Matt’s Note: Today’s Stock Power Daily: 9:46 Edition special series continues with an important message from Mike Carr on diversification.
According to Mike, you simply cannot expect to diversify your portfolio the same way you have for the last 40 years.
Mike shares how the biggest hedge funds in the world diversify … and how you should too.
Yesterday, I shared how you can’t simply invest the same way you did in the past 40 years.
That also means you can’t believe the things investors have believed for the past 40 years.
One of the things investors mistakenly believe is that stock diversification reduces risk. They think this means they should own dozens of stocks in different sectors.
That’s not diversification. It also doesn’t decrease risk.
Owning a lot of stocks simply re-creates an index like the S&P 500. And all that does is eliminate the risk of underperforming the index.
If you’re a professional investment manager, that’s fine. You won’t get fired if you lose 50% while the index loses 50%.
But if you’re an individual investor, losing 50% can be catastrophic. Re-creating an index by buying lots of different stocks does nothing to reduce risk when the whole market is falling.
That doesn’t mean you should eliminate diversification from your plan. It just means you need different strategies to diversify.
Right now, the risk level in the stock market is at its highest since the dot-com crash. All sectors are exposed to this risk in some way.
As I noted yesterday, I believe this will be the case for some time to come.
To preserve and grow your wealth in this extended period of volatility, you must understand that diversification isn’t simply about owning lots of different stocks.
It’s not about owning a few stocks, some bonds, some real estate and a tiny bit of gold, either.
To truly diversify, you need to trade using multiple strategies.
Here’s what I mean…
The Wrong Way to Diversify
Many investors and traders use strategies to build their portfolios.
Some rely on value. They buy stocks at a discount that only they can see.
I don’t understand that. If value is so obvious, wouldn’t everyone notice it at the same time? Still, some investors like to focus their efforts there.
Others use growth. They think some technology will change the world, so they buy stocks associated with that technology.
There’s a big problem with both strategies.
Neither of them considers risk. Each is all-in on one strategy — “value” or “growth.”
Let’s say it’s a bull market. You own 25 value stocks. Studies say you’re “diversified.”
But because you own only value stocks, you’re trailing the market a bit. The Vanguard Value Index Fund ETF (NYSE: VTV) is up about 328% from the 2009 bottom, while the S&P 500 is up 420%.
But then interest rates go up. A bear market strikes. Value is repriced and you suffer steep losses. Turns out value didn’t prepare you for interest rate risks.
And don’t think value is immune to market volatility. The Vanguard Value Index Fund ETF is down almost 10% from its peak and fell as much as 17% in 2022.
Likewise, imagine you own 25 tech stocks. You still have exposure to interest rates. You also have exposure to technological risks.
Maybe someone comes up with a better technology and your stocks lose value. Maybe the economy contracts and customers can’t afford new tech toys.
There are countless risks to a tech portfolio. And you can’t diversify them by adding more tech stocks. The Invesco QQQ Trust (Nasdaq: QQQ), which tracks the Nasdaq, is down by nearly 24% from its 2021 peak.
So what do you do?
One option is to combine tech and value. That doesn’t change the interest rate risk, but it is the right path toward diversification. With this portfolio, you give up some of the gains in a bull market but suffer fewer losses in a bear market.
This is just a simple example and by no means a recommendation for an optimal portfolio.
My point is, the best way to diversify is to add exposure to different strategies.
This is how the biggest hedge funds in the world diversify, and there’s no reason you can’t do the same thing.
How the Big Money Mitigates Risk
Renaissance Technologies provides an example of the right way to diversify. This is a hedge fund that generated average annual returns of 66% over 30 years.
The fund makes so much money, it pays its investors a dividend every year that’s believed to be equal to the fund’s profits.
The fund employs dozens of mathematicians with Ph.D.s. They don’t study individual companies looking for value, or buy stocks that build tech products.
They spend their time looking for strategies that work, no matter what they are and what stocks they have to buy.
In a Bloomberg interview, a company official said: “It turns out that when it’s cloudy in Paris, the French market is less likely to go up than when it’s sunny in Paris.”
Buying French stocks based on Parisian cloud cover is an example of extreme diversification. We don’t think of the weather and the stock market being related to each other. But Renaissance did. Maybe we should too. After all, the fund generated 66% a year for three decades.
This insight gave Renaissance an edge. They traded that idea until it stopped working. Managers also traded dozens of other strategies that they don’t share.
Then there’s Citadel. Led by Ken Griffin, the hedge fund uses several different strategies at once to help its investors beat the market.
Its flagship strategy is simple: It buys stocks that are going up, and shorts stocks that are going down. Combined, the firm hedges its risk and profits on both sides of the market.
That’s how it returned 38% in 2022.
It’s not likely we can duplicate the performance of hedge funds like Renaissance or Citadel. But we can duplicate its theories and trade multiple strategies to hedge against the risk of trading just one.
In Precision Profits, I’m currently trading seven strategies.
Six of them are short term, like the 9:46 Rule I described yesterday.
One is longer term, using an indicator I developed to monitor how emotional traders are in the market.
These strategies take just minutes a day to trade and offer real diversification since we aren’t simply re-creating an index. We also avoid sector and interest rate risk by focusing on shorter-term ideas.
Different strategies, along with short-term trading, really are the key to diversification. But many investors won’t believe that because they learned as long as you hold 25 stocks, you’re diversified.
They’ll suffer extreme losses in bear markets and will question how that happened. I don’t plan to do that, and I don’t plan for my subscribers to suffer that same fate.
Right now, the most promising strategy in my arsenal is the 9:46 Rule. It requires just 15 minutes of data, two minutes to place the trade and a couple hours to target 50% gains every single day the market is open.
It’s totally unbiased — offering trades to the upside and downside. That means you can make more money on up days AND down days.
If that sounds interesting to you, be sure to watch my full presentation on the 9:46 Rule, right here.
Speak to you then,
Mike Carr
Senior Technical Analyst
