Actual Diversification
Perceived vs Actual Diversification
The generally accepted standard of diversification is perceived diversification, which is based on asset class variation and straight line correlation analysis. The problem with using this method of diversification is that perceived diversification does not protect assets during market downturns and critical junctures, as most traditional portfolios are heavily influenced by stock market risk.
Actual diversification – which is true tactical diversification – can protect assets in all markets.
The TTM approach provides actual diversification incorporating four major types:
- Adaptive Tactical Methodologies
- Time Frame Variation
- Market Basket Variation
- Underwater Correlation Analysis
Diversification through Adaptive Tactical Methodologies
Having multiple methodologies with different buy and sell metrics creates return streams that are not correlated with each other. This works based on the following market dynamics: Markets move in recognizable short and intermediate-term trends and countertrends.
Over the intermediate term, asset classes that are strong tend to remain strong; asset classes that are weak tend to remain weak. Over the short term, markets are dominated by noise, fear and greed. This causes markets to overreact to the upside or downside before eventually moving back to equilibrium.
Diversification through Time Frame Variation
Tactical managers need to determine what time frame to look at to determine the trend of the market. Most managers will choose only one time frame ignoring the fact that different time frames work better in different types of markets. Trend Aggregation diversifies by mixing multiple time frames as the market dictates. For instance, shorter time frames work best in straight up or straight down markets; longer time frames work better in choppy markets.
Time Frame Variation involves:
Concentrating on only one time frame can cause an investor to miss opportunities. This can result in a strategy that underperforms in markets that are not ideal for the time frame selected.
Diversification through Market Basket Variation
Trend Aggregation constantly evaluates all asset classes and market sectors when creating market
baskets which become the potential investment universe for the methodology. This is in contrast to
having fixed allocations to stock and bond markets.
Different market baskets can manage the risk vs. return component of a methodology.
For example, adding bonds to the basket can decrease risk and return, whereas adding commodities can increase risk and return.
Diversification through Underwater Correlation Analysis
While general correlation has some merit, Trend Aggregation puts a stronger emphasis on underwater correlation. This indicates the extent of correlation between different asset classes or methodologies during periods of drawdown. Either might appear to be uncorrelated when viewed over one or more market cycles. Asset classes or return streams, which appear uncorrelated during market upturns, can easily become correlated during market downturns.
Underwater correlation is a more important calculation compared to traditional correlation. There is little concern if all asset classes are performing well together. However, there is concern if they are all declining at the same time.