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The Right Way to Diversify

The trend-follower says to pay attention to company size and location.

"Don't put all your eggs in one basket" is an oft-chanted mantra among investment advisers. Many investors equate diversification with portfolio allocation, defined as spreading assets among generally uncorrelated vehicles such as stocks, bonds and cash.

But what this really boils down to is a method that tries to guarantee mediocre returns by watering down the best performers with losers to protect against the "risky" side of your investments.

The

trend-follower's view of diversification is completely different. While portfolio allocation is a way to hedge your bets and minimize your losses, trend-following diversification is a way to boost your investments' performance.

Looking through the trend-following lens, diversification means including a variety of stocks and indices in your portfolio to reduce exposure to any individual stock. After all, if stocks traditionally bring in the best return, isn't that where you want your money?

Yes, it sounds risky. But not if you have a system that removes the risk when the market tanks. This is a key tenet of the trend-following risk-management discipline and should be part of every investor's strategy.

By following broad market trends, investors are able to maximize returns in both up or down markets by stepping aside, at the least -- or by shorting the market at best -- during down times. In doing so, you are able to manage your downside risk.

Also, I always recommend diversifying away from individual stocks. I think your most sound bet for bringing out the best in this approach is to choose an index-tracking or exchange-traded fund, both of which represent broad baskets of stocks.

In trend-following, we look at two primary ways to diversify:

  • By company size: for example, using an S&P 400 mid-cap index fund and a Nasdaq 100 large-cap index fund.
  • By geography: This is perhaps the most important diversification strategy. Why? One reason to diversify internationally is to hedge against a further decline in the U.S. dollar.

Another is that world economies have become joined at the hip in the last 20 years, as computers and instant communication put us closer together in real time. However, while world markets are generally correlated and move in sync, they don't all move at the same strength, or amplitude.

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In fact, currently, most international markets are outperforming U.S. markets. So, if you are diversified in the Russell 2000 and the Nikkei 225, the Nikkei is outperforming the Russell 2000 index. You may ask, if this is so, why stay in U.S. indices at all -- why not put all your money overseas?

Despite the serious challenges faced by the U.S. (ballooning national debt, escalating budget and trade deficits and two ongoing wars, to name a few), writing off the U.S. stock market is a decidedly shortsighted view. It still makes sense to stay invested in the U.S. market, because it's the most respected, stable and liquid market in the world.

Many Choices

Diversification possibilities and permutations are virtually endless when considering the number of investment vehicles available, including the numerous geographic-index ETFs and mutual funds (based on country or region) and the impact of any one investor's personal style and risk tolerance.

A solid "middle of the road" U.S. diversification plan is to allocate one-third of your portfolio to three primary indices, such as the Nasdaq 100, the Russell 2000 and the

S&P 500

. From there, feel free to experiment according to your own tastes and preferences.

In all, you should have no more than five funds in your portfolio. And yes, there is such a thing as too much diversification. Because trends typically last a year or more, you should be able to choose your funds based on the trend line you are following.

And always resist the temptation to outsmart diversification principles by heavily chasing last year's superstar. They are unlikely to crank out the hits year after year.

As far as which international funds to select, a basic guideline is that single-country and emerging-markets funds are notoriously volatile. Individual countries are more susceptible to falling out of sync with world markets than are regional funds -- even emerging-market funds.

Unless you have some insight into which country's stock market is going to do well, you are better off sticking with broader regional plays, such as a European, Pacific region or Latin American fund.

Frank Minssieux is president and co-founder of TimingCube (www.timingcube.com), a broad market trend-following model, and originator of its Trend Timing newsletter. Minssieux invites your questions and will answer as many as possible in future columns.