This video examines diversification…

• What is it?
• Why didn’t it work to reduce my portfolio risk?
• Is there something I can do to make diversification actually work? If so, what?

Diversification is extremely fundamental to the modern porftolio theory that so many financial planners talk about. But what isn’t talked about is how and why diversification is ineffective when applied to a portfolio that is invested in the stock market alone.

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This question is on the minds of millions of Americans. I know exactly how to recover your losses: get out of the U.S. stock market and recoup your losses elsewhere.

S&P 500 loses 28% in one year

The sales pitch of securities salesman is that the stock market goes up around 8% or 9% per year over the long run – so don’t ever sell as a reaction to losing money. Let’s examine this, and assume your investment performance equaled the S&P 500 (even though the majority of mutual funds’ performance is inferior to that of the S&P 500).

Scenario A – You entered the market one year ago. You experience a 28% loss. For you to get back on track for 8% annual gains, you’ll need a 62% gain this next year. Or if you take two years to get back on track, you’ll need a 32% gain each year. How likely do you think this will be?

Scenario B – You entered the market exactly four years ago. Thus far you’ve had a 1.5% loss. If you goal was to earn 8% per year in the stock market and you started with $100,000… you’ve come up short $37,548 of the $136,048 target. That’s the would-be power of compound interest. Over this four year period of time you’ve ended up almost 30% short of your target.

Solution: Get most of your money out of the stock market. It is a speculative investment vehicle masquerading as a predictable investment vehicle. Now the mask came off… take a good look.

While I generally avoid mutual funds like the plague, I don’t avoid the stock market altogether. I’ll split what I do in the stock market into two categories: long and short. Either way, I’m honest with myself in admitting that no matter what I do in the stock market, it will be speculative and risky.

Long

“Going long” means buying a stock and expecting its price or income to rise so I can sell later for a profit. There are millions of people who have access to the same information as you, and that is generally reflected in the price of that stock. If you know something non-public about the company, trading it may be illegal for you. I’ve bought individual stocks before; I just treat the situation honestly; it is speculative in nature, and I only make such trades with very small portions of my portfolio.

I don’t go long on mutual funds because I don’t know what I’m going long on. It is virtually impossible to know what I’m actually investing in when I buy shares of a fund.

Short

Selling Short… A short position is the opposite of a long one. Instead of buying low and selling high, selling short is a matter of selling high and then buying low. For me to do this, I borrow shares of a stock and simultaneously sell them at the market price in expectation of a price decrease. To close this position later, I just have to buy back shares of the same stock at the then market price and pay back the borrowed stock. If during my position the stock price declined, I profit; if the stock price increased, I have a loss.

Ex: ABC Company seems to be doomed. It’s currently trading at $50, but I think it will go much lower over the next couple months. I sell 100 shares short. This means I borrow 100 shares and simultaneously sell them for $5,000. A few months later I see the stock price has declined to $35. To close my position, I buy 100 shares back for $3,500. I pay back the borrowed shares and retain the $1,500 profit, less fees and commissions.

I like short selling more than going long. I often notice stocks crashing down faster and more predictably than they spike up. It also might be easier to confidently predict the demise of a company than the thriving of one. In the past, I liked a wind energy stock, but felt more strongly about the decline of home builders and mortgage lenders. So to me the better investment was to sell home builders and mortgage lenders short. Wind energy may really take off… but who knows if the company I’m looking at will be a forerunner. On the other hand, when the mortgage market is headed downhill, just about any mortgage company is going to be hurt, and it’s very easy to target those who readily admit to holding subprime notes.

Buying Put Options… Buying a put option is similar to short selling in that it is done when you expect a stock price to decline. Buying a put option means buying the right to sell a stock at a certain price. You don’t actually sell it right away; you just pay a premium for the right to sell it at a certain price in a certain window of time. If the stock price goes down, you can sell the option for a higher premium than you paid or you can exercise your option to claim the profit. I don’t like put options as much, because if a stock is already falling, then the premium you pay to buy the put rises because the seller of the put option knows it’s falling. That same already falling stock can be sold short (as soon as its price has an up tick) with no premium to pay.

Inverse Index Funds… An index fund is one that attempts to closely mimic the price movements of an entire group of stocks (an index) such as the S&P 500. Most index funds allow you to effectively “go long” on all the stocks in the index. An inverse index fund enables you mimic selling short an entire index. Such a fund is invested in a way that attempts to have price movements that are the opposite of the chosen index. So an inverse S&P 500 fund will go up in price $1 for every $1 decline in the S&P 500. It will also go down $1 for every $1 rise in price of the index. For extremely leveraged speculation, you can even choose a double inverse index fund – where the fund goes up $2 for every $1 that the chosen index declines. It also goes down $2 for every $1 rise in the chosen index.

The Window of Opportunity

The wild thing is that many people who own stocks or mutual funds aren’t even aware of short positions, leaving them with only long strategies. This benefits me because when a stock or fund is declining in value, financial advisors are often telling people to hold on for the long term. This keeps the price from falling too rapidly. As a result of the “hopers”, there is enough time for me to see the decline and still have time to profit from short selling it before its downward movement concludes.

Insider Trading… This is when a person has non-public information on which he bases a trade in a public securities market. It is illegal. Insider trading in public securities can lead to imprisonment. Insider trading in real estate and private investments can lead to extraordinary profits.

Arbitrage… This is the act of profiting from the mispricing of assets. When an ounce of gold costs $900 in New York and $895 in Japan, “arb” traders will buy lots of gold in Japan and immediately sell it in New York… theoretically risk free. When dealing with transaction costs, arb trading typically requires very large amounts of money to be carried out feasibly. For the Joe who has $150,000 in an IRA, arb trading probably isn’t feasible.

Big Fish… Investing in the stock market is a different story when you can afford to buy HUGE pieces of companies. Warren Buffett, often called the World’s Greatest Investor, invests on such a large scale that he recently commented that the Korean stock market is a great buy, but he won’t be investing in it… because most Korean stocks aren’t large enough to have a significant impact on his portfolio! You can’t follow Warren’s strategy because he reads all day in order to make trades in the several hundred million dollar range. What he does won’t exactly work when making $10,000 trades.

Geniuses… This may be you; it’s not me.

What I’m not saying

I don’t avoid the stock market like the plague. I do generally avoid mutual funds like the plague because it is surrendering – you don’t know where your money went. Picking stocks for your portfolio can make sense when you are honest with yourself in that it is speculative and high risk in nature. Accordingly, it should only be done with a small portion of an overall portfolio. What do you do with rest of your portfolio?