Does diversification make money?
Many consider diversification to be a defensive portfolio measure used to reduce volatility and
increase returns with less “risk.” That’s all fine and good, but what if diversification added some offense to your portfolio too?
Does Diversification Make Money?
What if in your pursuit to diversify away from having all your money in just stocks, you also found an opportunity to add returns. Especially when stocks are down, that could not only keep you from big losses but also might produce decent gains? And what if you could pursue that strategy with strict risk controls?
This could be possible if real diversification is used. What is real diversification? We will get to that later; but first, let’s examine the classic definition of diversification.
Diversification (via Investopedia):
A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
That’s the classic definition and reasoning behind diversification. And it’s not bad reasoning. For most people this will work fine. But what if you want to diversify and go on the “offense?” When markets are spiking or crashing, why settle for “smoothed out” risk when you can increase opportunities?
5 Year Bull Market in US Stocks – Isn’t NOW a Good Time to Think of Diversification?
It’s September 30, 2014 and we are past five years of a bull market in US stocks. We’ve had 2-3 decent little corrections in that time in the stock market but more interestingly, in those five years there have been major moves in currency, commodity, bond and foreign stock markets.
A few examples of those moves include:
- The Japanese Yen move over 20% versus the dollar.
- We had gold move from ~$900/oz in 2008 to $1,900/oz and back down to $1,200.
- Major agricultural commodities have crashed in the past 12 months.
- The US dollar has moved up in the past 3-4 months in what looks like a fresh trend.
- Indian stocks had a strong run up in anticipation of and following the election of what many consider a business-friendly PM in Modi.
How could we take advantage of such opportunities to diversify while keeping strict risk control? We can use both the multitude of Exchange Traded Funds (ETF) available in the market place today and option contracts available on those ETFs. And many of these markets are moving up and down for reasons unrelated to the stock market. That’s REAL diversification.
Does Diversification Make Money? An Example of Using Options to Take Advantage of Market Moves
Let’s take the Japanese yen for example. It recently resumed its downtrend vs the US dollar. However, did you know that there is an ETF available to invest in the Yen? With options? I will share an example. Assume you have a $100,000 portfolio. And assume it is currently invested in a simple diversified index portfolio of 55% in a Vanguard global fund and 25% in a Vanguard global bond fund. That leaves 20% in short term investments.
Furthermore, assume that for some reason (hopefully a good one), that you want to invest in the idea that the Yen keeps falling vs the dollar. And lets also lay out the following information. As of September 30, 2014:
- The ETF that represents the Yen, FXY, trades at $88.80 closing price
- A Put option strike 89 on FXY expiring in November (3rd Friday) closed at $1.05 (x100 = $105).
A person with a $100,000 portfolio could gain ~$8,900 exposure (100 shares from 1 option contract) to “shorting” the yen for $105 (plus trading costs). If the yen continues to fall, one could “exercise’ that option and be short the 100 shares and let the trend continue. If the Yen goes in the other direction, loss is capped at $105 = controlled risk.
This could be repeated with almost any market. Currencies, stock indices, commodities, bonds and others. Moreover, we can use this strategy defenisvely (shorting stocks to hedge your portfolio), and offensively (going long silver, cocoa, Indian stocks).
The bottom line from an allocation perspective is that a portfolio can benefit from both a diversification and risk management perspective by using options of funds invested in diversified markets in currencies, bonds, commodities and stocks.
Another Excellent Planning Use of Options
Protecting a large holding of concentrated company stock offers another opportunity to use options to hedge. Whether you own a concentrated stock position by choice, or because you are locked up due to an IPO, options could shield you from serious loss of value. Read more about this in another article we wrote here – Using Put Options to Protect...
Your ‘Does Diversification Make Money’ Action Plan
After you read this, go check your 401(k), IRA and other brokerage accounts. Determine if:
- all of your investments are similar (do you own all stock funds in your 401(k)?
- your investments are aggressive or conservative by nature
- you have a significant position in one stock (e.g. your company’s stock)
If any of these situations apply to you, ask yourself then if you can handle losing 40% of your money. Remember in the last 15 years the market experienced 2 corrections of this size or larger. And since the Federal Reserve is still stimulating the economy, I am not sure that their stimulus would “save” us from another large correction.
Besides all of that, anytime you have a fully invested equity portfolio, you must be ready for 20% corrections. Furthermore, a 40% correction could occur. And don’t assume the market always comes back (ask the Japanese). If you are not comfortable with losing like that, then you could benefit from hedging and diversifying.
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Thanks for reading!