WATCH: The 4 Stage Stock Market Cycle

Articles

In The Market's Darkest Hour, Your Diversification Fails

By Chris Rowe June 14, 2022 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

The last three trading days are creating panic. With the market gapping down to open the last two sessions and closing near the lows, it feels like we’re on the brink of a full on market crash.

I’ve been telling everyone to go to cash. If you want to be long the market, you better be in very select commodity-based stocks. Otherwise, you should already be in your bearish positions and possibly have a couple of bullish hedges for bear market rallies.

But most of your portfolio should already be in cash. And so while watching the market fall for the last couple of days is probably making you sweat, at least all you have to do is wipe your brow and move on.

For all of those financial advisors out there who discouraged their clients from selling, telling them not to worry because they have a balanced, well-diversified portfolio, I have something to say to you.

You’re full of it.

Traditional Diversification Doesn’t Work, Here’s Why

Everything is getting sucked down with the market right now. Even commodity-based stocks and bonds.

And we have not even entered into a full crash phase yet. The market is still testing a major support level. Take a look at the iShares Russell 2000 ETF (IWM), below. IWM is testing the 50% Fibonacci retracement from the COVID-19 low to the November 2021 high.

(Click any image to enlarge)

What market segments are going up right now? None. 

Take a look at the Energy Select Sector SPDR Fund (XLE)—an ETF representing the strongest sector in terms of relative strength of the 41 sectors we watch—Oil & Coal. It's falling with the rest of the market.

What about bonds? They’re falling apart with the rest of the market too. In fact, they’re very correlated to the market right now as interest rates go up and inflation worsens. Take a look at the iShares Core U.S. Aggregate Bond ETF (AGG).

When the market and sentiment are falling apart, investors just start to sell. I’m especially talking about the big investors. When the market breaks through significant levels of support, fund managers’ algorithmic systems have automatic sell orders in place.

The traditional, so-called “60/40” (60% stocks/40% bonds) diversification strategies, that most financial advisors recommend, make no sense. And it’s when the market is falling that investors need diversification to be the most effective.

Diversification is a risk management strategy after all. The idea is that when certain portions of your portfolio are struggling, other uncorrelated portions are doing well, buffering the losses of your entire portfolio.

But if all portions of your portfolio are falling apart, then diversification is failing you just when you need it most.

Right now is the time to be in cash. The market will reach a bottom, and when it does, you’ll have the money to buy back in.

We’re Not Yet In the Market’s Darkest Hour

The good news for those of you still holding onto your stocks—clinging to a “buy and hold” approach—is that you’re still not too late.

The market has not crashed yet. In fact, we’re probably far from the bottom.

But now is your last chance. And let me be very clear. I’m not even saying the market is going to fall 50%. That would be bad enough. But it gets worse.

If your portfolio is super correlated to the market, and the market falls 50% from a high, you’ll then need the market to return 100% from there just to get back to where you were at the end of last year, when the market was peaking.

But the risk of a 50% crash is real And that’s all you need to know to make the smart decision.

I can list reasons why the market could start to go back up. Here are a few.

    1. The Fed could tell everyone they won’t be raising interest rates anymore this year.
    2. The war between Russia and Ukraine could end.
    3. Inflation could slow down.

Do you really want to bet on any of that happening? You would have to be quite the counter trend trader to bet your future on any of those things.

Do I hope the market stops falling here and rebounds? Yes. But as I always explain, the most important part of trading is risk management.

If you’re sitting with your fingers crossed, hoping the market rallies back up, then risk management is the furthest thing from your mind. 

And traditional diversification strategies won’t save you either.

You need to be a bear right now, because we are in a bear market. And if you really want to diversify your portfolio, you need to use different trading strategies that have uncorrelated performances over time.

Those strategies can perform well together at times, and poorly together at times. But overall, your different trading approaches need to show they are uncorrelated to one another in terms of performance over time.

That’s the only way to truly diversify your portfolio. That’s why we offer education on such a wide variety of trading strategies here.

Not all the strategies will be right for you. It’s important you take the time to understand the risks of what you’re investing in and that includes if you have the time to dedicate to it.

But we endeavor to teach you what you need to make the best educated decision possible.

Together, we can navigate this market. I’m here for you. We’re here for you.

Chris Rowe

Founder and CEO, True Market Insiders

Archives