Last week’s foray into the passive investing side of the business was so fun, I’m returning to the well. If you missed Thursday’s Options Theory piece, go read it first because it provides the context needed for today’s follow-up.

Once again, I’m using a query (multiple queries, actually) from the great Jimbo to organize today’s post. It was asked in response to last week’s Options Theory article.

“This begs a new question… How would you diversify a “big” portfolio? You also introduced a sliver of doubt about one’s confidence (i.e., mine) in the market being able to maintain its existing lofty heights. Can you effectively time the market to move SPY and AGG to cash when the time is right? I get protective puts and the Bear Market Survival Guide. But when does it make sense to take your marbles and go home and wait for market conditions to improve like what happened in 2008? 2008 was a triple whammy. My 401k became a 201k. My 529 plan became a “29” plan. Real Estate was an albatross, and interest rates were bonkers. It was not a fun time to be an uneducated investor.”

Active vs. Passive

First, I want to re-emphasize the background of our discussion is passive investing, not actively trading. If Jimbo were asking how to diversify an active trading account I would point him to the expertly crafted S.T.E.P. System which includes the best blueprint & simulation I’ve ever seen:

In an active trading account, I would follow this template and use whatever cash flow/growth/speculation strategies I was the most confident in.

On to the questions at hand:

“How do I diversify a big portfolio?”

Diversification is a principle that scales. So, the method for spreading out your eggs in a $25k account is the same as if you had a $250k account. If you weren’t willing to experience the occasional bear market where your entire portfolio drops 30% to 50%, then you shouldn’t have 100% of it in stocks. The exact split between stocks and bonds would depend just how much exposure/volatility you’re willing to stomach.

Last week I shared a graphic that illustrated varying stock/bond splits and their accompanying volatilities over the past decade.

I will agree that some people may want to be more conservative with a larger account than a smaller one, though. Maybe you’re comfortable with 100% of a $25k account in stocks, but you’re not comfortable with 100% of a $250k account in stocks. If that’s the case, then I would hold more bonds/cash in the larger one.

Finally, some may add a real estate or commodity component to broaden the diversification.

Next comment:

“You also introduced a sliver of doubt about one’s confidence (i.e., mine) in the market being able to maintain its existing lofty heights.”

My remarks were not targeting the current market condition as much as they were referencing the time horizon of the investment. If someone has $50k in cash and they’re asking me if they should put it in a mix of stocks/bonds while learning how to trade instead of just keeping it in cash – then my answer is: it depends. The only reason you would be better off in stocks/bonds than cash is if they rise over your learning period. And since historically, stocks and bonds have a much higher chance of increasing over three years than three months, I like the idea better if you’re keeping it invested over a longer horizon.

The Bear Tamer

Final question:

“Can you effectively time the market to move SPY and AGG to cash when the time is right? I get protective puts and the Bear Market Survival Guide. But when does it make sense to take your marbles and go home and wait for market conditions to improve like what happened in 2008?”

First, bonds and stocks tend to have a negative correlation, particularly during times of turmoil. So when stocks dive bonds usually fly. That’s why bonds are viewed as a portfolio stabilizer or volatility reducer. Go look at how they performed in 2008 or 2011 or any other bearish episode. My point is you probably wouldn’t be running from AGG and into cash if the market was crashing. It would be the stock portion (SPY) you’d be worried about.

So what you really mean, then, is can I effectively time the market to move SPY to cash when the time is right?

The answer is NO, I cannot. I don’t trust myself to be in SPY when it’s rising, out when it’s falling, and back in when it’s rising. Not consistently at least. If I were trying to use a trend-following tactic like that though, my least bad idea would be using a moving average signal.

As for you “getting” protective puts and the Bear Market Survival Guide, I actually wonder if you do, in fact, get it. If so, you’ll realize that the Bear Tamer system outlined in the class IS MY SOLUTION to dealing with volatility and bear markets. My preferred method for handling a big, passively invested account is The Bear Tamer. Period. The End. I prefer it to simply riding out the bear market with my stock portfolio getting tarnished and hoping it ends quickly. I prefer it to timing the market and trusting myself to jump out and back in at the optimal times. I prefer it to any other method I’ve come across or heard of.

With the Bear Tamer, I never have to take my marbles and go home. I don’t have to time the market or wonder which 10% correction will morph into a mean, money-stealing, pain-inflicting bear market.

It effectively cuts the potential losses in bear markets small or large to approximately 10% to 13%. Or less if I’m managing well.

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