Why Traditional Portfolio Diversification Has A Major Flaw

portfolio diversification

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Ever heard the saying "A rising tide raises all ships"?

You know the idea that in a good market all stocks will rise together. Sure the better companies might rise faster than weaker companies but yet they all rise in value.

Likewise in a falling market even the great companies will take nose dive.

It's this classic thinking that actually might get you into trouble regardless if you diversify your portfolio or not.

And I've got a completely new spin on the idea. . .

Diversify Your Portfolio Over Time Not Sector

From a very young age we all hear the same damn thing about investing; diversify your portfolio. Separate out your money into many different assets so that one stock/sector doesn't carry too much risk.

While I don't disagree with the benefits of diversification because they are important, I also think it's equally important to diversify over time. As I'm sure most of you experienced in the last 5-10 years, when the market/economy fall there is very little that is safe for investors.

A diversified portfolio did just as bad as many stocks during the 2007-08 market crash. What's the point if the tide moves the broad market regardless?

Now if you had a portfolio diversified with strategies that profited based on different time frames you might have done better (dare I even say make money!).

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How Can You Use "Time-Diversification"

Okay, you're starting to see my point that is good but how exactly do you do it? Let's walk through it. . .

First you have to understand that we need to focus on the calendar and pick strategies that are geared toward making money at spaced intervals; 1 week, one month, 2-5 months, 1-3 years, etc.

There is no set formula on the timelines, but the point is to have multiple time frames and then diversify within those timeframes.

So you might trade weekly options each month coupled with some monthly credit spreads (like the ones we focus on here at Options Alpha) and then LEAP options.

As each passing week and month go by you'll continue to trade short-term, medium and long-term strategies. These positions are meant to create streams of income at different points in the future.

If you continued to follow, this mentality and the market crashed you could quickly adjust your weekly options followed by the credit spreads. Sure the LEAPS would take a beating but you could make up a lot more money trading the shorter timeframes and making faster adjustments along the way. And remember the LEAPS are long-term plays so you shouldn't be that concerned with short-term changes in value.

A well-rounded and "diversified" portfolio of stocks during a market crash would leave you little room to make adjustments other than selling at a loss and possibly shorting? Sounds like you've pinned yourself into a hole. . .

Ever Thought of Diversification This Way?

In all the investing you've done have you ever thought of diversifying over time instead the sector? Picking strategies that create profits at spaced intervals.

If you have, I'd love to hear how you set up your trades. If not let me know what you think of this idea and if it's something you might consider adding to your portfolio? Add your comments below and share your thoughts!

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.