In a bear market, diversification reduces losses. In a bull market, diversification can reduce your gains. This is the trade-off all investors face. The price of decreased risk is almost always lower returns. Despite its disadvantages, holding a diversified rather than a concentrated portfolio is usually the best choice for an individual investor.
Diversification is also the best choice for many institutional investors, including the managers of large endowment funds at colleges and charities. Managers of these funds must balance current income needs and demands for growth of capital that will allow the institution to continue meeting its goals in the future.
Historically, diversification has been the best way to strike this balance.
One of the research papers we recently read showed how profitable it would be to perfectly time the markets. If you could invest each year in the asset class that would prove to be that year's biggest winner, $10,000 would have grown to $959 million in 39 years. That is an average annual return of 34.2%.
Of course that gain is impossible because it requires knowing in advance which asset class will be the biggest winner. We can never know what will happen in the markets, but we do know what happened in the past -- and that can be profitable information.
This paper showed how you could trade once a year, buying the asset class that had the largest one-year gain in the previous year. The average annual return from this once-a-year trading system was 13.9%, and $10,000 would have grown to $1.6 million in the 29 years beginning in 1970.
This strategy looked at seven different asset classes, all available as exchange-traded funds (ETFs).
-- iShares Dow Jones US Real Estate (NYSE: IYR)
-- iShares Russell 2000 Index (NYSE: IWM)
-- PowerShares DB Commodity Index Tracking (NYSE: DBC)
-- SPDR S&P 500 (NYSE: SPY)
-- Vanguard Total World Stock Index ETF (NYSE: VT)
-- iShares Barclays 7-10 Year Treasury (NYSE: IEF)
-- iShares Barclays 1-3 Year Treasury Bond (NYSE: SHY)
The rules for this trading system are simple. Every January, calculate the total return for each ETF over the past 12 months. If the current holding is no longer the leader, sell it and replace it with the ETF that is the new leader.
That's the entire system. For such a simple strategy, the returns are impressive. The downside, however, is this system does not create a diversified portfolio since it is invested in only one ETF at a time.
To create a diversified portfolio, we recommend making the strategy just a little more complicated. Divide your initial investment into eighths and buy each of the seven ETFs with one eighth of your portfolio. Use the remaining eighth to apply this momentum rotation strategy. In addition to placing the momentum trade once a year, also rebalance your portfolio at that time. This would have gained an average of 10.6% a year since 1970.
You could also use options for the momentum strategy and increase your returns significantly.
With this variation of the strategy, instead of investing one eighth of your account into the ETF with the highest total return in the past year, you buy long-term call options on that ETF.
Call options give you the right but not the obligation to buy the underlying ETF at an agreed-upon price (known as the exercise price) before the expiration date of the option. You can find options with one year or more to expiration on most of the ETFs used in this strategy, and options with at least to six months to expiration will be available on all of them.
Options provide leverage, and you can see significantly larger gains when the options trades turn out to be winners. The risk of the option is limited to the amount you paid for the call.
At-the-money options with about a year to expiration should cost about 6% to 10% as much as the ETF would. We will use 10% in this model. That option should deliver an average gain of about 30% over time. When combined with the gains from the diversified portfolio, your total returns should be about 12.2% a year.
The rules are to allocate 12.8% of your portfolio to each of the seven ETFs identified above and rebalance these positions once a year. Use the rest of your portfolio to buy long-term options on the ETF that has the largest total return in the past year. Use call options with an exercise price near the current market price of the ETF.
We understand this system will require a little effort to implement, but the results should reward investors who make that effort.
Regardless of which system you prefer, you should consider maintaining a simple-to-manage diversified ETF portfolio and use options to boost the returns of that portfolio.
This article originally appeared on ProfitableTrading.com
This One-Trade-A-Year System Averages 12.8% a Year in Gains