Diversification - It's Not Just A Word

When the financial markets are extremely volatile traders can feel their stress levels rising. But there is no reason to be stressed if you are well diversified. If a position turns into a losing one, and that position is only 10% or 20% of a well diversified timing portfolio, you will not feel the same as you would if it was your entire portfolio. Diversified portfolios are just as profitable, but you sleep better.

The current markets are quite volatile. Huge rallies but then scary and steep declines. And this week, more so the declines.

Volatility is great if it is within a trend, but volatility that only moves the markets up and down quickly can be quite unsettling.

Such markets are great for day traders, or should we say those who happen to be nimble enough to take quick profits. But can be very worrisome for those with longer time-frames. This includes most mutual fund traders, who must make trades with a one day delay.

While no one wants to lose, we must keep things in perspective. Remember the saying, "keep your losses small, and let your profits run." There are times when you generate small losses, and that is just a fact of active market timing and in fact all trading.

But we should not lose sight of the second part of the saying... "let your profits run." This is what all market timers and trend followers look for. There is always another trend, and when it begins, that is when the profits are made.

There are powerful trends in progress right now! Look at the U.S. Dollar Timer and Gold Fund Timer. They are examples of what happens when a trend is in progress. The Gold Fund Timer currently has single trade gains exceeding 70% and the trend continues unabated. The bearish dollar trend is generating headlines every day.

We would never recommend either of these strategies to be used for one's entire investing account. Both are just too volatile as stand-alone strategies. But as a portion in a diversified portfolio they can be substantial profit generators.

Diversification Has A Place in All Portfolios

This commentary will look at the sectors as an answer to market volatility. For those who find current aggressive trading unsettling, we also suggest looking at the Diversified Timing Portfolio.

The Diversified portfolio consists of five sectors, most with different time frames. The first 20% follows the aggressive Bull and Bear strategy, 20% follows a conservatively timed International fund (we may soon add this as a stand alone strategy), 20% aggressively follows the U.S. Bond market, 20% conservatively follows the S&P 500 and 20% aggressively trades the Small Caps.

Check out the Diversified Portfolio. It is considerably less aggressive than trading any one of the other strategies as stand alones.

Remember that while very aggressive timing strategies do incredibly well over time, they can be frustrating over short time frames. The Bull and Bear Timer has huge gains this year (in the 50% range), but it is taking it on the chin this week.

This is normal! Corrections are always violent and aggressive timers do not exit at the first sign of selling. That is a sure way to generate whipsaw losses.

If the current selling is keeping you up at night, look to diversification.

During volatile times it is comforting to be diversified. We have spoken about and recommended diversification within timing strategies many times in this column. Believe me, it has its place in your timing portfolio.

"This is proactive money management at its best. Constantly putting your money in the strongest sectors while removing it from the weakest sectors."

Now we will discuss the sectors. One of the easiest ways to diversify, while still actively trading the markets, is to use sector funds. Our Sector Fund Timer rarely has large draw downs, and is a powerful profit generator. Let's take a look at the advantages of sector timing.

Trading the Sectors

How does a mutual fund market timer take advantage of volatility, while protecting themselves from the very real risks such volatility creates, as well as from the potential draw downs that can occur during such times? The answer is by trading the sector funds.

Here is a quick list of reasons why:

1. Diversification: By having small positions in multiple industries, you reduce exposure to any single industry being affected by a negative news event.

2. Volatility: While individual sectors are no less volatile than the rest of the market, they do not move together. So the volatility to one's portfolio is considerably reduced.

3. Draw downs: Because sector funds go to cash during sell signals, and because there are always some funds in bull markets at the same time there are others in bear markets (during which those sectors are protected in money market funds), portfolio draw downs are kept to extreme minimums.

4. Good in All Markets: There are always single industries in their own bull markets. Even during a cyclical bear market, such as we experienced during 2000-2002 and again on 2008-2009, there were always some industries moving higher. And if not, you are still protected by being in money market funds.

5. Active Timing: Though sector timing is not aggressive, it is certainly active. You will always be trading the bullish sectors, and exiting the under performing ones. In some respects, it is the equivalent of running your own well managed mutual fund.

6. Trends: Industry sectors tend to trend. And when they trend, they often move further (in either direction) than anyone expects. During a strong bull run, it is common to find individual sectors that double the gains of the overall market.

6. Performance: Sector timing is unlikely to generate huge profits like the Bull and Bear Timer does. But sector timing does not subject you to the volatility either. There is something to be said for sleeping well. If you tend to worry about aggressive timing, look to the sectors, or switch to the Diversified Portfolio.

Winning the Battle

The FibTimer sector timing strategy covers 16 industry specific sector funds found in the Rydex Fund Family. Several other widely used fund families also have sector funds, including ProFunds and Fidelity Funds which can be used with our sector timing signals. If a sector is not covered by another fund company, just don't trade it.

Even in volatile market conditions the Sector Timer strategy performs exceptionally well.

"...A two or three percent drawdown in a sector, that is only one-sixteenth of your portfolio, will not cause anyone to lose sleep."

Because those industries which are poor performers will push their corresponding sector funds into cash positions quickly, sector timing winds up with only the most bullish sectors actually invested. This is proactive money management at its best. Constantly putting your money in the strongest sectors while removing it from the weakest sectors.

This is where the diversity inherent in sector timing stands out. Top performing sectors are where your timing funds are allocated, and no one sector can cause irretrievable damage to the portfolio should that industry collapse without warning.

Conclusion

Over the years, sector fund timing may go down as one of the best strategy ever created because of its ability to target funds into "only" those industry sectors which are performing well.

The low draw downs, low volatility and diversification inherent in sector timing, not to mention strong profitability, cause this strategy to stand out from all the others.

In volatile market conditions, such as we are experiencing now, sector timing can create profits when other traders are lucky just to be holding onto their capital. Draw downs, if they occur at all, are always limited. A two or three percent draw down, in a sector that is only one-sixteenth of your portfolio, will not cause anyone to lose sleep.

Note; we do not consider it a draw down if, for example, a sector gains 30% and then loses 5% in a correction. A drawdown is when your invested capital is decreased.

While sector timing may not make huge gains during bear markets, being mostly in cash, the strategy will protect your investment capital. And it will then perform well during bull markets, always keeping you invested in those industries that are in their own bull markets. And remember, bear markets are not an every-day occurrence.

Sector timing does require active participation. The FibTimer Sector Timer usually makes a change once or twice a month.

Sector timing also requires a minimum account size. Remember, there "could" be as many as 16 open positions at any one time, and closed (bearish) positions should be in cash (money market funds) with those funds remaining untouched. A good guess is that a sector timing portfolio should be at least $20,000 - $25,000 to start if using a Rydex or ProFunds account.

Sector timing requires only a couple of minutes a day to check for and make changes if they are needed. Fibtimer sends an emailed update each evening with any changes.

Be sure to read the "Trading Rules and Details" at the bottom of the FibTimer Sector Timer report page before using the Sector Timing strategy.