Asset Allocation vs. Diversification

Patterns for Profits Newsletter - May 1, 2008

There are two tried and true ways of minimizing risk in investments, asset allocation and diversification. These are similar but different methods of attaining the same goal.

Asset Allocation
Assets are stocks, bonds, and cash as well as your home or other real estate. If you run your own business, that is also an asset.

For the sake of the discussion of asset allocation we will limit assets to stocks, bonds and cash equivalents such as bank accounts and money funds.

The purpose of asset allocation is to protect wealth. The purpose of investment is to gain wealth. Investing all in one asset category can make you rich and it can also make you poor. Allocation of your assets to investments in each of the categories of stocks, bonds and cash helps protect you from the uncertainties of the stock market, interest rates, and inflation to name a few risks.

Common advice is to accept more risk when you are young. That means invest in the stock market. The same advice says to move to bonds and then cash when you are ready for, or in, retirement as these vehicles are less risk prone.

The problem with early stock market investing is that you may not be as good at it for a number of years and may lose money early. The problem with allocating all of your assets to bonds and cash in your retirement is that inflation or a depreciating dollar can rob you of the rewards of years of saving and investing. Besides, when you have come to understand the market and have more time for research and to execute timely trades why get out?

Diversification
Allocation of assets is to the various investment categories, stocks, bonds, and cash. Diversification of investments is within these categories.

Diversification of investments within the stock market is a common practice. Investing parts of your money in energy stocks, food services, computer stocks, medical growth stocks, and manufacturing is an example of diversification. The theory here is that the various sectors of the stock market balance each other so that if one sector has problems the others will be making money. The idea is to search out investments in each asset category that will perform differently in various market conditions.

The often unmentioned advantage of diversifying is that diversifying often means having a larger number of individual investments. Sometimes just investing in more stocks in the same category has the effect of diversification. An example would be two pharmaceutical companies with different products in development for the same disease.

The stock market is one of the most accurately priced investments there is. That is, the information about stocks is there for anyone who cares to do their homework. The risks are known. The stock market over the long haul outperforms other investments. Diversifying simply admits to the truth that despite all the information available in investing in the stock market there are unknowns that fool everyone. You need enough variety to protect against the unknowns. Diversification does this.

The Long versus the Short Term and Asset Allocation versus Diversification
Much of what is said about asset allocation and diversification of investments has to do with long term, “buy and hold” investing. And, asset allocation is still a valid concept for the technically advanced day trader. For example this individual will have a pool of money with which to trade, separate from other assets.

Diversification is another matter. Diversification is a valid concept for buy and hold investors. The idea is to understand what you want in the long term, buy the stocks that you expect to do well in the long term and check in from time to time. That is a little too simple but you get my point.

Diversification works differently for the more technically advanced trader. The person who spends the time, does the research, has the appreciation of the patterns within the stock market will execute trades and be in and out of a stock in hours if not minutes. This trader does not need to be in seven different sectors of the market, watching each while he or she tries to follow a complex trading plan for each stock. Over time a trader will move throughout the stock market sectors as opportunity presents. However, homework, diligence, and close attention to market movement will replace any need for wide diversification.

“Take home” points: Don’t be afraid to be conservative when you are starting up. Don’t get out when you know what you are doing. Don’t be afraid to trust your skills and trading plan once you have developed a proven system. For the savvy day trader asset allocation is still a good idea but diversification may just be a distraction.

The daily chart of the SP 500 shows that it has been trading at the upper end of the range that formed beginning with February 2008 highs. Price has tested up as high as 1404 but so far has failed to break to the upside. The FOMC meeting ends today and possibly that will be a catalyst to move prices either higher through the resistance or it is possible to test lower prices again.

By the time you read this newsletter the above will have been answered.

The lows made in March are important lows to continue to monitor. This is a large range that has formed and if prices do turn back down there are many areas of support that will be tested.

The Crude oil market traded as high as $120 and completed the daily AB=CD sell pattern that we had been posting. As it was approaching the completion smaller intraday sell patterns were forming as well, there were 5 minute butterfly sell patterns and 5 minute AB=CD patterns as well. This may be the highs for awhile in crude oil and should offer good trading opportunities.

Patterns for Profits Trading Tips

What does Oprah have to do with trading? Oprah is known for many things and has helped countless groups, countries and individuals, but specifically helping traders has not been on that list. Regardless she has possibly some of the best information available for traders; learning to be in the present moment. This concept is extremely important to successful trading.

The title of my new book co-authored with Larry Pesavento, ‘Trade What You See – How to Profit from Pattern Recognition’, is in essence exactly about being in the present moment when trading.

If traders can learn to be in the present moment then they can observe the markets perspective and then act accordingly. They can perceive opportunity and that is what trading is all about.

When traders sit in front of their screens and are remembering past trades this is a recipe for disaster and conversely if they are projecting future events this also is detrimental to trading. The only space to be in is the present moment when trading. This allows the trader to perceive the price behavior objectively and without emotion and then act on those opportunities.

Eckhart also discusses in depth “ego”. Ego and trading do not mix; there is no way around that. Paul Tudor Jones I believe stated that he “leaves his ego at the door” when he trades.

The last several weeks Oprah has been presenting a live webcast on Monday evenings with author Eckhart Tolle. His new book is titled, ‘A New Earth – Awakening to Your Life’s Purpose’ and discusses among other things staying in the present moment. I have listened each week as Eckhart discusses this topic and can easily see the benefits applied to trading. If you have not had an opportunity to read this book or listen to the webcasts you can download the webcasts for free at www.oprah.com.

Learn Real Trading … Real Time …with Real Traders – Online!

Visit our homepage to sign up for our 5 Day Free Trial

www.tradingliveonline.com

Leslie Jouflas
Kelly Hill