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The Commitment of Traders data published by the Commodity Futures Trading Commission (CFTC) supported the idea that noncommercial investors in the futures markets adopt a trend-following approach. The hedging desires of the producers and those of the primary consumers are not symmetrical. When prices trend higher, the producers will have more of an incentive to sell but the primary consumers will have less of an incentive to buy, and vice versa. So the need for the outside investor will increase as the strength of price movement increases.

This argument is supported by the characteristics of the investor community. Most of the outside investors' funds are arranged in some sort of trend-following approach.

Even during the strongest of bull markets, not every investment rises at the same rate. This range of performance among different investments has led to money managers developing strategies to dynamically allocate among a choice of investments.

Individuals, professionals and institutions diversify their investments over several asset classes to seek a specific return versus risk objective. An example of a typical allocation might be 33% Equities, 33% Interest Rate sensitive instruments and 33% Commodity futures markets. Such allocations might be adjusted for investor risk tolerance and/or economic conditions, such as long-term interest rate, inflation, manufacturing capacity utilization, employment level and business cycle position. Usually, many factors are analyzed in combination to determine an asset allocation.

There are at least three approaches to asset allocation: strategic, tactical and dynamic. In strategic allocation, the investor allots a fixed percentage to several asset classes for a long period. Periodically, the portfolio is adjusted to bring it back to the original allocation weights, by selling winners and buying losers. When the return from one asset class rises, another typically declines, which reduces overall return.

The next approach is tactical asset allocation. Here, the investor changes asset weights by large increments between a few asset classes, based on market return predictions. This can be accomplished by either shifting resources from one business sector to another, depending on business cycle knowledge (this is known as sector rotation), or by utilizing classical market timing, which invests in stocks in up markets and cash equivalents in down markets. Classical market timers generally use technical and/or economic indicators to move between a specific asset class and a cash equivalent.

Dynamic asset allocation is the third approach, and it is the one in which the investor shifts capital among several asset classes, depending on market conditions.

IN PREVIOUS STUDIES

The five best mutual fund newsletter portfolios tracked by The Hulbert Financial Digest (as of 1995) have an average yearly return of 8.5% over the eight-year period ended August 31, 1995. This compares to a Wilshire 5000 total return (price appreciation and dividends) of 10.3% annually. In 1996, Hulbert reported that only five of the 30 bond-timing newsletters beat the average buy-and-hold Shearson Lehman Hutton All-Maturities Treasury Index of 7.5% per year over the five-year period ended August 31, 1996. The highest-performing newsletter obtained a return of 9.1%. Digest publisher Mark Hulbert observed that about 90% of the variance in the long-term newsletter portfolio performance is due to asset allocation, whereas market timing and selection make up about 10% of the performance.

A study in 1991 found that 91.5% of the pension fund differential return could be explained by the strategic asset allocation policy. Thus, of primary importance to investor return is correct asset allocation, and individual stock or fund selection is of secondary importance. And it is best to be in asset classes that appreciate at high rates.

The existence of equity markets in different countries affects the potential extent of portfolio diversification by traders and hence the required rate of return to compensate for risk.

Considerable evidence has been produced which shows that the ability to buy stocks (or trade indices, sectors) in different countries allows the formation of portfolios with lower risk and thereby reduces the expected yield that companies must offer on stock.

Risk reduction via diversification is generally considered in connection with decision on equities. However, because of exchange rate risks, default risks, and risks to bond values from changes in interest rates, risk reduction via diversification can easily applied to Interest Rate sensitive funds and commodity futures. Whenever there is some independence of returns on different securities, risks are reduced by maintaining only a portion of wealth in any asset. This will mean missing the maximum overall expected rate of return, because some wealth will be invested in assets with lower expected yields. However, given some degree of risk aversion on the part of a trader, having less risk will compensate for lower expected returns. This is an established part of portfolio theory orignially developed separately by Harry Markowitz and James Tobin. (See Harry Markowitz, Portfolio Selection: Efficient Diversification of Investments, John Wiley & Sons, New York, 1959, and James Tobin, "Liquidity Preference as Behavior toward Risk," Review of Economic Studies, vol. 25, February 1958, pp. 65-86.

