Diversification and a Winning Portfolio

Most people think of diversification in terms of ETF’s … buy the S&P 500 and you have shares in 500 companies.  Are you diversified?  No – you make money when the S&P goes up and lose money when the S&P goes down.  This is fine if you expect it to rise forever, but that doesn’t always happen … one look at the chart here: https://finance.yahoo.com/quote/^GSPC?p=^GSPC  and you can see that the 52-week range is between 2,146 and 3,198.  That’s pretty volatile for one year.

Aside from that, diversification is not an excuse to ignore your investments.  If you want good risk-adjusted returns then you have to put in the effort – otherwise you just get the illusion of safety, which can be dashed in a bear market, which typically happens about once per decade.

So how does good diversification work?  Well, I just came back from a 7-day trip to London and decided to take a look at my positions.  We’re hitting an options expiration this Friday, and I have a number of options expiring worthless.  A couple of weeks ago I had $1,000 in options, now it’s down to $400.  Is that bad?  By itself, sure – but during the same timeframe my overall portfolio went up a bit over $1,200 – even including those options.  My 10% gold weighting was roughly flat, My growth stocks had some flat ones, a decent winner and a decent loser, but my dividend stocks were doing great overall.  Should I quit buying growth stocks or puts?  Not so fast … it is very possible that the market could go up and I’ll want that growth, or that the market will drop and I’ll want that downside protection.  Also, dividend stocks can go down overall just like anything else.  Gold is a wonderful diversification asset as well from the standpoint that it has it’s own cycles.

Note by the way that I haven’t mentioned bonds in my portfolio above.  I’m down to a weighting of just over 3% bonds, as they’ve been slowly maturing or being called back (callable bonds can be bought back by the company prior to maturity, so they can re-finance at lower rates).  Not all assets are good at all times … I have no interest in locking money up for less than 2% a year, I think that a bond paying 4-5% is not rewarding you for the risk inherent in junk bonds, and I don’t think it’s a good time to speculate on long bonds going up in value … there’s a good chance that 20 year yields can rise even as short term yields are pinned lower.  Central banks are increasingly critical of the side effects of zero or negative interest rate policies, and the federal reserve in particular prefers a steepening yield curve to an inverting one.  Bonds will have their time, but not at the moment.

I’m still very nervous about our position in the overall market.  I’m at 60% cash at the moment and I’m preferring to err on the aggressive side with stop losses.  If we do hit a bear market in earnings, it could easily slow down the highly earnings-dependent stock buybacks.  Seeing as how these stock buybacks have been the big upward pressure over the past couple of years even while investors have been slowly selling, a correction like we had last October through December is quite likely.  For my own reasons, I think a sharp correction like this is more likely than a prolonged bear market (in stocks) like the drop from October 2007 through March 2009.  As you can imagine, a correction like that would make a 60% cash position a very valuable thing to have.  I’ll be watching the trendlines, and I won’t buy in until the momentum turns and is verified by volume … there is a big difference between buying a dip and hoping for a rebound versus spotting a legitimate switch in money flows back to accumulation.  Speaking of charts, I might as well mention some of the interesting movers I had:

Here’s Cardinal Health (CAH):


Cardinal Health had what looked like a breakout on good volume following a possible rounding bottom from April 2018-Oct 2019.  However, the significant high-volume selling in recent days is not something you want to follow.  I dumped the stock today fairly close to breakeven.

I’ll expound on the theory here of what’s going on … big players such as institutional investors (hedge funds, mutual funds, etc) tend to either accumulate (buy) or distribute (sell) shares over extended periods of time.  This is because their positions are large enough to move the market if they move too fast.  When you see a significant move with high volume, it typically means an institutional investor either bought or sold a block of shares.  If you’re into fundamental analysis, note that these big players have a significant research edge over you.  More importantly from the technical side, if a large investor plans on selling blocks of shares over time then that will pressure a stock lower regardless of fundamentals.

Big players don’t dump shares like this to buy them back a few dollars lower without a significant fundamental change.  Imagine being a trader at a big brokerage firm trying to explain these trades to your boss and with a big report on where you think the stock is going … changing direction after nothing more than a 5% price move is not something you can explain without him questioning your competence.  Anyway, the goal here is finding good evidence that big players are buying so you can ride the move up.

One more to end on a good note – Activision (ATVI):


Note that the above average volume isn’t nearly as high as in CAH above, but it is still a good sign.  I originally had my stop loss at 50, just below the big move in September.  Now I’ve moved it up to 57 which will lock in a 5% gain if it reverses, but gives me room to move higher.  If the big move on Dec 12 is reversed it would be a bearish sign, and I’d want to lock in gains before then.

Happy trading!

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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