashed and investors piled into green tech. But as the global economy gradually moves out of the pandemic their deeper relationship will become more apparent.

An investor seeking to diversify will have the discipline to look beyond the sectors they know best, to radically different fields like medicine, insurance, law, agriculture, and, property, disparate markets not necessarily in sync with the general economic cycle.

They will also think globally, looking beyond the indices with which they might be most familiar. China’s phenomenal economic growth has made it a favourite for investors looking to cast their net wide, but other fast growing eastern economies like Vietnam should not be overlooked. Japan has been out of fashion for some years, but is a major world economy with many strong companies. Certain emerging markets might offer good contrarian bets, but the particular risks associated with markets such as Russia, Azerbaijan, Kazakhstan, the Middle East, Africa, and India should be carefully considered.

Today’s investor has more opportunities than ever to diversify effectively, able to choose from a vast range of funds, trusts and trackers offering exposure to every index, region, country, and sector.

They also offer opportunities for looking beyond the biggest players in each market. When looking at international investment opportunities it’s tempting to just consider the biggest companies in each market: Sony, Gazprom, Taiwan Semiconductor and Lenovo, for example. But these are global players whose fortunes, not unlike Microsoft, Shell and Vodafone, depend on the ebb and flow of the global economy. Real diversification from these investments will come from companies oriented to their domestic economies, not just the more familiar flagship brands.

With all the many options available private investors have the opportunity to think creatively designing portfolios with a few contrarian selections offering potential for explosive growth. Such a portfolio may carry a lower risk than a collection of blue chips – stocks which are individually safe, but whose returns are likely to be strongly correlated with each other.

In his thought provoking manifesto The Long and the Short of It writes that for ‘the intelligent investor, risk is a characteristic of a portfolio, rather than of the individual security.’ A radically diverse portfolio would have shielded the investor from the worst of last year’s downturn. Despite what many say after the event we simply can’t predict economic cycles with any accuracy, or sudden breakdowns of social, political and economic institutions. A well-diversified portfolio gives you the best chance that at least some assets will retain their value. As Kay puts it: ‘You can build an investment portfolio for a rainy day, but what of a monsoon?’

Alternative asset classes

 

When investing in overseas stocks it’s worth considering doing so through funds and trusts rather than direct stakes in companies. The ability of fund managers to consistently beat the market when operating in more familiar markets is at best unproven, but good overseas markets specialists are in a position to justify their fees by picking out companies ordinary investors cannot easily research (and avoiding those with potential issues).

But a diversified portfolio should also go beyond equities. It simply isn’t possible to diversify short-term equity risk by spreading equity holdings: as the past year forcefully reminded us when there is a shock to the world market global equities fall together.

There are quite a few options. Real Estate Investment Trusts, better known as REITs, own and operate income-producing real estate. Infrastructure Investment Trusts (InvITs) and private equity trusts offer a share of the income stream from institutional investor stakes in infrastructure projects and non-listed companies

And then there are the time honoured diversifiers like bonds, gold, and of course cash. Last summer gold proved a useful hedge against turbulent markets, and bitcoin continues to press its claims as a viable haven as we discussed earlier this year.

As for bonds, the theory that the perfectly balanced portfolio should consist of 60pc equities and 40pc bonds continues to hold considerable sway. The idea is that the slight weight towards equities offers leeway for growth, with the significant bold holding acting as a stabiliser, providing fixed income and the prospect of rising value during times of market stress. The proportion can be fine-tuned, the balance shifting towards bonds as the strategy matures.

It’s a system that has held good for some 40 years, a 60/40 mix generating a compound annual growth rate of more than 10pc in the US since 1980. Over those years a pure equity portfolio has been significantly more volatile than a 60/40 portfolio, and brought little extra in the way of returns. Bond prices have duly risen when equities have been struggling, as in 1998, 2001 and 2008.

It’s possible to see the idea in action right now, with billions of dollars flowing from stocks to bonds as big investors move money to rebalance their portfolios in time for the end of the financial quarter. Bond prices have fallen lately as stocks have rallied, disturbing the classic 60/40 portfolio, so many pension funds, insurers and other large investment groups are loading up on bonds to get back in line.

But the sharp falls in the value of global bonds over the past few months has prompted a lively debate about the continued usefulness of the 60/40 strategy. The prospect of the global economy surging back borne on waves of government debt has sparked fears of higher inflation and attendant higher interest rates, which have devastating implications for most kinds of bonds. Though it hasn’t happened recently, it is perfectly possible for equities and bonds to fall together, as any economic history of the 1970s testifies.

Despite reams of commentary the picture is still unclear. But uncertainty about the value of bonds makes it important to look at the alternatives haven assets we have already mentioned. And unglamorous as it is, there’s much to be said for keeping some of your portfolio in cash, which offers a sure way to protect against assets falling concurrently, and the flexibility to move back into the market when prospects are less uncertain.

Big topic, simple principles

 

Today’s investor has endless options for diversification. You will have to make your own decisions. But the basic principles are simple: avoid over concentration; be aware of obscure connections; look beyond single sectors, indices, regions and assets.

During this article we briefly mentioned the value of funds as portfolio diversifiers, even for investors willing to pick single stocks. That opens up another huge debate within the investment world: whether to choose active funds in which stocks are selected and overseen by managers, or passives which simply track an index. Our next article will consider the lively active/passive debate.

 

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