A full time investor who has made decent investment returns, Tony blogs at A Young Investor and shares his financial thoughts.
The first thing an investor learns is to diversify. “Don’t put all your eggs in one basket, spread your risks, hedge your bets, blah blah blah”. Ok. We get the point. But how can we diversify?
This is somewhat of a no brainer: Spread your eggs among different industries. Since you’re trying to HEDGE your risks, what you need to do is to buy/sell stocks in industries that move in opposite directions. For example, if you buy auto stocks, you might also want to buy insurance stocks. This is because in poor economic weather, auto companies fare poorly (cars are seen as discretionary spending), while insurance stocks stay strong because people can’t live without insurance. This reduces your losses in poor economic weather, but also reduces your potential profit. Which is why the next diversification method is better.
Sell The Weakest and Buy The Strongest In The Industry
If you don’t want to hedge your risk across different industries, another approach (which I have used) is to sell the weakest stock in the industry and buy the strongest in the industry. Should the market rise, your short on the weakest stock(s) won’t turn into a big loss, but your long position on the strongest stock(s) will turn into a big profit. Should the market fall, your short position on the weakest stock(s) will yeild a big profit, while your long position won’t turn into a big loss because the stock(s) is/are strong.
I did this in 2008, when financial markets around the world came crashing down. I reasoned that financial corporations should fall, but not in a straight line. Like every bear market, there are temporary retracements. My strategy was to short the weakest financial stocks whenever I thought the market should fall and buy the strongest financial stocks whenever I thought the market would retrace. As such, 2008 has been my best year performance-wise.
This is a strategy that I prefer – diversify your portfolio among different asset classes. This can include stocks, commodities, currencies, and real estate (although I’m not too fond of investing in real estate). Different assets guarantee different returns, and different assets perform well in different markets. For example, if investors in 2007 had hedged their stocks with commodity buys, they would have lost money on their stock portfolio but made more money on their commodity positions!
Diversify Strategy, Not Portfolio
Everything I said in the above, I tried in the past. But here’s what I think is a better idea: according to my post Ideas About Investing & The Markets – #2, you should diversify your investment strategy, not asset classes. Buying and selling assets are just ways to express an investment strategy – your portfolio doesn’t make money when the assets you picked are in line with the market’s direction – your portfolio makes money when your investment/trading strategy is in line with the market’s direction.
Based upon this belief, it is wise to diversify your money among multiple strategies. HOWEVER, one person can only conform to one strategy – you cannot do two things and be two people at once. Hence, the conclusion can be made that you should diversify your money among fund managers that use different investment strategies. Unfortunately, this is not always possible, as many funds require you to have a certain amount of money to get in – an amount of money that most people don’t have. But if I had the money, this is definitely a method of diversification that I would take.