After trying to decipher the carnage that occurred in the global markets and exchange traded funds (ETFs) during the financial crisis, financial advisers and analysts are starting to question the dogma of asset allocation and diversification.
Last year, asset allocation made a spectacular belly flop as investors saw their diverse portfolios disintegrate along with practically every market, writes Tom Lauricella for The Wall Street Journal. Some believe the market meltdown was a freak occurrence, but a number of influential investors and analysts argue that asset-allocation strategies are fundamentally flawed.
Diversification is a key component in the investment strategy, combining varying investments that don’t move up or down together. But the problem was that when this strategy was being formed, investments, like global stock markets, began to move in sync and disparate forms of investments were becoming more correlated, commodities being the exception with a slightly negative correlation.
Commodities were also becoming more readily available to investors through the advent of ETFs. Billions of dollars found their way into commodities through ETFs and as the financial crisis became more severe, commodity ETF investors pulled out to raise money.
Chief economist Michele Gambera for Ibbotson Associates tracked the performance during extreme market moves and found that investments could suffer more on the way down than perform well on the way up; thus, explaining the steep drop in global markets. Gambera calculated that in the months following the 1973 market drop, gold and intermediate-term government bonds were among the top performers. Treasury Inflation Protected Securities (TIPS) have also gained 85% of the time during 20 big monthly declines for stocks.
Where does that leave us?
While being diversified is important, this only strengthens the argument for trend following. Strategies in which investors use the signals of the market to determine when they buy and sell, instead of relying on strategies such as asset allocation and buy and hold alone, is proving to be more prudent. Investors can no longer bank on the markets being stable and rational, and it’s time for them to take a more active role in their portfolios to protect themselves.
By using the 200-day moving average as a signal to buy, you can give yourself the chance to get in and take advantage of a potential long-term uptrend. On the flip side, having an 8% stop loss or exiting when a position drops below its long-term trend line has you out before you’ve potentially ridden it all the way to the floor.
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Max Chen contributed to this article.