Since the spring of 2007, we’ve seen markets express extremes of seemingly boundless euphoria and truly gut-wrenching despair. Investors have participated in the depths of the negative side of that ride, in a truly up-close and personal way, by lacking an exit strategy: They have taken to the road in a vehicle that had no brakes, doors, or windows. And they have paid the price.

This should come as no surprise. The sheer weight of “buy”-oriented recommendations reflected in reporting, promotion and discussion on all media fronts and pushed by fund sponsor, fund research and brokerage marketing mills, all but buries any discussion regarding exit points as a means to truly protect capital and preserve wealth. Look to any of the media sources to which you regularly turn and judge for yourself the entry/exit coverage balance—or, rather, lack thereof.

Diversification At The Investment Strategy Levels

Most investors are quite familiar with the long-standing “street” mantra touting the merits of the practice of diversification across holdings within a given investment strategy. As Harry Markowitz clearly illustrated many years ago, diversification across holdings within a given strategy can help moderate risk within that particular strategy.

But diversification among investment strategies having varied performance and risk attributes can likewise help reduce risk. Few investors, though, are nearly so well-versed in diversification disciplines at the investment strategy level; that is, diversification across investment strategy approaches based on strategies’ market and risk participation characteristics.

For many investors, a single, stand-alone investment approach (especially one that carries truly open-ended downside risk) engenders far too much volatility and poorly compensated risk. That simply isn’t good enough.

Maintaining a favorable performance profile while limiting capital losses is the name of the game, and is as important to aggressive investors as it is to conservative investors.

To illustrate this perspective, a diversified portfolio of strategies might include the following complementary components, in proportions suited to the investor’s risk appetite:

Strategies imparting open-ended or uncapped risk to invested capital:

Strategies engendering conditional market participation, with explicit exit protocols to limit risk:

Strategies providing full principal protection:

Diversification across investment strategies is where investors and advisers need to extend their thinking, as it is where the bulk of return and risk potentials is defined.

Orthodox ‘Buy-And-Hold’ Strategies: The Good And The Bad

Diversified buy-and-hold strategies—whether in the form of a “passive” ETF asset allocation or committing capital to an active money manager—tend to do well during periods of relative calm and positive price trends, including those punctuated by minor corrections.

But portfolios comprising diversified buy-and-hold strategies alone, carrying open-ended downside risk, got pummeled from 4Q 2007 through 1Q 2009, and suffered significantly in 2000-2002 as well.

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