Diversify Your Strategies, Not Just Your Securities

By now most investors are familiar with the term “diversification”. Most of us take that to mean we should invest in a basket of uncorrelated securities that perform differently in varying markets. However, I think there is a much more important discussion that should be taking place among investors. We all understand that diversification is critical and I have gone so far as to track several different potential ETF portfolios. However, diversification is critical not just in constructing a portfolio but also in constructing a comprehensive strategy. We should not limited ourselves to one strategy–traditionally this has been the buy and hold strategy–but should also diversify strategies in order to seek uncorrelated returns.

I have frequently discussed the benefits and rationale of one alternative strategy to buy and hold, the moving average strategy. However, I would be mistaken to say it is always going to outperform buy and hold. There are periods of time where buy and hold outperforms a moving average strategy. In addition, there is no one “holy grail” moving average that investors should use. It may make sense to use a shorter time frame like a 6 month average for part of your portfolio and a longer average such as a 12 month moving average for another portion (As an aside, Theodore Wong has tested out the 6 month moving average as having the best CAGR, which of course does not guarantee it will continue to outperform in the future).

It is also fair to say that a moving average strategies are not the “holy grail” of strategies. Investors could seek to diversify away from both buy and hold and moving average systems. One alternative strategy detailed by Mebane Faber and one I will be tracking on Scott’s Investments at the end of this month is a rotation momentum system which you can also combine with a moving average system. It sounds complicated but is incredibly simple and will be detailed in a future post.

If you are feeling a bit more confident in your trading skills and temperment, you could use significant support and resistance levels and/or use trend lines to trade a portion of your portfolio. Keep in mind this takes more practice and education then a 7 minute video, but you can get a idea of that strategy using the SPY here. Another idea would be to use a weekly trading service like Decision Moose, the trend analysis of INO.com (see banner above-note I am an affiliate but used the free service long before I became an affiliate) or another service you are comfortable with for part of your allocation.

There are two possible courses of action an investor could take that I will discuss below.

1) There is still resistance in the investment community to the idea of “timing” the market. Thus, investors who wish to have some constant exposure to the market could decide to keep 50% of their portfolio invested at all times. The first step would be to determine your portfolio composition (for some ideas see here). For simplicity lets use a basic portfolio I previously discussed as an example, 20% VTI (US Stock), 20% VEU (International Stock), 20% BND (Bond), 20% VNQ (REIT), 20% DBC (Commodities).

Invest 50% of your portfolio in all of the securities in your asset allocation plan, so you would have an allocation of:

10% VTI

10% VEU

10% BND

10% VNQ

10% DBC

At the end of each year, rebalance the buy and hold portion of the portfolio.

Then, take the other 50% of the portfolio and trade it on a monthly basis using a monthly moving average-such as the 10 month or 6 month-using the exact same asset allocation. At the beginning of this month a strategy based on the 200 day MA would have looked like:

10% VTI

10% VEU

10% BND

10% Cash (VNQ was below the 200 day MA)

10% DBC

In this strategy, the investor would have had 30% allocated to stocks and REITS in 2008 and lost money on that portion but they would have had 40%+ allocated to cash for almost the entire year, minimizing drawdowns.

2) Another possibility would be to do the same as above but with additional strategies involved. The number of strategies you can employ will depend on your portfolio size. If you are investing $5000 it is not feasible to have a diversified portfolio of securities and have them diversified among 4 different strategies without getting eaten up by commissions. Size does matter.

Take 25% of your allocation and buy and hold. Take 25% of the same allocation and trade it using a shorter time frame moving average like the 6 month. Trade 25% using a longer time frame (10-12 month moving average). Take 25% and use a momentum system that rotates among the best performing sectors or ETFs. This final 25% may not have the same allocation as the first 3 strategies, especially if you use the method described here.

Again, if the portfolio size is not significant, this strategy is not recommended.

There are a number of other portfolio strategies one could easily implement depending on the portfolio size, however please do your research first. Make the sure the system has been tested in and out of sample and across a wide number of different markets in different time periods. Also, please carefully consider your portfolio size when putting your plan together.

When considering portfolio construction it is time for investors to think not just in terms of allocations in value vs. growth, international equities vs. US equities, but also strategy A vs. strategy B.