Making the Case for Diversification

VTS Community,

If you were to make a list of the most common buzzwords used in the financial industry, surely "diversification" would be right near the top.  Article after article talking about the importance of diversification, but what does that word really mean?  

According to many portfolio managers, diversification is when you hold a variety of different asset classes within the same portfolio.  This is meant to protect the investor in the event of a significant decline in the stock market.

But why do that at all? 

Since the stock market is the best performer of all the major asset classes, why not just hold stocks and just maximize rate of return?  Don't even mess around with bonds, precious metals, or emerging markets.  Just buy and hold stocks right?

The simple reason is, the vast majority of investors don't have the risk tolerance to sustain a 50% or more drawdown that does occasionally happen.  They'll pull the plug and miss out on any subsequent recovery.

Now in practise that doesn't work very well because we know that many of the major asset classes are correlated with each other and will go down together in a crisis.  The attempt at diversification only ends up reducing rate of return and the majority of investors underperform anyway.

However, the general concept of drawdown reduction is sound.

Why diversify at all?

Within our current suite of 5 strategies, why not just choose the one with the highest rate of return and simply put all our money in that one?

In our case, it's our VTS Defensive Rotation Strategy:

As our top performing strategy long-term it may be tempting for people to just allocate entirely there and don't even bother with the other strategies.  Let me try to make a case for diversification anyway...

Diversification reason #1)  We can't see the future

I launched Volatility Trading Strategies in January 2012, so now over 12 years later it's easy enough to check results and identify the best strategy to put all our money into.  However, that's backward looking.  We only know that information after it's already happened.

I couldn't have known in real time that was going to be the case, and still today I don't know if that's going to maintain going forward.  For all I know, Defensive Rotation will be one of the lowest performers going forward.  Now, I doubt it, but I don't have a crystal ball.

That's the same as the stock market.  It's easy enough to check the results going backward and state that stocks outperform other assets.

But what makes you so sure that will continue?

There have been periods where bonds significantly outperformed stocks, and even gold had a decent run of outperformance. 

It's the same with our VTS strategies.  There have been times when our Tactical Volatility strategy beat Defensive Rotation, and Strategic Tail Risk, Volatility Trend, they've also had periods where they did better.

* Recall that in 2022 the Defensive Rotation Strategy was down -38.87% where as our Iron Condor Strategy was up +26.06%.  Could I have know that ahead of time?  No, of course not.  We trade a diversified portfolio of strategies because we can't be sure which ones will have the best forward performance.  Markets change, strategy performance ebbs and flows, so it's best to spread out the risk.

Diversification reason #2)  Reduces maximum drawdown

Even if I could be sure the Defensive Rotation Strategy will continue to yield the best return, I'd still want to spread out the allocations to our other strategies for the purpose of smoothing out the performance curve.

People can easily look at the results after the fact and say, a 32% annual rate of return, sign me up!  However, the truth is in live trading a 40% maximum drawdown for the Defensive Rotation Strategy in 2022 is no joke.  In real time that's difficult to stomach.  

In contrast, our VTS Iron Condor Strategy has a lower annual rate of return at 16.51% but a much more manageable maximum drawdown at just -15.27%.  All investors can easily sustain a 15% drawdown and stay the course, which makes that strategy easier on the emotions.

Even with the best asset managers and the top performance, your ability to maintain allocation to the portfolio is going to be tested at some point.  Investing is hard and nobody avoids all rough periods forever, so true strategy diversification is always the best course of action.

50% Defensive Rotation Strategy  +  50% VTS Iron Condor Strategy

Just with a simple 2 strategy portfolio, Defensive Rotation and Iron Condors, we can significantly reduce the impact of those down years and get the drawdown to a level that most investors can tolerate. 

It's true that will almost certainly reduce the potential rate of return, but don't forget that if an investor pulls the plug on something in a drawdown then all of this is a moot point anyway.

Staying focused on my purpose

My goal is to give investors a high return portfolio that won't breach their risk tolerance, and they can be comfortable investing their entire investable capital for the long-term.  That's the only way to reach a comfortable retirement.

Chasing shiny objects because they have brief periods of tremendous performance, only to pull the plug during a drawdown will end up being worse in the long run.

-  We trade the VTS Defensive Rotation Strategy because very often it's the high beta tech stocks that perform the best and we can capitalize on these periods.

-  We trade the VTS Iron Condor Strategy because there are times the market just chops around sideways without making any forward progress, and market neutral Iron Condors will be the best performer.

-  We trade the VTS Tactical Volatility Strategy because the Volatility space allows us to quantify our entry and exit signals and profit from Volatility ETFs that mathematically track underlying indexes.

-  We trade the VTS Strategic Tail Risk Strategy because even though it's been a long time since the market all out crashed, it will happen at some point and we want to actually profit from that. 

-  We trade the VTS Volatility Trend Overlay because the structure of Broken Wing Butterflies on UVXY means we can add some portfolio Alpha without requiring any additional margin to open the trades.

The benefits of diversification aren't always obvious

During stable periods in the market when everything is behaving normally  (and certainly during a mostly 14 year bull market)  I'll admit it's hard to see why we wouldn't just trade the best one or two strategies.  I've caught myself pondering this once or twice myself in the past. 

However, the market has a funny way of reminding people of the benefits of diversification.  Just when you think you've got it all figured out, your best strategy underperforms and something that you weren't expecting to do well suddenly does. 

If I make sure all five strategies on their own out perform the market long-term, then putting all five together in a diversified portfolio will surely lead to the success we are all chasing.