One of the first lessons I learnrned about life, and myself, emerged on the tennis court.
Like many kids, I grew up playing sports… soccer (briefly), basketball (more briefly)… and many years of baseball and tennis.
And at the apex of my pre-teen growth spurt, I found myself still playing tennis with a “juniors” racquet that my parents and coaches were equally vying to rip from my tight grip.
The pleas were well-founded: “It’s too small.” “You’ll get more power from a bigger racquet.” “Adam… it’s time to move on!”
There wasn’t anything particularly special about that racquet I wouldn’t give up. It was lent to me by my dad’s best friend. It was well-wornrn.
But it was my racquet. My first, and only. And it felt so comfortable… like an extension of my arm.
Every other racquet I picked up just felt foreign and awkward.
I can’t actually remember the tipping point… when I finally caved and retired the “toddler racquet” (as my dad would jest). But I did fumble through a few weeks of practice getting acquainted with my new, properly-sized equipment. Eventually, it too began to feel comfortable in my grip.
And it gave me the power and reach I needed to take my game to the next level… state championships and all!
Switching racquets was definitely the right thing to do, but…
…it sure didn’t feel good.
Let’s face it: Humans are creatures of habit.
Knowing a bit about biology (my undergrad major), I realize there are evolutionary advantages to creating and executing habitual behaviors. This M.O. allows us to be more efficient with routine tasks, even paving the way for multi-tasking. Doing things we’ve done many times before helps us operate with confidence, which is a key to success.
But there’s also a detrimental side to habits. They prevent us from adapting to change.
We’re all aware “Change is the only constant.” That’s true in science and the evolution of species. And it’s also true in free markets.
In fact, the ideas of change, evolution and adaptation are central to Adam Smith’s view of free markets. Smith, the 18th century pioneer of economics, saw competition as the force that drives businesses to perpetually innovate… to adapt to an ever-changing business environment.
This system ultimately creates value for all. Businesses that can’t adapt to changing conditions die… and we’re better off without them. While businesses that do adapt thrive, offering better products and services at cheaper prices.
With all that in mind, let me ask you a personal question: When it comes to investing, are you still holding on to your “toddler racquet?”
For decades, it worked just fine to take a comfortable approach to investing. That involved buying a mix of stocks and bonds… and holding for the long haul.
And after years of success with this simple method, I fully understand that investors find most other strategies foreign and awkward… just like that new, properly-sized tennis racquet felt to me at first.
But, if you find yourself holding tight to old habits… you’re not adapting.
Financial markets are truly global these days. So looking only to the U.S. stock market for wealth-building strategies makes little sense.
Until recently, gaining access to foreign markets, let alone commodity and currency markets, was difficult for the average retail investor. Hedge funds traded them. But only institutional and high-net-worth investors could afford the fee structure and minimum investment levels these funds required.
The ETF (exchange-traded fund) has changed that.
The $2.3 Trillion ETF Market
Just as mutual funds revolutionized the investment landscape in the 1970s, the growing popularity of ETFs has generally been a win for retail investors.
ETFs give retail investors access to markets and sectors that were previously cost prohibitive. And they give investors the ability to trade in and out of positions instantly, with only a click of the mouse.
The Investment Company Institute publishes an annual Fact Book on industry trends. All 294 pages of this year’s report can be freely accessed here. There’s also an infographic by Kurtosys.com, which boils the data down nicely: The Growth of Exchange-Traded Funds.
One portion of the infographic shows the growing number of ETFs introduced… and the investment assets they’ve garnrnered:
Of course, the mere existence of ETFs doesn’t mean investors are automatically or properly diversified. In fact, the full infographic shows that a whopping $444 billion was concentrated in U.S. large-cap stock ETFs last year. That’s nearly twice the size of the next largest category: bond and hybrid ETFs.
For true diversification, you have to take a page from the hedge fund playbook.
Diversification… Precisely When You NEED It
I take issue with Wall Street’s traditional definition of diversification. True: small-cap stocks typically perform better than large-caps in bull markets, and worse in bear markets. True: utilities stocks and technology stocks perform differently during different phases of the business cycle.
That’s why the theory holds that a diversified basket of stocks should be less volatile than an all-eggs-in-one-basket approach.
But during bear markets, stock correlations rise dramatically. That means that most stocks — more than 80% typically — will fall in lock-step during times of turmoil.
It’s cruel. Just when investors need the protection that a diversified approach should afford… diversification — at least in the traditional sense — fails them.
The lesson from this is simple: You have to look outside the stock market for true diversification.
A perfect example of this took place in 2008 when the S&P 500 lost 38%, yet the Newedge CTA Index, which is a proxy for a true diversification strategy, produced a solid 13% gain.
That performance was possible because, as stocks were tanking, non-correlated markets were surging.
The Japanese yen jumped 19%…
10-year Treasury notes gained 22%…
And platinum surged 45% between January and March…
Of course, since early 2009 U.S. stocks have been the best game in town — some would say the only game in town — against the backdrop of the Fed’s punch bowl of monetary stimulus.
But now, stocks have started to stumble.
While I’ve spent years studying global markets, my primary focus over the last couple has been to recommend market-beating stock option plays to subscribers of my trading service, Cycle 9 Alert. This includes honing in on the best way to offer true, global diversification.
Adam O’Dell, CMT