The Future of Investing: A New Diversification Approach

Another great comment came from a Seeking Alpha contributor, who happens to be a full-time investor. The reader suggested that combining some of the indicators mentioned might be good idea.

"Thanks for one of the best articles I've ever read tellingly refuting the commonly accepted myth of 'time not timing'... If one were to combine the 2 indicators you mention with all the other important back-tested leading indicators the evidence one can outperform the general market with astute timing is overwhelming. Too bad all those 'buy and hold until you die' sheeple in mutual funds will never read this article."

This brings up a VERY important point regarding what is likely the future of investing in general and diversification in particular: Creating multiple strategy portfolios.

The Old Way to Diversify a Portfolio

Traditionally, a diversified portfolio has spread assets across multiple classes. Modern Portfolio Theory (which, by the way, was developed between 1950 and 1970) has split portfolios among U.S. stocks, foreign stocks, bonds, and cash. And then more recently, the concept has been expanded to include additional asset classes such as real estate, gold, commodities, emerging markets, currencies, alternatives, hedge funds, and foreign bonds.

According to Wikipedia, "MPT models an asset's return as a normally distributed function (or more generally as an elliptically distributed random variable), defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets, so that the return of a portfolio is the weighted combination of the assets' returns."

In recent years however, the MPT approach has come under fire as evidence has surfaced that financial returns do not actually follow the prescribed distribution curve and that correlations between asset classes are far from fixed and can vary widely - especially in times of crisis.

Speaking of crises, investors learned (the hard way) that traditional diversification strategies did little to protect them from the two brutal bear markets that occurred in 2000-02 and again in 2008.

There are Ways To Avoid the Bears

On Friday, a single, long-term indicator was highlighted that has done a stellar job at keeping investors on the right side of the really big, really important trends. The idea is to review the technical health of the more than 100 sub-industry groups and use the weight of the evidence to determine when to be invested and when to be on the sidelines. It was suggested that if one was stranded on a desert island, THIS would be the indicator to have in your backpack.

Looking at the historical data, the system would have been right 88% of the time since 1980 and produced hypothetical compound returns of +18.2% per year (before fees, commissions, and taxes) when using a Long/Short approach versus +8.7% for the overall market.

But here's the thing... Even this indicator stumbles at times. It is vital to understand that NO INDICATOR IS PERFECT! Sorry folks, there is no such thing as the Holy Grail of stock market indicators.

So what's the answer then? How does one run with the bulls and still avoid being mauled by the bears? By diversifying your portfolio, of course. But PLEASE keep reading because today's markets demand a new approach to this age-old concept.

The NEW Diversification Approach

Again, this is not about diversifying by asset class here. No, the trick to creating an "all weather" type of portfolio that makes hay while the sun shines and seeks shelter when a financial storm hits is to implement what we'll call the NEW diversification.

When correlations amongst asset classes go to "1" as they have so often during all the crises that have occurred since 2007, traditional diversification is next-to useless as a means to preserve/protect capital.

What is needed is to create "true diversification." This involves incorporating multiple investment strategies and diversifying across holding time frames, manager methodologies, underlying asset classes, and most importantly, investment managers.

Creating a portfolio that utilizes multiple managers, strategies, and methodologies is likely the future of the investment business. The bottom line is that no single investment manager or firm can consistently "kill it" in all asset classes and all market environments. To think otherwise is sheer folly.

The Strategy for 2015 and Beyond

So, when you are plotting your strategy for 2015, think about this. Explore using more than one strategy and more than one methodology. For example, if you currently utilize a short-term approach, consider adding a long-term strategy as well.

Such an approach would have definitely been beneficial in 2014. While most shorter-term strategies have struggled to a certain degree this year, the longer-term approaches have ignored all the noise and kept investors "long and strong."

Thus, using a short-term strategy can help navigate the short- and intermediate-term opportunities in the market while a long-term approach will focus on the really big, really important trends.

In closing, if you want to stay on the cutting edge of the investing game, start moving toward "the NEW diversification" in your portfolio. Such an approach will likely smooth out the ride and hopefully create a lot less angst when things get nasty.