Diversification – A Win-Win In a Difficult Market

While the Morningstar boxes often constrained portfolio managers, they provided a key benefit to investors: diversification.

Equity market participants used to be able to spread their investment capital (and risk) across the nine “style” boxes. And it used to be that these investment styles – small cap growth, large cap value, etc. – were not correlated. That meant a few of the boxes would perform well in some environments, while a few boxes lagged behind.

Over time, each style would rotate in and out of favor and the well-diversified investor got to participate in the gains, while minimizing the volatility involved with putting all their eggs in one basket.

But as Rodney points out, nearly all the Morningstar boxes move in tandem these days. Investment returns aren’t driven by market capitalization or “growth vs. value” styles. Instead, today is simply a game of “risk on” and “risk off.”

In a “risk on” environment, nearly all stocks go up together. Likewise, most stocks sink in “risk off” environments.

That has forced smart investors to look outside the equity markets for diversification. Many are turning to metals, bonds and currencies as a way to smooth out the volatile (and disappointing) returns of the equity markets.

One simple strategy involves gaining exposure to four key asset classes:

1) U.S. Treasury Bonds
2) U.S. Dollar
3) Gold
4) S&P 500

These broad asset classes are directly impacted by the “risk on” versus “risk off” driver that is prevalent today. By moving in and out of each asset class – sometimes going long, sometimes selling short – an investor can stay diversified and capture gains that can’t easily be had in the equity markets alone.

Here’s a look at how this approach fared over the past 10 years (in blue), compared to the S&P 500 (in red)… which has gone mostly sideways for a decade.

See image larger

As you can see, investing $100,000 in the S&P 500 10 years ago would have helped you earn about $25,000.

But by following the ebbs and flows of the risk on/risk off environment, you could have done much better. The long/short strategy generated over $250,000 in profits over the same period. And, the diversification gained by investing in multiple asset classes made the ride a lot less bumpy.

That’s a “win-win” in this difficult market environment.

If you haven’t done so already read the Survive & Prosper issue on “Small Cap & Large Cap Investments Are Not Enough”

 

 

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Categories: Economy

About Author

Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.