When Diversification Leads To Dismal Returns

by: Suzanne Hamilton

Yes, I get it -- throughout our careers we have been taught to diversify, diversify, and then diversify some more -- across asset classes, across style, large cap, small cap, value, country, dividend, and so forth. At the end of the day, or more precisely at the end of the year, if your portfolio is up say 6-10% you have done an awesome job either as a professional or an individual investor. Now I have written articles in the past that stressed that true diversification wasn't only based on asset class but based on correlation -- the true diversifier and only hedge for a long is a short. I stated the "reason one wouldn't care if they are in a bull or bear market is when that investor has a real diversified portfolio. Not a falsely diversified portfolio consisting of long only choices of equities, bonds, real estate, commodities, and even private equity. A real diversified portfolio would consist of these asset classes but both long and short."

So for years I built portfolios that were long or short (or long the inverse ETF when shorting was not allowed) up to 24 ETFs to represent the various asset classes. Had to run technical models on each one throughout the day and nightly to get the entry, readjust stops based on the day's range averaged out over the week, etc. Why am I boring you with all of this? Simply to say that at the end of a lot of number crunching, following every asset class known to man that has a corresponding ETF (not to mention I was lucky there was such an invention as an ETF so I didn't have to build my own basket of stocks), and taking on overnight risk -- the return at the end of the day was negligible, at the end of the month maybe 1 to 3% and the end of the year roughly 10%. Yes, not bad, especially to make single digit returns for the year in 2008 when markets were down double digits, something like 37% for the S&P. But I am not bragging here, because I no longer want to do this for myself nor for clients. In fact, I have since shut down my hedge fund and my RIA, and I am trying something totally crazy by some if not all "expert's" definition. But remember, we are seeking alpha here on this site, so all is fair in love and alpha -- but this must be done while strictly controlling downside risk and reducing volatility.

So here is my premise, instead of following the universe of asset classes long and short -- how about just trading 1 product, yes just 1, nothing else. That is my level of diversification here -- although I will trade it long and short. I have chosen the 30-year US Treasury bond. It is not a stock that can go to zero. It is backed by the government, it is volatile intraday, and with our trillion dollar deficit -- not going to go away anytime soon. The big picture view is simple, don't fight the fed. Far less time spent on the macro view, far more time concentrated on the micro view -- yes we are talking minutes. I am sure at this point I will lose the majority of readers -- this goes against anything we have ever been told or read. Also, unlike buy and hold, this is not a passive form of investing so those readers can stop here as well.

This is a method where intraday, in a matter of minutes to at most a few hours, an entire month's worth of returns can be made -- and 5-10% monthly returns are to be expected, if not more. I have taken the models that were based on daily, weekly and monthly charts and reduced them to 1 minute, 30 minute, and for the really long term (sarcasm here) the daily chart. I am only in the market when all indicators align, and the pattern indicates an 80% chance of a winning trade, with stops of course just in case. Otherwise, I am not in the market -- nothing at risk, no overnight positions, no diversification or hedging necessary. Going for a few singles during the day that can add up to a home run at the end of that day, and avoiding as much as possible any losing trades. Using the magic of compounding, a small .5% gain over and over is enough to take a tiny sum and turn it into something substantial. Think it can't be done? Well I may just have to put it to the test -- even going as far as using my IRA money to prove how safe I believe it is when a trader strictly limits time in the market which equates to funds at risk to the most opportune moments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may initiate a long or short position in the 30yr tsy bond futures contract.