Portfolio Review: Diversification and Asset Allocation

Includes: DIA, QQQ, SPY
by: Mark Hines

Diversification and Asset Allocation are two of my very favorite concepts. One way to view these concepts is through broad market categories such as Agricultural Investments, Energy Investments, Emerging Markets, Non-U.S. Developed Markets, Absolute Return Investments, and U.S. Stocks. This blog post describes how I'm playing each of these categories.

Before I get into the specifics, I want to give some high level perspective. First of all, I believe portfolio diversification can reduce downside risk while still leaving plenty of room for upside gains. I don't take it so far as to calculate optimal portfolio weights by using correlation matrixes and efficient frontier concepts because I believe the assumptions behind these academic models are silly. However, I do believe diversification is an important part of risk management, and I currently view allocation among the broad market categories listed above as follows:

Agricultural Investments: The recent run-up in agricultural commodities and agricultural stocks has been described by many as a bubble. Personally, I believe there are some agricultural investments that are in bubble territory, but there are others that are not. Moreover, I believe the recent increase in agricultural investments is driven mainly by increases in worldwide demand, and I don't think this demand will reduce ever. Granted, there will be short and mid term pullbacks in agricultural investment prices, but the long term demand will not shrink. Even the US Department of Agriculture is predicting increased worldwide demand in their World Agricultural Supply and Demand Estimates report. Check out my private blog and portfolio holdings to see how I'm playing Agriculture.

Energy Investments: Similar to agriculture (described above), energy has been described by some as being in bubble territory. Unfortunately, I don't agree. In my opinion, higher prices and worldwide demand for energy is here to stay. Again, we may see some pullbacks in the short term, but long term higher energy prices will persist. I believe the investment management team at CastleArk Management in Chicago does a nice job summing up energy demand on their website (www.castleark.com) as follows:

"due to the maturity of the world's reserves, there will be a supply shortfall of energy until new, large discoveries are made. In combination with continued worldwide energy demand growth, highly priced oil and gas will likely persist and energy consumers will probably continue to see shortages... this supply-demand imbalance will endure for a period of time, providing fundamental support to the earnings prospects of these companies. Because Wall Street and many investors have not fully recognized the attractive investment characteristics of this industry in the current environment, there is a unique opportunity to make excess returns in the energy industry for several years to come."

Emerging Markets: I think Jeremy Grantham of G M O does a fabulous job describing the future prospects for emerging market growth in his most recent Quarterly letter. This guy is about as smart as they come (that's probably why he has over $150 billion in assets under management), and he believes "developed countries are a tired old story and that those who want to make money should buy emerging." His entire quarterly report is chalk full of references to future appreciation in emerging market investments, and when he speaks... people should listen.

Non-U.S. Developed Markets: There are a variety of Non-U.S. Developed markets that U.S. investors can participate in. My two main reasons for investing in Non-U.S. Developed Markets are: 1) As a hedge on U.S. currency (no one really knows if the U.S. dollar will continue to depreciate or appreciate against other non-U.S. developed currencies, and I believe it's wise to have some of your equity investments denominated in something other than the U.S. dollar), and 2) The U.S. economy has been in a funk lately (GDP growth is slowing, and the stock market has been sputtering), and no one really knows if or when it will recover; some will even go far as to suggest the U.S. has lost its edge as the worldwide market leader (i.e. Jeremy Grantham above), and it's time to look elsewhere; further, there are other non-U.S. developed market economies that are functioning well... so why not take advantage.

Absolute Return Investments: This category is challenging for individual investors because it's usually only available to institutional investors (i.e. people with tons of money). Absolute return investments include things such as private equity investments and hedge funds. Recently public firms like Blackstone (BX) and Fortress (FIG) are the obvious choices, but since I don't like either of those right now, I've taken a different approach. Subscribers can see what I'm talking about by viewing my private blog.

Diversified Portfolio of U.S. Stocks: I continue to allocate a significant portion of my investments to U.S. stocks. Despite our sputtering economy, there is still money to be made on underpriced companies that are performing quite well. Additionally, I believe there are a variety of U.S. stocks that can be used to benefit from the other broad investment categories described above. Subscribers are welcome to view all of my portfolio holdings to see how I'm playing each of these broad market categories right now.