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While we wait on the Trump administration's proposal for reforming the tax code - a proposal that is likely to include a dramatic reduction in corporate tax rates - we might as well continue the discussion on how to build what I call "modern portfolio diversification" into portfolios.

To review, the idea here is to design portfolios that attempt to "be around" the benchmark return during most calendar years and then strive to "lose less" during those nasty bear market periods.

Last time, we discussed the idea of incorporating some form of risk management strategy into our portfolios. The idea is certainly simple enough; one attempts to reduce market exposure when risk factors are high. Piece of cake, right? After all, there are a gazillion different indicators available on the internet today to help you out with this. Heck, I even publish a pretty complete indicator review every Monday morning. So, finding indicators isn't a problem.

But here's the rub. History is replete with markets that saw risk factors stay high for very long periods of time. This type of situation can make one look/feel VERY foolish as stocks charge higher in the face of sky high valuations, a developing crisis, an unfriendly Fed, an external event, etc. For example, does anybody remember what happened during 1999?

If you will recall, stock market valuations were at never-before seen levels. It was a new era. Analysts were making up new indicators for the new paradigm because traditional metrics were clearly wrong. This time it really was different!

And yet, stocks kept moving higher, for months. In fact, the S&P 500 didn't actually start to decline in earnest until the spring of 2000.

So, if you tried to manage the risk of insanely high valuations that were present in 1999, you were made to look like a fool. Sure, the broad market indices struggled, but the NASDAQ kept ripping. Risk? What risk?

The point is that if you take action to avoid a potential storm, you must recognize that you could be wrong!

The storm may take much longer than you anticipated to arrive. The storm may not be as bad as you expected. Or, even worse, the storm may not come at all.

And then, what happens to your portfolio if you prepare for a storm that is either delayed or doesn't materialize as you expected? Severe underperformance, that's what.

A Dual Mandate

Lest we forget, we have a two-pronged goal here. I.E. a dual mandate. Yes, we want to manage risk or "lose less" when the bears come to call. But, we also want to "be around" the benchmark during most calendar years. And believe it or not, THIS is the hard part.

Thus, from our dual mandate perspective, being early is the same as being just plain wrong - because poor timing for an extended period of time likely means you won't "be around" the benchmark that year. Sure, you may eventually "be right." But it is vital to realize that we aren't trying to "be right." We are trying to "get it right" - year after year. And if you get too cautious too early, you run the risk of failing the first mandate.

So, one of the really big, really important lessons I've learned is that there is no one single methodology, no single strategy, and no single manager that can consistently achieve this dual mandate alone. Why not? Because, in short, all managers and all strategies can get it wrong from time to time.

An Oldie But A Goodie

This is where diversification comes in. But not the traditional approach that financial advisors have been promoting for eons. No, in today's modern markets, I believe we need to go beyond diversification by asset class and find a way to modulate exposure so that we can take more risk when times are good and less risk when times are bad.

To review, I don't believe these goals can be achieved via a single strategy or product. No, from my perch, one needs to utilize a diversified mix of methodologies, strategies, and managers – all in the same portfolio.

But to be sure, finding the right mix of investing methodologies, strategies, and managers that will allow us to try and "be around" the benchmarks most years and then "lose less" during big, bad bears is no easy task. But here's what I've come up with.

Start With the Core

We start by developing a healthy core to the portfolio. For me, this means allocating between 25% and 40% to passive or strategic allocation strategies. I prefer to use mutual funds here in order to let the manager try and create some "selection alpha," which can help the portfolio "be around" the benchmark.

Layer In a "Stratactical" Approach

Next, I like to layer on what I call a "stratactical" approach. This strategy starts with a risk-targeted asset allocation (for example: 40/60, 60/40, 80/20) and then focuses on overweighting and underweighting the primary asset classes relative to the overall environment. For example, in good times, such a strategy should be overweight stocks and underweight bonds and cash. Then when times get tough, bonds and cash are likely to be overweighted while exposure to stocks is underweighted.

The idea here is to get it "mostly right, most of the time," without making a big bet and risk being really wrong. This section of the portfolio can actually help achieve both mandates, albeit in a very slow-moving fashion.

Pour In Some Risk Management

From there, I try to incorporate a purely risk-managed strategy designed to raise high levels of cash in times of market strife. This is in there to help us "lose less" when the bears are mauling the stock market indices.

Sprinkle On Some Leverage (When Appropriate)

Next, I like to build in a turbo-charger, something designed to provide outperformance when times are good. To me, this means the utilization of the third alpha factor - leverage. This is where the gasps begin for more moderate investors. And yes, using leverage is certainly a higher-risk endeavor.

However, I'm not talking about exposing the entire portfolio to a 2X levered long position. No, I'm talking about exposing a portion of the portfolio to leverage (a level appropriate for the overall risk appetite of the investor) and then doing so ONLY when conditions are right. As such, we need to identify a way to sprinkle in some aggressive behavior at the appropriate times.

Salt to Taste

From there, the remainder of the portfolio tends to be allocated to what I call "dealers choice." Some folks want alternatives. Others want individual stocks or bonds. And still others want to play the global rotation game or dabble in emerging markets, gold, etc. And this is where taking a consultative approach to portfolio design is preferred over the typical "one size fits all," computerized approach.

In closing, it is my sincere hope that this little series on portfolio design has been helpful in some small way. Granted, we took a very high level look at the approach I prefer to use when building portfolios. But the big takeaway should be that (a) I strive to achieve the dual mandates of "being around" the benchmarks most years and (b) to lose less during severely negative environments.

And frankly, the age-old approaches to asset allocation aren't likely to get the job done in today's modern markets. As such, I believe you have to work at it a bit if you want to succeed in the long-run.

Thought For The Day:

Discipline is the bridge between goals and accomplishment - Jim Rohn

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of Trump Administration Policies
      2. The State of World Politics
      3. The State of the U.S. Economy
      4. The State of Earning Season


Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Sowell Management Services

Disclosure: At the time of publication, Mr. Moenning and/or Sowell Management Services held long positions in the following securities mentioned: none. Note that positions may change at any time.

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The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

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