Financial media and the financial industry pepper us with advice and recommended choices for “properly” diversifying our portfolios.
Almost without fail, this magic formula consists of a mix of stocks, bonds and cash. The more adventurous may go as far as recommending a real estate investment trust (REIT) or Master Limited Partnership (MLP).
Yet, CNBC.com ran an insightful article several months back entitled “The Top 5 Mistakes Made by High Net Worth Investors”
Most telling was the #1 mistake on the list: Lack of Diversification.
It’s not surprising.
While many of us like to think we’re diversified, we’re really not.
Real Diversification is not always what your financial advisor tells you it is. You can spread your capital across as many “diversified sectors” as you wish. You’re still in stocks. You can buy as many kinds of bond funds as you want. You’re still in debt paper. A hit to the asset class is a big hit to you, regardless of how many different varieties you bought. If you question this wisdom, take a look at how many of your stocks or stock funds went up when the DOW took a nosedive in September.
Sophisticated investors seek and acquire alternative assets that go outside of this traditional model. But to be truly diversified, you’ll need to make sure the alternatives you select meet at least one and preferably both of the following criteria.
- Diversification of Asset Class
The first step in gaining real diversification to not only protect but enhance your portfolio is this: Diversify into Alternative Asset Classes. Common advice among top wealth advisors is to have 15% to 40% of your assets in alternative asset classes. These could include but are not limited to:
Real Estate
Precious Metals
Commodities
Coins
Art
Antiques
Cars
Collectables
Diversification of asset class is an excellent first step in proper diversification. But done alone, buying these assets has one major flaw.
They ALL rely on asset appreciation.
You make money here one way. You buy it and the value has to go up. That works fine, as long as inflation and/or appreciation keep pace. But what if it doesn’t? Or worse yet, what if we enter into a deflationary period? Chances are, whether you’re holding property, coins or even a commodity fund, the value is headed lower. The strategy here is buy and hold…….or as one of the wealthiest clients I ever had once told me “Buy and Hope.”
…the more sophisticated investor chooses alternatives that are both diversified in asset class and diversified in strategy.
There is nothing wrong with buying alternative asset classes and it is a good idea to gain some diversification.
But if you want real and total diversification, you’ll need to add one more step.
2. Diversification of Strategy
This means diversifying away from all buy and hold strategies in your portfolio and explore trading models that do not require underlying asset appreciation to make you money. Examples include:
Hedge Funds
Shorting stocks
Selling Stock options
Selling Futures Options
Private Equity
Real diversification means investments that can potentially offer return regardless of what is happening to asset prices, the economy or the world. It doesn’t mean they’ll perform all the time in every circumstance. But they can perform, sometimes very well, in environments where more traditional investments won’t. That feature can not only help protect your portfolio, it can help boost your overall return.
Thus,.the more sophisticated investor chooses alternatives that are both diversified in asset class and diversified in strategy. Lets see how the above examples stack up:
Hedge Funds – May or may not be diversified in strategy or asset class. A secret many investors don’t know is that many hedge fund managers are just stock pickers with a different title. Hedge funds can’t be ruled out but there is much due diligence that should be done in identifying strategy, asset classes traded, and the experience of the manager.
Shorting Stocks – Diversified in strategy but not in asset class. Does not meet both criteria.
Selling Stock Options – Good way to diversify strategy. But does not meet diversification of asset class requirement
Selling Commodities (Futures) Options – Meets both criteria of diversification of asset class and diversification of strategy. Requires certain degree of expertise.
Private Equity – Could potentially meet both criteria but depending on what is being funded, could be affected by same factors that affect stock prices. Requires substantial amount of expertise.
Conclusion
In the current age of investing, proper diversification is critical when it comes to protecting and growing your wealth. Traditional models of what passes for diversification do not always best serve the interests of high net worth investors. Real diversification means building an “all weather” portfolio. Assets to collect in such a portfolio are ones that offer diversification of asset class or diversification of strategy. The ideal diversifier is one that can offer both.
Michael Gross is Director of Research at OptionSellers.com and co-author of McGraw-Hill’s The Complete Guide to Option Selling 3rd Edition.
