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Dave and Donald Moenning
Dave and Donald Moenning
Articles (34)  | Author's Website |

How to Stop "Diworsifying" Your Portfolio

Thursday's missive exposed the fact that a diversified portfolio is dramatically underperforming the return of the U.S. stock market in 2013.

While some may argue that we will soon see this phenomenon dissipate due to the propensity of financial assets to ultimately revert back to the mean, this fact isn't helping investors who are currently staring at returns which are at best in the low single digits this year.

As was stated yesterday, part of the problem is that the long-term bull market in bonds is likely in the process of morphing into a secular bear market. Another big part of the problem is the fact that the U.S. economy as well as the dollar are heading the wrong direction for trades in commodities and emerging markets. Now toss in the ongoing difficulties in Europe and it becomes clear that the problems being created by what is usually considered a "well- diversified portfolio" may be with us for quite a while.

What's the Solution?

For those investors that like the comfort generally provided by a diversified portfolio, here's an idea that will allow you to (a) maintain a diversified allocation in your portfolio and (b) stay out of trouble when the big, bad bears come to call on an asset class or two.

The idea is to break your portfolio up into parts according to the desired asset allocation and then install a "risk management" strategy for each part of the portfolio. For this example, let's use the generic diversified portfolio laid out yesterday (only the math will add up correctly today) which is broken up as follows: 50 percent stocks (25 percent U.S., 15 percent foreign, and 10 percent emerging) 30 percent bonds (10 percent U.S. 7-10 Treasuries, 10 percent U.S. 20-plus Treasuries and 10 percent Junk), and 20 percent "real assets" (10 percent commodities, 10 percent gold).

In simple terms, we then create a "sell strategy" for each asset class. This can be something as simple as a 150-day moving average or as complex as a market model dedicated to each asset class being managed. And here's the kicker; it almost doesn't matter what sell strategy you use. No, it's the fact that you have one that REALLY matters.

What's This Portfolio Look Like Now?

Instead of lazily sitting in all asset classes at all times and being exposed to the brutality that accompanies most major bear markets, the idea is to use both components of the traditional "buy low and sell high" approach. The key is that the approach I champion here has the ability to take the exposure of each asset class in your portfolio to zero when the bears are present.

In order to keep things simple, let's use a 15-month weighted moving average as our "bear market" signal for each asset class. In short, if the asset class is above the 15-month average you hold long and if it is below, you move that portion of the portfolio to cash.

Here is an example of using this approach for the S&P 500 since the mid-1990s:


As you can see, the S&P 500 is currently above its 15-month ma, so you would simply hold on to the U.S. stock positions in your portfolio.

Running through the entire diversified portfolio, the current positions and signals would look like this:

  • U.S. Stocks (25 percent) - SPY: Buy/Hold long

  • Foreign Stocks (15 percent) - EFA: Buy/Hold long

  • Emerging Market Stocks (10 percent) - EFA: Cash

  • U.S. Treasury 7-10 Yr (10 percent) - IEF: Cash

  • U.S. Treasury 20+ Yr (10 percent) - TLT: Cash

  • High Yield Bonds (10 percent) - JNK: Cash

  • Commodities (10 percent) - DBC: Cash

  • Gold (10 percent) - GLD: Cash
The Bottom Line

To be sure, this not a fool-proof strategy as using a single, very simplistic indicator on a monthly basis can produce a large amount of whipsaws over time. As such, it would be wise to utilize an approach incorporating at the very least, some technical analysis triggers such as trend lines and support/resistance zones as well. However, the bottom line is that your portfolio would currently hold a large amount of cash (60 percent) and would not be exposed to the damage occurring in bonds, junk, commodities and gold.

While such an approach makes infinite sense, you may be surprised to learn that the majority of financial advisors do not advocate such a strategy. Why not? In short, while the blind, "buy and hope" approach is easy, managing risk requires significantly more time, effort and expertise.

If you have any hope of avoiding the big, portfolio crippling losses that have occurred in bear markets over the past 15 years, managing risk - in whatever fashion you may choose - is the way to go.

Dave Moenning is speaking at the Traders Library event, on Friday morning and will not publish morning report. Regular "State" reports will return on Monday.

Mr. David Moenning is a full-time professional money manager and is the president and chief investment strategist at Heritage Capital Management. He focuses on stock market risk management, stock analysis, stock trading, market news and research. Click here to claim a free copy of Dave's Special Report on changes in the current market.

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