Idiot Physics And The Case For Diversification

by: Adam Aloisi

I was never a big fan of physics. It was one of those subjects both in high school and college that I was forced to endure. As a junior at Penn State many moons ago, I enrolled in Physics I, affectionately known as "idiot physics" by PSU students because it covered only general physics fundamentals for liberal arts majors like myself, not complex formulaic particulars. One of the concepts we spent a fair amount of time discussing in that class was Heisenberg's Uncertainty Principle, a concept that in my estimation, seems to have a surprising amount of relation to the situation we investors always face in financial markets, but perhaps even more so today.

The basic explanation of the Uncertainty Principle is that position and momentum of a particle cannot be measured accurately simultaneously. And as more precision is known about position, the less precision there is in determining momentum, and vice versa -- an inverse relationship. Assuming we change the word "particle" to "security" in the above definition, I believe students of physics and investors have more to chat about than first thought. I would argue that Heisenberg's principle confirms the perpetual "uncertainty" of financial markets, and as such, investors should exercise extreme participatory prudence.

The Principle's Relation To Investors And Traders

Long-term investors tend to focus on point-in-time analysis of securities, which would include present valuation and fiscal position, current and future macroeconomic data, and future prospects for the securities being contemplated. The more due diligence that is undertaken, the more confident an investor can be when the security is purchased, shorted, or a more complicated position taken.

The fixation for an investor is upon current stability of fundamentals and a value/growth hypothesis, with the belief that over time, price change will occur as positions slowly move in a desired direction. Investors attempting to evaluate securities are typically scared away by intense momentum, as due diligence is difficult to engage in when price runs away in one direction, or fluctuates rapidly on a regular basis. While investors can articulate an investment thesis well, little is known about the ultimate direction the position takes.

Traders, however, thrive on momentum. They want knowledge that a security is already moving, or will move immediately upon purchase. The trader will focus on stocks with unusual positive or negative news, high volume, or other fundamental or technical data that serve purpose. If momentum is known or present, the trader is there to take advantage of it. However, just as the long-term investor is not guaranteed price movement to his/her liking, neither is the momentum player.

Once momentum dries up or moves counter to the trader's thesis, the position is generally exited. In most cases, a strict momentum trader will have minimal to no care about point-in-time security fundamentals or analysis. He or she just cares that the security is moving quickly in a preferred direction.

Thus, Heisenberg's principle seems to hold weight in a financial market sense. There is an inverse relationship between the existing precision traders and investors can maintain with regard to point-in-time security position/analysis and price motion. In other words, one way or another, every market participant is predisposed to uncertainty.

Battling Uncertainty

The best way for the average investor to contest uncertainty is to diversify prudently amongst various asset classes, investment styles and strategies, and market sectors. In this day and age, where economic ambiguity seems more profound than ever, investors need to position themselves in a way that provides upside opportunity, but protects against the obvious pitfalls that globally abound today.

While investors should be willing to overweight or underweight sectors or strategies that they have conviction in, they should think long and hard before heavily committing to any one idea or abandoning other ideas. For instance, bonds, while admittedly not a sexy asset class or growth idea presently because of ZIRP, do provide stability to a portfolio. Additionally, in a protracted low rate environment or equity freefall scenario, bonds may not necessarily be a portfolio burden. Holding a heavy cash position, while maybe a strategically sound strategy should markets tank, would backfire if the train were to proverbially leave the station near term and never come back.

Everyone's strategy and risk profile is different, and we all need to sleep well at night. From a strategic view, however, we need to remember that uncertainty rules the day. And while we can hope all the decisions we make are the right ones, the reality is we will make mistakes, sometimes big ones. So manage your risk, prepare for various upside and downside scenarios, and don't let emotion get the better of you.

How I Fight Uncertainty

For me, the battle against uncertainty is a total return positioning with an eclectic, diversified mix of value and growth stocks and bonds, and currently, a higher-than-usual allocation to cash. I'm currently partial towards dividend equity and higher yielding fixed-income in the more passive portion of my portfolio. When assembling, reviewing, and reallocating my portfolio, I attempt to achieve a high level of market cap, sector, region, risk, and style diversity, and purposefully include non-correlative assets and securities.

Core long-time, long-term positions include Exxon (NYSE:XOM), Colgate (NYSE:CL), and Lockheed Martin (NYSE:LMT). These are companies, like other portfolio mainstays, I will trade around depending on valuation and portfolio concentration. I also include higher-yielding, riskier names, including oil shipper Teekay Tankers (NYSE:TNK) -- a contrarian idea -- and business development company Apollo Investment Mgmt. (NASDAQ:AINV), which trades at book value and is reorganizing its operations. Some smaller-cap growth and contrarian ideas that I like include Shuffle Master (NASDAQ:SHFL), Callaway Golf (NYSE:ELY), and Ruth's Hospitality Group (NASDAQ:RUTH).

From a fixed income perspective, I hold very safe individual investment grade bonds for stability, but typically turn to closed-end funds for instant diversity, exposure to higher-yielding, international credit., and pricing inefficiency. Alliance Bernstein Global High-Yield (NYSE:AWF) and Western Asset Emerging Market Debt (NYSE:ESD) are two of my current holdings in that space. In my view, closed-end funds are an under-appreciated vehicle where investors can reap tremendous value when they are analyzed correctly. Think out of the box!

One of the latest non-correlative additions to my portfolio was the iShares International Select Dividend Index Fund (BATS:IDV). My attraction to this ETF was manifold. It provides diversified access to a variety of non-domestic equity markets -- which I have mostly avoided over the past several years -- and boasts a very attractive 5.3% yield point. For my purposes, I considered it a somewhat conservative, contrarian, total return idea that I plan on holding long term. International markets are out of favor currently and while the path going forward may be rocky, I think IDV provides a sensible way for investors to access higher-yielding, non-U.S. equity exposure.

Ben Franklin once said the only certainties in life are death and taxes. I think the only certainty for today's market participants, no matter how they invest, is uncertainty. The most prudent way to approach the situation, in my view, is by diversifying assets in a thoughtful manner, and by reallocating frequently as changing macroeconomic and security specific data dictate. This goes especially for those of us only bright enough to take idiot physics!

Disclosure: I am long AINV, ESD, SHFL, AWF, IDV, TNK, CL, LMT, XOM, ELY, RUTH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.