Lessons from the Pros

Conventional Portfolio Diversification: Risk Disguised as Opportunity

As we begin a new year, I thought it would be appropriate to discuss a financial issue many people seem to handle incorrectly – diversification. Instead of wasting another year with the "hope and pray" method of investing, here is a chance to take action yourself. After all, no one cares about your money and retirement more than you, never forget that.

If you are like the millions of Americans who over the past decade bought into the illusion of safety and security from conventional investment portfolio diversification, don’t allow yourself to be blindsided again. Conventional diversification attempts to decrease risk and offer more opportunity for the average investor. However, when we observe conventional diversification protocol through the objective eyes of pure supply and demand, it becomes quite clear that conventional diversification actually increases risk and decreases opportunity. With retirement ever so close for the most populous and wealthy generation in history, this is an issue that can’t be ignored. In this piece, we will learn how to assess the markets through the laws of supply and demand, explore an alarming reality of conventional diversification, and provide a framework and foundation from which the average investor can properly diversify their own portfolio.

The Foundation: Quantify Supply and Demand

The movement of price in any and all free markets is a function of the laws of pure supply and demand. Low risk / high reward buying and selling opportunity emerges when this simple and straight-forward relationship is out of balance. Let’s review chart 1 to get a basic understanding of how and why we quantify supply and demand as this will lead us to our objective opportunities for low risk gains.

Figure 1

Notice price level "A". For a period of time, price was stable, suggesting supply and demand is in balance (equilibrium) at that level. Once price moves higher from "A", it is clear that there was no equilibrium at "A". In fact, we can now say that price level "A" represents a major supply and demand imbalance. We know this to be true because the only reason price moves higher from "A" is because there were many more willing buyers than sellers at "A", it simply took time for this unbalanced equation to play out. You don’t need a technical indicator or some professional to tell you this; it’s simple logic. "B" represents the first decline in price to the objective demand level which is where we find our lowest risk / highest reward buying opportunity. For diversification purposes, "B" would be the low risk / high reward / high probability time to buy into this market.

"C" is just the opposite. It is a price level where objectively, supply exceeds demand. For a period of time, price was stable at level "C", and then there was a sharp decline. The decline tells us that there is much more supply than demand at "C". "D" represents the first time price revisits the objective supply level which is where we want to sell or sell short. For diversification purposes, "D" would be the time to take profits in this market and move your investments to a market that is approaching a demand level such as demand level "A". In short, ideal diversification would be to realize profit at "D" and reinvest at "B".

The Simplicity of Markets

Put quite simply, a trading and investing market is made up of three components – buyers, sellers, and a widget being bought or sold. These widgets may be shares of a stock, S&P futures, foreign currencies, bonds, and many more tangible and intangible "widgets". For example, let’s say the widget is a stock. This stock has some value. That value or "price" as we call it is determined simply by the supply and demand for the stock, which is the ongoing interaction of all the buyers and sellers taking action with regard to that particular stock.

A market is always in one of three states:

1. First, it can be in a state where demand exceeds supply which means there is competition to buy and that leads to higher prices.
2. Second, it can be in a state where supply exceeds demand which means there is competition to sell and this leads to declining prices.
3. Third, it can be in a state of equilibrium. At equilibrium, there is no competition to buy or sell because the market is at a price where everyone can buy or sell as much as they want. However, as the market moves away from equilibrium, competition increases which forces price back to equilibrium. In other words, competition eliminates itself by forcing markets back to equilibrium.

The Greater the Supply and Demand Imbalance, the Greater the Opportunity

This is true when buying and selling anything, not just with your investments. While many "professionals" would have you diversify your portfolio by buying many different stocks or a "ladder" of bonds for example, a much more efficient, lower risk / higher reward approach is to identify the markets with the greatest supply / demand imbalance and risk your hard-earned capital there.

This is not all that different from stretching a rubber band. The more you stretch it, the more potential energy is stored, waiting until it reaches a threshold where that energy is released and it snaps back. The thresholds in markets where prices turn are the price levels on the supply and demand curve where supply and demand are out of balance.

Seeing the Curve on a Price Chart

How do we know when we are at these levels, far from equilibrium? Please revert back to chart 1. Price levels "A" and "C" represent the boundaries of this curve. All you have to do is look at a larger time-frame chart (or smaller if you’re an active trader) and do the following:

1. Identify current price.
2. Identify the trend of current price on the daily chart.
3. Identify the demand level below current price.
4. Identify the supply level above current price.

The Problems with Conventional Portfolio Diversification

For most investors, your portfolio is split between stocks and bonds. Whatever the split is, have you ever realized that almost every investment in a typical portfolio appreciates only when prices go up? What happens if these markets go down for a significant period like they did in Japan for over 10 years? And worse, what happens if this decline in price begins when you are near retirement like the markets and some baby boomers today?

When we break down portfolio diversification in stocks, there is another issue to be aware of. Your average investor will typically be told to reduce risk by investing portions of their portfolio in different stock sectors and stock markets. An example would be to have a portion of your stock portfolio Dow stocks which are typically large cap stocks and a portion in the tech heavy NASDAQ market. Consider these charts.

Figure 2

At first glance, these two charts appear to be the same chart. During almost any period in time, equity markets move in the same general direction. As you can see here, diversifying in these two markets is really not decreasing risk, it is actually increasing risk. The average investor thinks their hard-earned capital is diversified properly between two semi-uncorrelated markets but the truth is, the risk is actually DOUBLED as these markets almost always move in the same direction. Again, conventional diversification is typically risk disguised as opportunity for the ill-informed investor. These days, it is also very uncommon for a foreign equity market to move in the opposite direction of the major U.S. equity markets for any sustained period of time. This high-risk approach is typically pushed by those who have a financial benefit to push it.

10-YEAR NOTE

QQQQ (NASDAQ)

Okay, enough questions and alarming issues, let’s use pure supply and demand and learn how to properly diversify your portfolio. Notice the daily charts above. Here, we are looking at the same period of time in the NASDAQ and the 10 Year Note (bonds). Area "A" in the 10-Year chart represents a major supply level for reasons mentioned prior in this piece. "B" is the first time price revisits that area of imbalance which is where we would want to sell for profits or initiate a short position. We actually shorted that in the Extended Learning Track (XLT) Futures class. Let’s take a look at the NASDAQ chart. Area "C" represents a major demand level, again, for reasons discussed earlier in this piece. "D" represents the low risk / high reward time to buy into the NASDAQ stock market.

Take Action When Risk is Lowest and Reward is Highest

As you can see, at the exact same period of time, the 10-Year Note begins its decline from supply and the NASDAQ begins its rally from demand. The proper action for the astute diversifier is to take profits (sell) on much if not all of your bond position and buy into the stock market. This is how we diversify our portfolio based on REAL demand and supply analysis. When we focus on real demand and supply, we are able to quantify real risk and reward, not the illusions of conventional portfolio diversification.

Hope this was helpful. Have a good day.

- Sam Seiden

sseiden@tradingacademy.com