The above chart represents the return for nearly every combination of equity investments you could have made over the last year. No sector, style, world region or market cap escaped devaluing more than 25%. Compare this to the start of our last recession between 2000 and 2001. 

Just within U.S. equities, proper diversification likely could have avoided 40% losses caused mainly by one sector. And, in fact, it was eminently possible to find a safe haven sector (ironically, financials) to hide from the carnage. 

While The Curious Investor and most investing blogs our there focus mainly on equity investments, the past year has taught us that the old adage, “There’s always a bull market somewhere,” is not always the case for the equity markets.  Or, is it? 

Diversification is more than buying stocks in different industries and geographies
Risk comes in many types. Diversification through different companies and industries can help to insulate you only a few unsystematic risks namely industry risk, company specific event risk, and geopolitical risk. To properly diversify, you need to consider investments outside of equity markets – asset allocation.

Asset Allocation with a Brokerage Account
It can be difficult for retail investors to access non-equity assets. Most brokerages offer some access to U.S. Treasuries and other government or municipal bonds as well as a small amount of corporate bond placements. But, these can often come with significant fees or minimum investments. There is a more cost effective route. Ironically, these investment vehicles trade through typical stock exchanges. Just as The Curious Investor has previously discussed using ETFs and ETNs to create hedges and passive indexing, it’s possible to use ETFs and ETNs to gain access to assets outside of the markets.

For me personally, given the state of our economy and the likely pressures on the U.S. dollar as a result of policy actions to remedy the situation, I’m interested in adding commodity exposure (click to check out my rationale on gold and oil) and foreign bond exposure. It just so happens that there’s an ETF for all these purposes – IAU, OIL, and IGOV (and more if you look around). While the IGOV was brought to market less than a month ago, data for IAU and OIL show correlation of .20 and .33, respectively. About as uncorrelated as a risk asset can get and exactly what you’re looking for when properly diversified.

Now, this strategy works quite well in allowing you to capitalize on a good stock pick while at the same time offering protection of your invested capital, but unfortunately it increases the number of transactions involved in a round trip investment as it necessitates multiple sales. Obviously, you’re not going to sell incrementally on every 1%, 5% or even 10% gain. Furthermore, the ability to sell shares incrementally also depends on how many shares you’re able to buy. If you bought 2 shares of Google at $500, selling just one share at $600 would decrease your exposure below your target amount.

Herein lies one of the difficulties of having a small portfolio and one of the reasons it is so difficult preserve capital in a small portfolio. There is very little room for error as partial selling is typically impossible unless you manage to get a double in your stock pick. It’s also the reason why you’ll rarely see me announce partial “taking some off the table” sales in my portfolios on this site. Unfortunately, it also increases risk since, as positions grow, the portfolio becomes disproportionately weighted to the best performers which will at some point also become the most overvalued.

A good example of this is my position in China Mobile, the initial investment which sparked my interest in trying to learn to time sells. I bought this stock in the mid-forties and it quickly ran to the mid-fifties before turning down. The trader in me could have quickly sold for a 15% gain in just a few weeks, but the technicals signaled that there may be more to the story. I held on and the stock quickly rocketed to new highs.

Here, the play worked marvelously as I eventually was sitting on a double in my investment. Now, the true sell signal was made about halfway through the above graph when the stock dropped precipitously from its high near $105 and subsequent rallies were unable to attain new highs. Lower highs followed, before the bottom dropped out and the stock fell into a trading range between $70 and $80. (Sidenote: I should have sold near $90, but the markets were in such a frenzy and China Mobile’s fundamental story remained sound so in lieu of other opportunities, I decided to hold on.)

As you can tell, my sell strategy is not very refined as of yet. And, to my own demise, I do not often follow it in a disciplined and stringent manner. The moral of the story as far as selling stocks is that selling for profit is always good. Yes, capital gains taxes can be a pain especially short term capital gains, but just remember if you’re paying taxes it means you made money! Strategies as simple as sell whenever you make $50 or 10% or whatever else work as well as any others. The number one rule of investing is DON’T LOSE MONEY. In the end, compounding will take you just as far as those few home run stock picks. (A lesson I should have learned by now.)

So, for those of you who aren’t simply experimenting with investing strategies in your portfolios as I am here, make sure to take some time and pick a strategy that works for you. The basic principle is to sell when you have realized acceptable return on your investment. Don’t get greedy or feel bad if you “sell early” on a stock. Unless you’re a financial whiz or clairvoyant, it’s very difficult to time the very peak of a stock’s advance. In fact, value investors almost never hit the top as a top often marks the territory of hyper-inflated value based on irrational expectations. Instead, pick your targets realistically and sell when you reach them. It could be as simple as saying to yourself, “I want to make $100 on this investment,” or “10% in the next 6 months is great return,” and sticking to it.

