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Diversification Is Not Enough
Ken Kam, 01.05.10, 06:45 PM EST
The stock market has belched blood twice in the last decade. Don’t be unprepared the next time it happens.

In the last decade the S&P 500 has suffered two severe drops–one of 46% and the other of 56%–that have ruined many people’s financial plans. We think the next 10 years are going to be more of the same: big booms followed by devastating crashes. If you cannot afford a 50% loss at some point in the next 10 years, you can’t afford a strategy of being 100% invested in the market all the time, even if you have a diversified portfolio.

Why? Because the big risks we are facing are systemic risks from which diversification will not offer much downside protection. In the past, systemic risk was generally ignored and the emphasis was placed on diversifying away other kinds of risks. Now that we have seen that a systemic crisis can result in the whole market losing half its value, we can’t afford to ignore it anymore. For this reason, investors need to pay as much attention to protecting their portfolios as they do to the performance of their portfolios.

The epicenter of the systemic risk we are facing is still the financial sector.

Is your portfolio ready for 2010? Click here for a new special investment report outlining Marketocracy founder Ken Kam’s 2010 game plan, including specific sector picks.

One of the biggest lasting effects of the financial crisis is the collapse of credit for small companies like those in the Russell 2000. This makes the ProShares UltraShort Russell 2000 ETF ( TWM – news – people ) a good choice for investors looking for some protection from another devastating systemic crash. If there is another crisis, small companies will fall hard just like last time, and this leveraged inverse ETF is designed to rise by double the daily drop in the Russell 2000 index.

If, as we all hope, the market is spared another crash, a contracting or slow-growing U.S. economy and a continued lack of bank financing create strong headwinds for small companies. In this scenario, TWM may lose money and you have to look at this as the cost of providing some protection against a system-wide crash. It may help to think about this position like fire insurance for your home. Is fire insurance a bad investment if your house doesn’t burn down? On the contrary, fire insurance enables you to enjoy an asset you could not afford to lose. There is value in that.

At this point, the SWAN (Sleep Well At Night) team has about 8.5% in double-inverse ETFs like TWM. Long positions make up 73% of the portfolio with the balance in cash. Since the 8.5% hedge consists of 2x leveraged ETFs, they offset about 17% of the long positions so the net exposure is about 56%.

The hedge position serves two purposes. It reduces losses in the event of a crash and provides some buying power to take advantage of the low post-crash prices so the portfolio can recover more quickly.

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Using inverse ETFs to hedge is preferable to shorting stocks (which is the conventional way to hedge) because if the market goes up and you start losing money on the hedge, the size of the inverse ETF position shrinks so it hurts you less as the market moves against you. In contrast, a short position that goes against you becomes a bigger position in your portfolio, so the pain increases the more the market moves against you.

Adding a little TWM to your portfolio gives you some protection from a systemic crash and enables you to sleep better at night with your portfolio of stocks even though there is a risk of losing nearly 50% in a crash.

In this era of systemic risk, investors have to protect themselves, because most mutual funds, index funds and ETFs are designed to stay 100% invested no matter what happens.

Ken Kam is founder of Marketocracy.com and Marketocracy Capital Management, a Web site and advisory service tracking the trades of the best online investors. Kam may hold positions in the securities mentioned in this article.


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