Lessons from the Pros

Stocks

Asset Allocation

Last evening, I was having a conversation with a fellow trader discussing the importance of asset classes as they relate to each other. Even though my friend is primarily a trader in stocks, he analyzes the futures markets for guidance and uses options strategies designed to help improve rate of return and to manage his risk.

Most investors and traders fail to recognize the benefits that related asset classes offer to the stock trader. We are incorrectly trained to believe that we will meet our goals focusing solely on the equity markets and diversifying our portfolio in different stock sectors. The truth is that no matter how many stock sectors you buy, they are all likely to fall when the markets crash. The only true diversification comes from holding different asset classes.

S&P sector performance graph

As you can see from the preceding chart, a diversified stock portfolio would have still lost money during the market crash of 2007. Traders and investors who diversified their portfolio in different assets, however, could have seen gains.

Benefits of Investing in Multiple Asset Classes

The other asset classes, such as futures and Forex, are beneficial for stock traders and investors in many ways.

  1. They can often offer a warning before the stock market changes direction and trend
  2. They can be used to hedge portfolios
  3. A portfolio comprised of stocks, futures and currency is properly diversified.

Forecasting the Markets

When looking for a forecast tool for the stock market, you need to understand the correlations between the stock market and several other assets. For example, as seen in the charts below, the market crash in 2008 and recovery in 2009 was preceded by turns in both the commodity and currency markets.

Chart demonstrating the 2007 drop in the AUD/JPY prior to the drop in the stock market

Chart demonstrating the drop in copper prior to the drop in the stock market

On a day to day basis, stocks will often react, and play catch up to, the equity futures markets. Futures trade nearly 24 hours a day and will act in response to news before the stock market opens. I have written about this before when discussing Program Trading. By understanding the futures markets, you can predict the morning movements and trading opportunities of the stock markets.

Hedging Portfolios

Since some currency pairs and futures mimic the stock market, a shorting position in these securities could be used to hedge the risk of a stock portfolio. Your gains in the short would offset the losses in the portfolio in the event of a market crash. There is a bit more that would need to be done to ensure the hedge is done properly, such as beta weighting the portfolio, but it is a strategy worth considering. Additionally, options on futures or indexes would allow you to create a hedge using less money.

Taking Advantage of Offsetting Rallies

Bonds, stocks, currencies and commodities all have differing cycles that they go through. Some are bullish while others are bearish. Creating a truly diverse portfolio of various assets can be a viable strategy to minimize risk in the event the market drops. Once again, diversification in different sectors is often just not enough.

Graph demonstrating that different asset classes have offsetting rallies

We have discovered several reasons why having knowledge of multiple asset classes can be a huge benefit for the stock trader/investor. You can learn more about these assets at your local Online Trading Academy center. Enroll in free workshop today.


DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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