Finally, learn to identify trading ranges and support levels before any purchase of a stock. Then, watch these levels and aggressively cut your losses. A good thing to remember is that, with any stock pick, you’re wrong until proven right. This way you won’t sit on losers trying to convince yourself that your research was good or that the market just doesn’t understand what you see. If you don’t have time to do this, simply give yourself a disciplined stop-loss somewhere around 8-10%. This way, your downside losses will hopefully never be as great as your gains, thus helping you to keep money in your pocket and keep the powers of compounding at work.

An Investors’ Perspective (Aetna)
Given the current market climate, I’ve found myself often repeating Ben Graham’s mantra, “In the long run, the market is a weighing machine. In the short run, it is a voting machine.” What this basically means is that a person who invests with conviction and with fundamental principles should not worry about near term and, often unavoidable, event risk. Instead, you should hold your investments with confidence that as future events unfold, short term shocks will be smoothed out and overcome.

No one likes to lose money from day to day, but with my investment in Aetna and my strategy for Portfolio B as a whole, it is important to keep an eye towards my underlying reasons for investing in Aetna. My investment thesis goes as follows:

• Industry leading ability to manage costs and provide innovative products
• Positioned to benefit from increasing political support for mandated healthcare
• An industry which should maintain demand even in an economic slowdown
• Positioned unlike any other large firm in the health insurance industry to grow revenues through expanding enrollment

These basic operational and strategic points were supported by the fact that the company seems to have embarked on an effort to expand enrollment and has subsequently submitted six straight quarters of impressive year over year growth and continues to project 15% growth throughout the next year. Generally speaking, I expect P/E in the range of 10-12 for a company with minimal growth, yet this firm is set to grow earnings well in excess of 10% and thus I had an expectation for the stock to reach a value north of $60.

As Aetna has reaffirmed its profit outlook (albeit with little mitigating affect on today’s drop in share price), I do believe that my fundamental reasons for investing in this company remain in tact and I should be willing to continue to hold despite my current paper loss. In fact, if I had more money to commit, it may even be prudent to begin allocating into this position so as to cost average down my buy price and hopefully profit more as the company’s performance and improving market conditions bring the stock back to my fair valuation level.

Truth be told, the stock did reach “fair” valuation for a brief moment about a month ago and I likely should have considered a sale then, unfortunately, subsequent market volatility beat it down faster and with more vigor than I would have anticipated. Here, is where I made the mistake of investing in a stock without a significantly high margin of safety. My fair valuation for the stock translated to about a 20-25% gain on my buy price. This left little margin in the case of near term event risk and, as a result, I’ve paid the price. I do, however, intend to continue to hold this stock provided new information surfaces which changes my intrinsic understanding of the company and its operational strategy.

A Trader’s Point of View (HUM)
Humana was a company that I picked based on my proposed earnings beat strategy. The company’s stock looked to be coming out of a longterm base (nearly 1 year long) and had been on an even longer uptrend (a continuum of higher lowers and higher highs lasting 5 years). Earnings performance had recently improved significantly with quarterly reports showing upwards of 30% year-over-year growth with little response in the stock’s price. I projected the stock’s basing to be completed and primed for a breakout right around the same time as its Q3 2007 report and I positioned myself to buy. Things worked swimmingly with a pop on earnings, but subsequent doldrums due to political pressure. (Humana, it turns out, is unique in that it makes most of its money off of providing Medicare coverage and politicians were unhappy that it could be so profitable doing so.)

Despite this, technicals remained strong, and I held the stock expecting a continued run now that it’s earnings performance had been “discovered.” Q4 earnings were strong once again and the stock roared to near $90/share. It was hear that my weak sell strategy cost me. Early in my investing experience, I lost out on significant earnings with some stock picks (notably GRMN and TIF) and I decided this year to focus on trying to find exhaustion sell points. That is, chart and indicator patterns which signify a rally is over. Typically speaking, this involves waiting for a data point of a high followed by a lower high.

Again, inexperience seems to have cost me, as this strategy necessitates a stock to bounce after an initial shock knocks it off a rally. Here again, in this volatile and uncertain market, buying power was not around to produce a typical bounce for Humana. The stock swiftly fell back to break out level where I thought that it had found buying support. Clearly, after today’s action, the support is gone. Humana’s stock has fallen out of its breakout price level and below that of critical support at its previous base level. This indicates to me that the supply and demand equation for this stock has all but evaporated. I have no intentions on continuing to hold this stock and will likely look for an opportune time to unload my position after today’s initial sell-off.

1 Year Portfolio Performance Metrics (right click -> save as)