Designing Portfolios with Four Diversification Elements
By Leland B. Hevner
President, National Association of Online Investors (NAOI)
This is Article 6 in a Series that shows how the NAOI is changing the way investing works at a fundamental level in order to provide individuals with portfolios that produce higher returns, lower risk and absolute protection from stock market crashes. Previous articles in the Series can be accessed at this link.
The NAOI is the market’s premier supplier of objective and comprehensive education to the investing public. As such, we are a major influencer of how individuals invest today and which advisors / financial organizations they choose to work with. The information discussed in this series of articles describes the innovative investing methods that we are teaching.
The Power of Portfolio Diversification
I think we can all agree that diversification of equity holdings is key to the success of investment portfolios. Today’s industry standard for portfolio design, called Modern Portfolio Theory (MPT), uses two diversification elements. In this article I discuss how the NAOI is teaching our students to add two additional diversification elements, for a total of four, resulting in far more effective portfolios than they hold today.
MPT Diversification Elements
Modern Portfolio Theory dictates that portfolios are to be designed to match the risk tolerance of each investor using asset allocation techniques. Then these portfolios are to be bought and held for the long-term. MPT uses the following two diversification elements:
- Company Diversification – Achieved by using mutual funds and/or ETFs as the primary investment vehicles – both hold baskets of equities, reducing company risk.
- Asset Class Diversification – Achieved by holding non-correlated investments at all times – primarily Stocks and Bonds, reducing asset-class risk.
Company and Asset Diversification reduce risk but also reduce returns as MPT-based portfolios are designed to hold both winning and losing investments at all times.
MPT Portfolio Performance Example
A typical MPT portfolio with a 60% allocation to a Total Stock ETF and a 40% allocation to a Total Bond ETF for the period from the start of 2008 to the end of 2019 produced the performance presented in the Table below. Note that the Sharpe Ratio is a measure of risk, showing the amount of return received for each unit of risk taken.
MPT is the portfolio design and management approach that the NAOI taught from our inception in 1997 until 2009, when the stock market crashed and the MPT portfolios we were teaching our students to create and hold crashed along with it.
Adding “Time” Diversification Using NAOI Dynamic Investments
In 2008-2009 the stock market suffered one of the worst crashes in history. During this period it lost over 50% and MPT portfolio holders lost significant sums of money as advisors told them to do nothing as stocks would eventually recover. And they did; 5 years later! This was 5 years during which MPT portfolios did nothing but try to regain their pre-2008 value. Many individuals could not wait that long and had to sell and accept their losses. This event caused many people to leave the market as they lost faith in MPT methods and the financial professionals who advised them.
As a result, soon after the crash, the NAOI stopped all investor education classes until we could find a better approach to investing. We saw very clearly that MPT methods, introduced to the market in 1952, simply couldn’t cope with modern markets.
In Article 2 of this Series I discussed how, following a multi-year R&D project, we found a better approach to portfolio design and management in the form of Dynamic Investment Theory (DIT) and a new investment type that DIT creates called Dynamic Investments (DIs). DIs are capable of automatically changing the equities they hold based on a periodic sampling of market trends.
An illustration of how Dynamic Investments Work
Below is an illustration, first presented in Article 3, of how a simple DI works, one that rotates only between a Total Market ETF and a Bond ETF based on a quarterly sampling of the price trend of each.
The top chart shows theoretical price cycles of the Stock and Bond ETFs that, because they are uncorrelated, move up and down at different times and from which we could infer that at all times one should be trending up in price.
Vertical lines on the chart represent quarterly Review Events by the DI during which the price trend of each ETF is sampled and ONLY the ETF moving up in price is purchased and held until the next Review. At the bottom of each Review line is the ETF purchased with S=Stocks and B=Bonds.
These periodic trend Reviews provide DIs with a built-in trading plan that buys only into the asset-class that is moving up at the time of Review. A DI designer determines the timing of the periodic Reviews with “quarterly” being the default value. In the chart, the ETF holding periods are labeled 1 through 6.
How Dynamic Investments Work
The bottom chart in the above illustration shows the growth of this DI’s value as at each Review event it purchases only the ETF that is moving up in price. It is then held until the next Review event.
Dynamic Investment Performance
During the period from 2008-2019 the simple DI illustrated above produced the performance shown in the top row of the following table as compared to the MPT portfolio discussed earlier.
