Portfolio Diversification: Truth vs Myth

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Sam Seiden

17 Dec, 2007

in Swing & Position Trading

Are you like many investors who go to sleep each night feeling safe and secure because their investment portfolios are properly diversified? Conventional diversification attempts to decrease risk and offer more opportunity for the average investor. However, when we observe conventional diversification protocol through the objective eyes of pure supply and demand, it becomes quite clear that conventional diversification actually increases risk and decreases opportunity.

The Foundation: Quantify Supply and Demand
As I have repeated so many times, the movement of price in any and all free markets is a function of the laws of pure supply and demand. Low risk/high reward buying and selling opportunity emerges when this simple and straight forward relationship is out of balance. Let's review the chart below to refresh how and why we quantify supply and demand as this will lead us to our objective opportunities for low risk gains and how to properly diversify.

This is a weekly chart of the S&P 500. Notice price level "A". For a period of time, price was stable, suggesting supply and demand is in balance (equilibrium) at that level. Once price moves higher "B", it is clear that there was no equilibrium at "A". In fact, we can now say that price level "A" represents a major supply and demand imbalance. We know this to be true because the only reason price moves higher from "A" is because there were many more willing buyers than sellers at "A", and it simply took time for this unbalanced equation to play out. You don't need a technical indicator or some professional to tell you this, it's simple logic. "D" represents the first decline in price to the objective demand level which is where we find our lowest risk/highest reward buying opportunity. For diversification purposes, this would be the ideal time to buy into the S&P 500.

"C" is just the opposite. It is a price level where objectively, supply exceeds demand. For a period of time, price was stable at level "C", and then there was a sharp decline. The decline tells us that there is much more supply than demand at "C". "E" represents the first time price revisits the objective supply level which is where we want to sell or sell short.

The Simplicity of Markets
Put quite simply, a trading and investing market is made up of three components: buyers, sellers, and a widget being bought or sold. These widgets may be shares of a stock, S&P futures, foreign currencies, bonds, and many more tangible and intangible "widgets". For example, let's say the widget is a stock. This stock has some value. That value or "price" as we call it is determined simply by the supply and demand for the stock, which is the ongoing interaction of all the buyers and sellers taking action with regard to that particular stock.

A market is always in one of three states:

  1. First, it can be in a state where demand exceeds supply which means there is competition to buy and that leads to higher prices. 
  2. Second, it can be in a state where supply exceeds demand which means there is competition to sell and this leads to declining prices.
  3. Third, it can be in a state of equilibrium. At equilibrium, there is no competition to buy or sell because the market is at a price where everyone can buy or sell as much as they want. However, as the market moves away from equilibrium, competition increases which forces price back to equilibrium. In other words, competition eliminates itself by forcing markets back to equilibrium.

The greater the supply and demand imbalance, the greater the opportunity
This is true when buying and selling anything, not just with your investments. While many "professionals" would have you diversify your portfolio by buying many different stocks or a "ladder" of bonds for example, a much more efficient, lower risk/higher reward approach is to identify the markets with the greatest supply/demand imbalance and risk your hard earned capital there. This is not all that different from stretching a rubber band. The more you stretch it, the more potential energy is stored, waiting until it reaches a threshold where that energy is released and it snaps back. The thresholds in markets where prices turn are the price levels where supply and demand are out of balance, period.

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