Diversification is one of the least understood aspects of conservative investing. One reason for that is that it is a term with many meanings.

Since many investors think that their portfolio should be “diversified,” many of the leading investment houses pick between 20 and 40 stocks in different categories and allocate some to each account. Certainly owning different stocks is a form of diversification, but that form of diversification is not very effective as an investment strategy. That is just diversification for the sake of diversification, not for the sake of putting together a good portfolio.

For example, these same investment advisors almost always include some foreign stocks and some investments in “emerging markets.” But in today’s world I’m not very impressed with that. If some market is emerging it is much more likely that an enterprising U.S.-based company will take advantage of that new market than some local company in that emerging market. And why buy stock in a foreign country, like China for example, when you can buy a stock like Apple that is more likely than a Chinese company to sell a lot of product there?

Except for special circumstances, I have much less confidence in companies in foreign countries than in U.S. companies. The SEC and the IRS, plus the criminal justice system, are good deterrents to corrupt business practices in the U.S. These protections are rarely present in foreign countries and emerging markets.

There are exceptions. When Brazil discovered a big oil field off its coast I bought some of the Brazil Exchange-traded Fund (ETF). I figured that the influx of money would boost the economy. So far that hasn’t happened, but I remain optimistic. And from time to time I’ve invested in start-ups in Israel because that country is an incubator for a lot of hi-tech products. But I haven’t yet hit a really big success story there either.

So, if I want international diversification I look for stocks that are selling into foreign markets, not foreign companies.

Another form of diversification, one often overlooked, is who is handling your money. Perhaps this is not a problem for most investors if their money is with a solid brokerage house and is government guaranteed. Still, when Bear Stearns went under people with accounts there lost some time and suffered a bit of anxiety. But when I suggest to investors that they put some of their portfolio with two or three managers or brokerage houses, and they snicker, I just remind them of Bernie Madoff.

Investment advisors usually diversify by picking a mix of stocks and bonds, and in the equity section they diversify by sector. So they buy some commodities (maybe some gold), some technical stocks, some pharmaceuticals, some companies that sell household items, and so forth. This is certainly a form of diversification, but whether or not it is effective in providing profits depends on several factors.

If the idea, for example, is to buy a bit of everything and sell whichever ones go up and reinvest, that might work if you hold for really long term. But that means that your advisor (or you) has to be on top of the market, set profit goals for each sector and sell when the goal is met.

A better investment model to me is to pick which sectors look best in the mid-term, say a year or so out, and put your money exclusively there. For example, I don’t think gold is a very good investment for the near or medium term. So why should I own it just because it diversifies my portfolio? If I have confidence in my analysis of sectors, why not put the money instead into pharmaceuticals and housing, which seem to me more likely to go up over the next six to 12 months?

So if gold is such a poor investment, why do I own some? Because opposites attract! The concept of diversification that I follow is to hedge my investments by buying assets that move opposite to each other, and relying on dividends and option premiums on both sides for profit, rather than relying solely on my ability to evaluate companies or even sectors.

So, for example (although I haven’t really done an historical study on this), I figure that when interest rates go up, inflation will also go up.  That will adversely affect the overall market and the S&P 500. But gold will then go up as it usually does when inflation goes up. So I own a bit of each. And, when premiums justify it, I sell covered calls on each and take in premium income.

If oil goes up, who suffers? Airlines. So if I were to buy an airline stock, I would also buy some oil stock at the same time. If the oil stock goes up I figure the airline stock will go down, and vice versa. I try to find companies or ETFs in these sectors that pay a nice dividend, and I try to collect in option premiums on them. And when something really hits, I take a profit.

To paraphrase Groucho Marx, “I have my principles, and I believe strongly in them, and if you don’t like them, I have others.”

 

For information about Merv Hecht and more details on the strategies and stocks he writes about in this column, visit his website at DoubleYourYield.com.

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