Before reading this article, please ensure you have an understanding of stock correlation as discussed here.
The goal when creating a stock portfolio is to maximize the potential return while minimizing the risk you take on to achieve that return. There are numerous ways to define risk as it applies to a portfolio. One of these is to look at the standard deviation of the portfolio's returns. In essence, the standard deviation quantifies how volatile the portfolio's returns are. The goal is to minimize the standard deviation (ie: volatility) of the portfolio while maximizing the returns.
When it comes to the stock market, traditional diversification principles are often ineffective and riskier than most investors realize. The general thinking is to have a stock / bond split of some pre-determined percentage depending on your risk appetite. With respect to the stock portion of the portfolio the thinking is to add multiple stocks into a basket, thus diversifying your risk.
The problem with this is that portfolio correlation is not taken into account, resulting in portfolio's that not only waste capital through inefficient allocation but are actually riskier than the 'marketing hype' would have you believe.
To demonstrate why it is important to take correlation into account when managing your stock portfolio, we will combine 3 separate pairs of stocks with differing correlations.
Combining highly correlated stocks
The following chart shows a portfolio consisting of $GS (Goldman Sachs Group) and $JPM (JPMorgan Chase). These stocks have a 0.87 correlation which means they move in the same direction an extraordinarily high percentage of the time.
Each dot represents a certain percentage holding of each stock in the portfolio. For example the left most dot represents a portfolio only consisting of JPM shares. The next dot to the right represents a portfolio of 95% $JPM shares and 5% $GS shares.
As you continue moving to the right, the percentage holding of each stock adjusts in 5% increments until the far right dot where the portfolio consists solely of $GS shares.
- The Y-Axis represents the portfolio return as a percentage.
- The X-Axis represents the standard deviation (ie: volatility or risk) of the portfolio. The smaller the standard deviation, the lower the volatility.
As shown, holding 100% $JPM resulted in the least amount of risk but also the smallest return. Holding 100% $GS resulted in the highest return but was also the most volatile and therefore the riskiest. There are a few key takeaways from this:
- There was no way to combine these stocks in a portfolio such that your portfolio risk was reduced.
- Combining stocks that are highly correlated into a portfolio is an inefficient use of capital. The reason for this is that you are doubling down on the same assumption. You are investing in two stocks that have a history of moving together. If you are wrong on one of them, it is highly likely you will lose money on both.
Combining low correlation stocks
Next we take a look at combining the $SPY (S&P500 ETF) and $GLD (Gold ETF) which have a very low correlation of -0.26.
In this example, holding either of these stocks by themselves is riskier than combining them into a portfolio. There are several weightings that result in a lower risk portfolio. 50% in each stock results in the lowest standard deviation of returns which is what we are looking for.
The key take away here is that combining stocks that have a low correlation to each other reduces your portfolio risk, smooths your returns and results in true diversification.
Combining negatively correlated stocks
Lastly we will look at combining $TLT (20+ Year Treasury Bond) and $MET (Metlife) which have a negative correlation of -0.61.
As was the case with low correlation stocks, negatively correlated stocks also provide many opportunities to create lower risk portfolios. A portfolio consisting of 50% $TLT and 50% $MET results in the lowest risk.
Aim for low or negatively correlated portfolios
What the above examples demonstrate is that when constructing a portfolio we should always aim to include low or negatively correlated stocks. This not only reduces our risk and smooths our returns, but it also ensures our capital is used efficiently because we are not doubling down on stocks that have a history of moving together.
You may be asking, why bother with all of this? All i'm doing by reducing my risk is also reducing my potential return? All I care about is profit! There are a few points worth considering:
- Firstly, no one knows which positions will be profitable and which will be losers. It doesn't matter how much technical or fundamental analysis you do, you still don't know which positions will be profitable. This means that you have to constantly be looking for new positions to add to your portfolio so that over time and over a large number of positions you maximize your profitability.
- With the above point in mind, you should always be looking for positions to add to your portfolio that behave independently. If you were to split $15 000 into 3 new positions which are all highly correlated, you actually only have 1 x $15 000 position. You don't have 3 x $5 000 positions because they are all highly correlated. If you lose in one, you will likely lose in all of them.
- Lastly, your goal should be to have a portfolio that delivers smooth returns over time. This means having a portfolio that stair steps up over time with shallow draw downs as far as possible. Having a volatile portfolio with big draw downs should be avoided.
True diversification in action
The following chart shows a portfolio consisting of 4 stocks which all have low correlations to each other. By looking closely at each individual stock, it is clear there are times of high volatility in all the individual stocks. The portfolio return represented by the thick blue line on the other hand is far less volatile and ultimately less risky than holding any of the individual stocks.
The largest draw downs for each stock and the combined portfolio are as follows:
- $FB: -13.65%
- $GS: -16.45%
- $NFLX: -23.47%
- $WYNN: -22.23%
- Portfolio: -11.98%
This is the power of correlation based portfolio construction. Every single stock experienced larger losses at some point than what the portfolio as a whole did. This is only possible because of how the portfolio was constructed.
Portfolio diversification is important regardless of whether you consider yourself an investor or trader. Regardless of whether your trades last a few days or several years. Correlation and diversification are critical to portfolio construction. Not knowing how your trades fit together within your portfolio increases your risk and wastes capital through inefficient allocation.
Ensure you have access to tools that help you construct and manage a truly diversified stock portfolio. The tools available from www.diversifyportfolio.com have been developed from the ground up to aid in smart portfolio construction.
Stay informed by joining our mailing list where you'll receive strategy, diversification and educational articles to help maximize your profit in the stock market while minimizing your risk.
DiversifyPortfolio does not make trading or investing recommendations. This article, as well as all the content and analysis tools on DiversifyPortfolio is published as a research and informational service. Please refer to our Disclaimer.