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Wide diversification and a ‘buy and hold’ strategy are not necessary for success. In fact, there are much better ways to hedge the market, capitalize on upside, and protect yourself from downside. Here is how I diversify my portfolio. Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett Every couple weeks I list my portfolio along with top-rated stocks to members of Tipping the Scale. I do this because my holdings often change depending on stock gains, valuation, and when new opportunities arise. Soon after my last update, a person noted that I did not own any materials, utilities, and was very light on industrial stocks and ETFs. He continued that for a portfolio of my size, he was surprised I did not prioritize “diversification”. My response is that I do diversify, just differently, and that my intention is not to track the market, but to rather beat the market. With well over a decade of consistency, my bottom line approach has not changed much, having worked very well in all markets. Here’s what I do. Rather than prioritizing industries and sectors of the market to achieve diversification, I diversify by purpose. Each holding in my portfolio fits into one of five categories, my sectors if you will, and thereby having a purpose. That category dictates management style, selection, and activity. Here are the five categories and the weight that each has in my portfolio Category Weight Top rated stocks 35% Dividend & Income Stocks 30% Deep Value 10% Growth & Momentum 5% Cash 20% Top-rated stocks are those that score in the upper echelon of companies covered in Tipping The Scale. Typically these are stock that score 88 or higher, meaning the company had to score relatively high in all 10 categories that TTS tracks. These include business growth, macro outlook, profitability, management vision, valuation, etc. Due to such a high rating, my theory is that “top-rated stocks” are worth holding through volatility, and should not be sold, only acquired in periods of loss until the company’s rating starts to decline. In the first three months of TTS, top-rated stocks (seven stocks with a score better than 90) traded higher by more than 9% versus a loss of 1% in the S&P 500. Therefore, these stocks tend to perform well both in short and long term, which is why they are such a staple in my portfolio. For investors considering my portfolio strategy, 35% of your holdings would be allocated to those stocks where you have the most confidence, and are the best of the best, however it is that you determine “the best”. Dividend And Income stocks provide some balance to my portfolio, as these are typically low beta, safe investments. Seeing as how 40 of the potential 100 points for TTS stocks are tied to business growth, macro outlook, and the amount of short and long-term upside in a stock, large companies with high dividends don’t typically rank as “top rated stocks”. Therefore, I hedge those types of investments with stocks that don’t necessarily have tons of upside or growth (i.e. AT&T (NYSE: T ) or Corning (NYSE: GLW )) but have high yields. These are companies that would rank high in other areas, but just don’t have the growth upside of a top-rated stock. Furthermore, this is where I put REITs like the Vanguard REIT Index Fund (NYSEARCA: VNQ ) and ETFs that have high yields. The key with the dividend and income section is to invest in entities that pay a high yield. The average yield of my holdings that fit into this section is 4.6%. With 30% of my portfolio allocated to dividend and income, that 4.6% yield for 30% of my portfolio translates to a 1.4% yield for the entire portfolio. Not to mention, often times a company that pays a dividend will fit into another category, thereby not considered part of the dividend & income section. A good example is Apple (NASDAQ: AAPL ) and Schlumberger (NYSE: SLB ), which fit into the top rated and deep value sections of the portfolio, respectively. All in all, the yield of my total portfolio is 1.8%, just about equal to the SPDR S&P 500 ETF Trust (NYSEARCA: SPY ). That gives me a downside cushion while also hedging my top rated holdings. With that said, the top rated stocks and dividend & income sections serve as a natural hedge against the other, limiting downside risk in the face of a market correction. The Deep Value and Growth And Momentum sections tend to do the same. Albeit, I don’t worry about how many holdings in each sector are in my portfolio, but by allocating my portfolio based on goals, you end up owning stakes in most industries. For example, energy and financial stocks trade at the lowest multiples and are mostly cheap because of macro-related factors, whether it be oil prices or low interest rates. This gives investors an opportunity to cherry pick top companies in those respective industries, those that have fallen below their worth because of macro-related concerns. My belief is that once those macro-related concerns stabilize, those top companies like Schlumberger, EOG Resources, JPMorgan (NYSE: JPM ), and Goldman Sachs (NYSE: GS ) will be the ones to outperform their peers. However, if those macro factors don’t improve, then not much of your portfolio is tied to such stocks. That said, there is certainly no valuation considerations for stocks included in my growth and momentum section. This is where I own companies like FireEye (NASDAQ: FEYE ), Facebook (NASDAQ: FB ), or speculative biotechnology companies. As explained in a recent blog , this is where I trade stocks based on their score in TTS. This is where I buy momentum stocks when volatility makes them cheap, and then sell when that price gets too high. Notably, if the market turns for the worse, these are usually the first stocks to go lower, and that’s why when owning such stocks it is good to keep a close eye and set stern stop-loss and limit orders. Finally, I keep a cash stake that equates to 20% of my total portfolio, which too fluctuates depending on the performance of the market. Believe it or not, cash is where investors can really hedge the performance of the market, and use volatility to their advantage. Below is a chart that I follow as a way to determine the size of my cash stake. Cash as percentage of portfolio S&P 500 performance 15% bull market 20% 2% to 5% off highs 25% 5% to 8% off highs 30% 9% to 12% off highs 35% 13% to 30% off highs 50% 31% or more off highs We are coming off a five year bull market that has seen very little economic growth, one that I fear has been driven by lower interest rates and multiple expansion. I have said on many occasions that I expect a correction. The problem is that there’s no way to know when that correction will come or how bad it will be. So, when the market starts to dip, I start cutting my growth and momentum stocks. If it keeps falling, I will trim value stocks that are hurt by macro conditions. Finally, if the market keeps going lower, surpassing that 30% from market high levels, I will start cutting dividend stocks. However, unless something changes the outlook for those high rated stocks, I will not sell, not until my price target is reached. With that said, this is a hedge that I have found to be very useful over the years. For one, both times that the market has exceeded a loss of 30% off its high since the year 2000, it continued to dip significantly lower. Therefore, I protect myself from future losses, and by quickly increasing my cash position and removing high beta stocks, while retaining low beta stocks (dividend), my portfolio tends to outperform the market. Then, by decreasing cash and increasing my stake in high beta momentum stocks, my gains tend to outperform the broader market as it recovers. However, the final and most important piece of the puzzle are those high rated stocks, because as I already explained, those stocks consistently outperform the market due to having the total package in those 10 essential categories. All things considered, the buy-and-hold, complete diversification strategy by owning all industries of the market is not a bad way to structure a portfolio, but I don’t think it is the best way, and neither does Warren Buffett. Instead, it is best to determine what you want from a portfolio, and then create it from those goals. Over the years, as my net worth has grown larger, I’ll be the first to say that my appetite for risk has diminished, and where I used to own more momentum stocks, I have since found high yield to be most important. However, the one thing that has not changed is my desire to own as many high quality companies as possible. In any market, those are the ones that thrive, and that’s why I would tell anyone to diversify by owning what’s best, and not to own a little piece of everything. Disclosure: I am/we are long AAPL, GS, T, JPM, SLB, GLW. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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