Correlations exist that show the presence of some independence between markets of different countries with correlations as low as .335 in the case of the U.S. and the Euro market. We should expect clear gains from a diversified stock portfolio.

An indication of the size of the gains from including foriegn stocks in a portfolio has been provided by the Research of Bruno Solnick. (See Bertrand Jacquillat and Bruno H. Solnik, "Multinationals Are Poor Tools for Diversification." Journal of Portfolio Management, winter 1978, pp. 8-12. Solnick computed the risk of portfolios of n securities for different values of n in terms of the variance of these portfolios. The variance of a portfolio was compared with the variance of a typical stock, and it was found that the risk declines as more stocks are added. Solnick discovered that an international portfolio of stocks from numerous markets has about half as much risk as a portfolio of comparable size of only U.S. stocks. The risk of U.S. stocks for portfolios of over about 17 stocks is approximately 17 percent of the risk of a typical security, whereas the risk of a well-diversified international portfolio is only about 12 percent of the risk of a typical security. When Solnick considered other countries which have far smaller markets, he found however, that the gains from international diversification were, not surprisingly, much larger. The gain from diversification from holding equities of different countries turned out to greatly exceed the gain from holding different equities within a single country.

The independence of the markets of different countries can be valuable in portfolio management.

The ability to more effectivley allocate wealth when more investment opportunities are available allows investors to reduce the risk they must bear. In the standard theory of finance the unavoidable risk is known as the undiversifiable or systematic risk. If the risk that must be borne is reduced, the equilibrium yields required on the securities will be reduced.

The risks faced with foreign investments that are not explicitly faced with domestic investments are those from foreign exchange and political events. These risks, like business risk, can be diversified if a trader invests in a portfolio of securities of differenct countries which are denominated in many different currencies. This means that the risk premium on the discount rate which reflects only the systematic risk might not be very large. I recommend a Diversification strategy which allocates an equal amount to all the 3 major sectors (Commodities, Interest Rate sensitive Instruments and Equities). This way when one of the sector makes a profit you can re-distribute to the other sectors to maintain a 33% allocation to each sector, say probably every day or week or month or quarter or year depending on the account equity which allows your average return to always goes up no matter what happens to the world economy... There was a book written on this very same theme by Dr. Harry Brown...

The stock market isn't the only asset class available to qualified investors; for example, there are managed futures and hedge funds. Here's an overview of the hedge fund industry, as well as recent performance tables.

Is the stock market due for a more substantial correction? Will volatility increase? Is this volatility setting the market up for a substantial move, down or up? Regardless of the outcome, wise investors should be looking to diversify their portfolios into noncorrelated investments, because portfolios of noncorrelated assets should potentially show a smoother long-term growth curve. This strategy is based on the expectation that positive returns in a portfolio of noncorrelated assets should at least offset and preferably outperform the negative returns. Investors need and should demand noncorrelated investments inside and outside traditional asset classes or investment categories.

There are a number of asset classes that are not correlated to the stock market, but institutions and accredited investors are investing record amounts into two: managed futures and hedge funds. While these categories make up a wide array of investments, collectively, they are referred to as alternative investments. Either of these investments have the potential to do well during a variety of market conditions, such as when the stock and bond markets are underperforming their historical returns. Thus, investors should consider either of these alternative asset classes for their portfolios.

Managed futures, which are composed of a group of professional traders referred to as Commodity Trading Advisors (CTAs), trade in more than 100 financial and commodity sectors. CTAs can profit by going long or short 100 different markets. As long as there is movement in a specific financial or commodity market, there is a profit opportunity. Studies indicate that the long-term inclusion of managed futures in a portfolio reduces risk and increases profit potential.