SIX YEARS AFTER Nasdaq’s peak, most people have now picked up on the importance of diversification. Few investors still have their entire portfolio in the S&P 500. Small stocks, foreign stocks and even some commodities or foreign exchange have become commonplace in accounts big and small.
But for the active trader, the notion of diversifying should move beyond simply spreading around your assets to more than a solitary fund. There are a number of smart ways to use a diversified approach that you might have never even considered.
The most basic way to diversify your portfolio is by time. Most people invest as if they were burying a time capsule. They commit their entire risk capital in one day, usually as soon as the check clears or the brokerage account is actually opened. If they have $50,000 on March 1, they invest $50,000 on March 1. Six months later, they dust off their IRA statement from the bottom of a pile of mail and see if there’s any buried treasure to be found.
Bull and bear markets don’t turn on a dime, and just as the ocean is made up of many waves, the market is really a number of smaller markets in varying stages of maturity. It’s not a static still-life, but an ever-changing watercolor that never dries.
And because the investment landscape can shift, you always want to maintain some liquidity in order to capitalize on the next big thing. The point isn’t to always be sitting on cash, but rather to pace the deployment of your assets over time. Today, the market looks strong. A week from now, it might be an entirely different picture altogether. Trading capital shouldn’t come sloshing into the market in an afternoon, but dripped in on an ongoing, continual basis. I picture a portfolio as dead wood being cleared away while mature trades thrive and promising newborns are just being born.
Less obvious, but an even more important way to diversify a portfolio, is by varying the liquidity of the instruments in which you invest. Most trades are disillusioned by a quiet stock. Personally, as I’ve written before, I think less liquid trades are where the best opportunities are often found. A trader’s job is to provide liquidity. As long as a market is acting right, it doesn’t bother me to account for a big part of the daily volume. For example, some of the best utilities trades I was fortunate enough to own over the last two years, names like BIW (BIW) and International Power (IPR), have been rather illiquid stocks. The correct approach isn’t to avoid risk, but to mitigate it by diversifying your exposure.
So when putting money to work, I like to mix up the relative liquidity of my exposure by offsetting one illiquid trade with a trade in a deeper market somewhere else. For example, take the variable-rate preferreds I mentioned late last year. Like most big ideas, this group’s liquidity ranges from names like HSBC USA Inc., Adj Rate Dep Shares Cumul Preferred Stock, Series D (HBA-D) (average daily volume 1,700 shares) to the comparatively active Merrill Lynch & Co. Inc., Floating Rate Dep Shares Noncumul Pfd Stock Series 2 (MER-H), which lately trades well north of 300,000 shares each day. Rather than choose between the two, my approach is to own a piece of both. The idea is to expand the exposure, but do it in a prudent way by varying the liquidity risks of the overall trade.
As I pointed out last week, active markets are vibrant markets, where buyers and sellers can easily hedge or assume any types of risk they choose. And despite a ridiculously inefficient regulatory burden it takes to develop them, the presence of new financial products (and the active investors willing to trade them) has been a major benefit to the stability and growth of markets world-wide. They allow one to diversify by product with an efficiency that was impossible only a few years ago.
And for an active investor, these are absolute boom times for portfolio management. Beyond simply buying stocks, you can tailor exposure using options, futures, and a host of exchange-traded and open-ended funds. And while the best approach is usually the most simple, I do usually opt to own a number of products within one particular idea or theme.
For example, take some of the telecoms I last mentioned a few weeks back as showing some leadership. A long position in Qwest Communications (Q) or Hungarian Telephone & Cable (HTC), for example, might be coupled with an “index” exposure using a security like Vanguard Telecommunication Services VIPERs (VOX) or Telecom HOLDRS Trust (TTH). Or if you’re still waiting for Verizon Communications (VZ) to turn around, you might consider augmenting the trade with an international twist with iShares S&P Global Telecommunications Sector Index Fund (IXP) or Emerging Markets Telecommunications fund (ETF), or selling a put option on AT&T (T). The idea is that you’ve expanded your exposure to the trade but diversified the product used.
An obvious benefit of using this approach is that it can often save your hide if you pick the right race but wrong horse. Too often we end up owning the weakest stock in a sector where everything else seems to jump higher. By adding another equity or even broad index exposure, you “cover your bases” in case your particular pick ends up being the runt of an otherwise winning litter.
Moreover, having two different exposures, even through options or mutual funds, gives you the chance to manage your risk more closely. For example, instead of just owning Barrick Gold (ABX), you might consider adding a position in Goldcorp (GG) or ASA (Bermuda) (ASA) as well. It’s quite likely a rising tide will lift all boasts, and if one trade gets stopped out, you are still “in the game” with the other allocation. This approach often keeps me participating in trades where losses in one particular name would mistakenly prompt me to cut and run altogether.
– Originally on Mar 06, 2006 by Jonathan Hoenig
