Lessons from the Pros

Stocks

Dead-On Diversification

Many investors are told that the best strategy is to buy and hold and, unfortunately, this is not the only bad advice that is being provided by financial advisors. The additional advice often given is to diversify your portfolio. In order to accomplish this, advisors will use your capital to purchase stocks of companies working in various sectors.

While many of these financial advisors may mean well, they are either under-educated or mis-informed on how to do this properly. Most portfolios will simply have shares of stocks or ETFs that are from different sectors. While this does spread your financial risk over multiple sectors, it isn’t going to truly protect you in a market crash. Even worse, it could lead to poor returns even in bullish markets.

Chart showing sector performance during the market crash, December 2007 - March 2009

Actively Managed Funds Rarely Beat Index ETFs

We want to maximize our investing and trading dollars, so the investments most people have outside of individual stocks are usually in mutual funds. A selling point of these actively managed funds is that with professionals actively managing the investments you are likely to get better returns. The reality is the opposite! According to a Standard & Poor’s report looking at the last 15 years of data, they found that only one in 20 actively managed funds actually does better than an index fund.

That brings us to the market indexes themselves. When viewed over a large period, you can easily see that the indexes consistently move upward. This is more by design than by accident. The indexes are a numerical average of the prices of a group of stocks selected by a company. When the company notices that one of the stocks in the index is underperforming, it is removed and replaced by a better stock. In effect, the indexes professionals practice active rotation of the markets to capture better returns!

Stock chart showing long term growth in the markets

So why is it that we listen to financial advisors instead of following that same strategy for our personal portfolios? If we hold a diversified portfolio, we are attempting to perform as the markets are. Looking over the last 11.5 years, that would net us approximately 9.3% a year.

SPX Stock chart from July 2007 - July 2019

But what if we could use the same rotation tactics as the professionals in our own accounts? We would be looking to rotate what we own in order to get better returns by holding the better stocks and sectors based on the market conditions. Looking at the following sector analysis, you can see that there is not a single sector that is consistently at or near the top. What if we could average fourth best? By actively managing our portfolio and having the correct knowledge, there is a high probability of holding the sector that is likely to perform in the top four each year.

Sector performance in the S&P from 2007 - mid 2019

We may do better or worse than fourth each year, but if we could average the returns of the fourth best sector each year, we would have an annual rate of return around 16.3%, an improvement of over seven percent per year!

Free Trading WorkshopThis has the potential to be much better than a traditional buy and hold strategy that money managers and financial advisors tend to recommend for individuals. It also has the potential to be better than simply holding the broad markets in an index fund. If you want to get better returns, perhaps it is time to take charge and learn strategies to navigate the markets.


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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