Last week I promised you a blog on diversification so here it is.
Did you ever have your grandmother tell you not to put all of your eggs in one basket?
Well it turns out grandma was right. Grandma, knew a great deal about the power of diversification and how it reduces risk both in business and in trading.
IN BUSINESS ...
What if McDonalds only sold hamburgers, do you think they would still be competitive when the world is turning to healthier lifestyles. Now don't get me wrong every once in a while I like to chow down on a nice juicy hamburger. But I also like to eat healthy and so do a great many other people. McDonalds moved with the times and diversified into chicken wraps, salads and a whole host of other healthier food groups. In other words they diversified.
IN TRADING ...
It just doesn't make sense to trade just one market, there's just too much risk and too little opportunity in one market. A trader needs to stay flexible and at the same time be diversified.
Before we get into the meat and potatoes of market diversification let's take a look and see how the dictionary defines "diversification"
1. the act or process of diversifying; state of being diversified.
2. the act or practice of manufacturing a variety of products, investing in a variety of securities, selling a variety of merchandise, etc., so that a failure in or an economic slump affecting one of them will not be disastrous.
Based on the Random House Unabridged Dictionary, © Random House, Inc. 2006.
That's the official version of diversification. Now let's apply that to the markets. First off, we have to accept that the market can do only three things, it can go up, it can go down and it can go sideways.
Your portfolio on the other hand, can only move two ways. It can go up, or it can go down.
We all know the direction our portfolio should go, and we want to see it go in that direction with the least amount of risk. That's where diversification comes in.
NUMBER ONE SECRET TO DIVERSIFICATION
Here is the number one secret to market diversification, spread the risk and trade in non correlating assets.
Here's an example of a non diversified portfolio.
Say you are bullish on Crude Oil and you buy a futures contract in crude, but what if the rest of your portfolio was full of energy stocks?
What you have created is one basket of eggs. In this case a basket of energy eggs. Your portfolio is dependent on one sector and that is energy. This is just too risky for the average investor. No matter how many stories you hear from the various experts saying that energy is going through the roof you don't bet the farm on one market ... ever.
You need to have as many non correlating asset classes as you can follow. This short video illustrates diversification perfectly.
The other key to diversification is cash. You don't have to be in all the markets everyday. Cash is a way of diversify ... Swiss Francs, Canadian Dollars, Euros, etc etc.
Here's an example of how a well diversified portfolio.
Stocks, bonds, futures and cash.
Out of those four asset classes, you have a multitude of choices. Stocks allow you to cover a broad spectrum of different domestic and international sectors. Bonds do the same thing, and the futures markets cover everything from raw commodities to financial instruments.
You can divide your portfolio into different percentages and allocate then to various asset classes. The more you divide into non correlated asset the less your risk will be.
Here's what I am suggesting. I call it the Will Rogers approach. Here Will Rogers was known for his famous quips.
"I'm more concerned about the return of my money than with the return on my money".
I guess Merrill Lynch should have remembered that when it had to write off 8.4 billion dollars and cause the firm to have it's first loss in 93 years. Diversification would have smoothed that disaster for Merrill, what got in their way was plain old fashioned greed.
The American humorist Will Rogers (1879 - 1935) had a special way of making a point. Here's another one of his insights about trading and investing.
"Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it". -- Will Rogers
Will was right!
Only buy sectors when they are going up. When they turn down, get out and move into cash. Then look for another non correlating market sector for your portfolio that's moving up. For sophisticated traders you can even short different asset classes which is a way to turbo charge your returns.
Learning when a market is moving higher or lower is not as difficult as you might think. Take a look at how you can tell if your favorite market is going higher or lower here.
Yes, it takes time to analyze the markets and find winners, but the time of a buy and hold strategy is gone forever.
We are living in extraordinary times, never before have we had so many people living on the planet. Never before have we had so many major countries competing for an ever shrinking supply of raw commodities. Never before have we seen times like this that present both great opportunity and great risk.
Diversify ... spread your risk, don't be a Merrill. You can do well and thrive in the future with a well balanced and diversified portfolio.
Next week: Money management.
Have a great weekend and a super profitable trading week.