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As the market gets more volatile, Andy Crowder says there’s a better way than diversification to protect your portfolio.
Everything you’ve heard about investing from the mainstream media, your mutual fund advisor and your tax accountant is a lie.
I know that sounds overly dramatic, but hear me out.
Investors have been led to believe by the financial industry that the entire point of portfolio diversification is to mitigate downside risk. Yet, when the market experiences the inevitable return of the bears every sector pushes significantly lower – and your diversified portfolio suffers as a result.
The idea of diversifying your portfolio began with Harry Markowitz’s article in 1952 on portfolio diversification. And since that time, diversification has been the cornerstone of Modern Portfolio Theory and portfolio risk management.
Literally – the entire “retail” sector of investing, including all mutual funds, all 401(k) managers, index investing – it all grows out of that original diversification idea from Markowitz.
We have been taught to spread our investments across a healthy range of stocks across different industries to reduce our downside risk exposure.
The logic behind this approach to risk management (a form of investment portfolio “insurance”) goes something like this: If, for example, the retail sector falters, an entirely different industry such as consumer staples may be immune to whatever plagued the retail sector. If, for example, retail companies’ stocks plunge because a recession hits, broke consumers are not going to stop buying more defensive consumer staples like toothpaste and laundry detergent – so consumer staples stocks are less likely to suffer.
But, as you can plainly see from the chart below, when a bear market occurs like in 2002 and again in 2008, it doesn’t matter what sector you choose. While I have chosen retail and consumer staples for my example, all sectors fail during significant downturns, and fail miserably.
When Harry Markowitz came up with the Modern Portfolio theory in 1952 he wasn’t privy to the ultimate way to truly protect your portfolio.
The best way to mitigate and insure against downside risk literally did not exist in 1952. So while Harry did his best given the tools available at the time, his recommendations for diversification simply can’t provide real insurance.
It was roughly twenty-one years AFTER Harry Markowitz introduced his theory that real stock market insurance was brought to market. And even though it’s been another 40 years since that advent, most investors STILL don’t realize that the single best and easiest method of portfolio insurance even exists.
If you haven’t guessed yet, I’m talking about options.
And you probably didn’t realize it, but options were originally created to act as a form of insurance. That’s because options really are just contracts to cover your stock holdings under very specific circumstances.
While options were created to help investors mitigate risk, most investors are using options for speculation. That’s not how I use them in our Options Advantage and High Yield Trader services. On the contrary, you can use options to protect (hedge) your investments – across any sector.
But a good options strategy can be more than an insurance policy. It can also deliver cash straight into your hands – more quickly, and often more lucratively, than dividend-paying stocks. Using options as an income strategy can actually diversify your portfolio.
Whether we’re traders or long-term, buy-and-hold investors, we all want to protect our capital, especially in a market that is getting increasingly volatile. In my opinion, using options is one of the most effective ways to do that.
How to Make 13% a Month Trading Volatility
I recently held a webinar about the “New Bull Market” in volatility and the options strategies I am using to take advantage of it. If you are interested in learning my approach and how I use probabilities to my advantage please click here.