The reason for the DI’s significantly higher performance is its use of an additional diversification element that we call “time-diversification”; i.e. the ETF it holds automatically changes over time. Thus, DIs use three diversification elements as listed below.
- Company – by working with ETFs
- Asset Class – by working with multiple, uncorrelated asset classes
- Time – by changing the one ETF the DI holds, selected based on the price trend of each at a periodic review
The benefits of time-diversity are many. Here are just a few:
- It makes a portfolio market-sensitive and able to detect and buy only equities that are moving up in price
- It has a built-in trading plan that bases trades on objective observations of market data, not on subjective human judgments – and by doing so eliminating a massive element of “human-risk” from the investing process
- It protects portfolios from market crashes by placing a trailing stop-loss order on the ETF owned at any one time. This is illustrated in Period 4 of the DI illustration presented above.
Time diversification changes the world of investing at a fundamental level, enabling investors to take advantage of the predictive power of equity price trends in a simple, safe and effective manner.
Adding “Methodology-Diversification” via the use of Dynamic Portfolios (DPorts)
While the Dynamic Investment discussed above can work perfectly well as the only investment in a portfolio, the NAOI knows that individuals are not comfortable allocating all of their money to one ETF at a time. So, as discussed in Article 4 and Article 5, we teach our students to use DIs as building blocks in traditional MPT portfolios. Adding a DI to an MPT portfolio makes it dynamic, market-sensitive and intelligent; having a built-in trading plan as described for the DI just above.
The diagram below shows the configuration of a typical DPort. It includes both a DIT and an MPT Segment with allocations to each being at the discretion of the designer. A “default” set of allocations that the NAOI recommends to our students is shown in the diagram.
Dynamic Portfolio Configuration
Dynamic Portfolio Performance
Following is the performance of this DPort for the period from 2008-2019 as compared to our other example investments.
You can see that while the single Dynamic Investment produced higher returns for the period, the DPort was less risky as indicated by its higher Sharpe Ratio. The NAOI found that students feel more comfortable with the Dynamic Portfolio as it, at all times, holds either two or three ETFs that track uncorrelated asset classes.
It should be noted that the MPT portion of a Dynamic Portfolio can be a portfolio designed by an advisor. Thus, investment advisors and financial organizations can simply use DIs as building blocks in the portfolios they are now creating. The added DI will enable the MPT portfolio to produce significantly higher performance with minimal disruption to current methods.
DPorts use four diversification elements as listed below.
- Company
- Asset Class
- Time
- Methodology – DPorts use both MPT, buy-and-hold methods and DIT, buy-and-sell methods, taking advantage of the best features of each.
As promised at the start of this Article we now have a portfolio configuration that utilizes 4 diversification elements. The first two in the above list, used by MPT, reduce risk but also reduce returns. The bottom two, used only by Dynamic Portfolios, not only reduce risk but also enhance returns. This is a huge advance in field of portfolio design.
Summary – The Benefits of “Thinking Differently” about Investing
In this article I have shown that a portfolio using four diversification elements provides significantly better performance than today’s MPT portfolios that use only two. The additional diversification elements are “time” and “methodology”. They are used by NAOI Dynamic Portfolios.
These valuable diversification elements were discovered by the NAOI R&D Division thinking differently about investing and stepping out of the MPT box in which the industry has been entrapped for decades.
The NAOI Education Division is currently teaching our students how to create, manage and use DIs and DPorts. Their positive feedback to this new investing approach has motivated us to expand our education channels to reach millions of investors, and we will do so in the fourth quarter of 2020.
As individuals learn about the benefits of DIs and DPorts, demand for them will grow. Advisors and financial organizations that offer this new approach will capture a massive new client base. Those that don’t will struggle to compete.
The NAOI offers Consulting Agreements, see this link, and Partnerships, see this link to show investing professionals how to meet the coming demand. And the NAOI’s new book explaining Dynamic Investment Theory, Dynamic Investments and Dynamic Portfolios in detail, can be purchased at this link.
Coming Next – The next Article of this Series, posted here in about two weeks, will discuss how Dynamic Investments and Dynamic Portfolios enable the Productization of Investing – the “Holy Grail” of investing that the financial services industry has been seeking for decades. They haven’t found it. The NAOI has.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.