For Portfolio Diversification, Try This 10% Solution

Includes: DBV, DIA, DSX, QQQ, SPY
by: Roger Nusbaum

I put up a similar chart on December 13, which was about the last time the S&P 500 turned around at the line drawn in red here.

I've been saying for a while now that I think a bear market has started. I've also been saying that if a bear has in fact started, the way this bear is starting is very typical.

The point of this post is about exploring a different concept than just stocks, bonds, cash for constructing a portfolio. Some people might say that in addition to stocks, bonds and cash, real estate (primarily REITs) and commodities should also be included. What about private equity?

What probably makes sense for most people is some sort of a broad category that is perhaps labeled alternative or other (I'll take suggestions on a better name). This could take in the following;

  • Absolute return ideas (like a long/short fund)
  • Some strategy funds, like G10 Currency Harvest Fund (NYSEARCA:DBV) or the Rydex Managed Futures (MUTF:RYMZX) (MUTF:RYMFX) (MUTF:RYMTX), both of which are personal holdings

  • Infrastructure
  • Plane leasing
  • A Put Write fund (if one ever comes into existence)
  • One of the merger funds. (This probably counts as absolute return, but this is the type of thing that gets forgotten about)
  • Foreign currency (I include this in cash but some may think of it as "other")

All of these categories (if I have left any out please leave a comment) have both positives and drawbacks. There was an article Thursday in the WSJ about long short funds that have done poorly this year in a market in which I would think they would shine.

Within each segment there are varying characteristics. The context I am going for here is finding a low correlation to U.S. stocks, a little bit of yield, and low volatility, although that is not as important as the other two.

My "10% Solution" idea is that of allocating 10% of a portfolio spread across several of the sub-groups listed above; maybe 2% each in five different categories, whatever. In looking at each of the seven listed, they each have a couple of obvious risks, but I would want to spread it out for fear of the risks, to steal a page from Nassim Nicholas Taleb, that are not obvious.

I think these segments all live in their own world relative to the others. If you put 2% in a plane leasing company and something unforeseen happens, it is likely that the other segments would be untouched. A good example from the last few months might be some of the shipping stocks. Picking a relatively undramatic name, Diana Shipping (NYSE:DSX) is down 26% from its high while the market is only down 6% or so from its high. So 2% in DSX bought at the worst time possible, in moderation, is far from a death blow.

The big macro question here is: If the chart above does portend a bear market of some sort, where can money go to give a chance of better weathering of a bear? Then, once the next bear is over, does it makes sense to keep these types of holdings, to perpetually own names with the attributes of low correlation and above-market yields?

Don't take 10% as any kind of magic number either. I think a persuasive argument for 3% each allocated to five or six "others" could easily be made. The problem I can see, and this is always the way, is that one or two of them do very well, and instead of a moderate allocation of 2-3% in one segment, people go with 10-15%. Then it blows up and they have completely neutralized their bear market protection.

I write this sort of post often as I believe that the average 10% return from U.S. markets may be harder to come by in the next few years. If U.S. equities can only average 5% then you either need to own equities in foreign markets that can deliver 10%, or get that 5% with assets that are generally not as risky as U.S. equities, or some combo of both. Obviously I vote for the combo.