The New Science of Diversification

There have been numerous articles in recent months saying diversification doesn't work and others reassuring investors that, yes, diversification still works.

As with many debates, the answer might be in the middle. Investors may need to come to grips with the idea that they still need to diversify, but there is an evolution both in the science of portfolio construction and the management of a diversified portfolio in stock-market cycles.

Tying the concepts I've been writing about for several years along with work done by others including RealMoney contributor Mebane Faber, we can explore how to account for the continued need to get a return on savings and acknowledge that buying and holding all the way down through a bear market is not comfortable for many people.

Starting at the asset-class level:

• Domestic equities, 20%: iShares Russell 3000 Index Fund (IWV Quote).
• Foreign equities, 15%: SPDR ACWI ex-US ETF (CWI Quote).
• Commodities, 5%: PowerShares DB Commodity Tracking Fund (DBC Quote).
• Domestic bonds, 10%: iShares Barclays Aggregate Bond Fund (AGG Quote).
• Foreign bonds, 10%: SPDR Barclays International Treasury Bond ETF (BWX Quote).
• Inflation-protected, 10%: iShares Barclays TIP Bond Fund (TIP Quote).
• Absolute return, 15% (5% each): Nakoma Absolute Return (NARFX Quote), Rydex Managed Futures (RYMFX Quote), Dover Long Short Sector Fund (DLSAX Quote).
• Cash, 15%.

The above allocation is intended to be very conservative and capture most asset classes while not adhering to buy-and-hold. Over the last few years, I've written several articles about taking defensive action within the portfolio when the S&P 500 falls below its 200-day moving average, or DMA, and getting fully invested when it goes back above its 200-DMA. This approach can also work with individual holdings.

The basic idea is to pick a simple but effective proxy for the asset classes you believe are important, weighted suitably and own them when they are above their respective 200-DMAs and be out of them while they are below their respective 200-DMAs. Being out in this case means holding cash as opposed to buying something else -- this would defeat the purpose of the defensive action.