Diversification – it’s every asset manager’s favorite word, and for a good reason. However, as we all know, too much of any one thing (no matter how good it is) can become a bad thing.
Diversification refers to the mix of stocks and other securities within an investment portfolio. One of the most common measures of diversification is correlation.
Correlation measures the strength of a relationship between two variables, or stocks. In financial markets, correlation is used to analyze the historical relationship of price movements between two stocks and/or other securities. Correlation coefficients range from -1.0 to 1.0. A correlation coefficient of -1.0 implies where X increases by 1.0, Y will decrease by the same amount. Conversely, where the correlation coefficient equals 1.0 – given a 1.0 unit increase in X, Y will increase by the same amount.
If I had a crystal ball, I would put 100% of my money in a single stock that I thought, well knew, would increase in value. The correlation coefficient on such a portfolio would be 1.0. For each $100 increase in the stock, the value of my portfolio would increase by $100 – this is referred to as perfect correlation. As you add more and more stocks to your portfolio it is extremely important to manage the correlation between the individual stocks you own. As the correlation of a portfolio approaches 1.0 the risk of loss increases.
Conceptually, the idea behind diversification is to own a mix of stocks which maximize potential return while simultaneously minimizing risk of loss. There are no guarantees in financial markets – which is why diversification is extremely important but it must be managed in the same way that risk must be managed.
Statistical analysis, such as correlation, provides us with the data to make more informed decisions based on historical relationships. However, if the underlying fundamentals change – those same historical relationships can quickly become meaningless.
For example, let’s look at one of the most popular trades over the past two years – Oil. Based on information from CNBC (as of December 2015) the correlation between the price of crude oil and airline stocks exhibited a consistent inverse correlation, meaning as the price of oil decreased, the airline stocks increased; said differently they moved in opposite directions.
So what does all of this mean? Consider you believe the price of crude oil is going to make a huge recovery, but you can’t risk everything so you decide to hedge that risk by purchasing shares of United Continental, Southwest, American and Delta Airlines. Based on the information above, given a 1.0 unit change in oil prices the value of the basket of airline stocks will change by about .23775 (simple average of the correlation coefficients) in the other direction. You may not make as money if the trade moves in your favor, but if it moves against you, you won’t lose as much either. At the time this data was published, the price of crude oil was in a steady decline as it had been for quite some time, and showed no signs of slowing down. Many investors and traders took positions in airline stocks to offset their losses driven by investments related to the Oil & Gas Industry. Simply, the data above tells us that by taking a long position in airline stocks – one could offset their losses in Oil & Gas by nearly 24% by purchasing airline stocks.
The Needle vs. The Hay Stack
This phrase is fairly common in the stock market however, many people don’t realize it is a direct discussion about the correct way to manage the correlation coefficient of a portfolio.
The Needle – Individual stocks and/or other securities – your investment idea is driven by the idea that the company or underlying asset (The Needle) will earn profits that are in excess of the average return on the market as a whole, this excess return is referred to as “alpha.”
The Hay Stack – Mutual Funds, Broad Based ETFs, Index Funds etc… Going long the Hay Stack (or buying the Hay Stack” is also referred to as a Passive Investment Strategy – The idea is to cover all the different sectors of the market and profit based on the growth of market as a whole over time.
The Needle vs. The Hay Stack argument is one of the most fiercely debated ideas on Wall Street. After all, fund managers AKA “The Experts” make a HUGE amount of money – shouldn’t they be able to beat the overall market average? Well, historical evidence suggests otherwise.
Over the past eight years we have had the pleasure of living and investing under a Bull Market – unfortunately, this can’t go on forever. Over this time period, if you have been long Needles – or the Hay Stack you have probably done pretty well, but what happens when all the hay stacks are gone and making money isn’t quite as easy? When the market changes course, making money won’t be so easy and the ability to find the needles and managing the correlation between your needles may become much more valuable.
One way to evaluate diversification and portfolio risk is by looking at the measure of correlation within your portfolio. Most asset managers achieve diversification benefits through exposure to a number of different industries – a great way to test your ability to stay diversified is by playing the daily games in the “League Play” section of our app Copper Street – if you’re wondering, no, this was not done by accident. If you aren’t familiar with Copper Street – we took Fantasy Football, Trivia, Educational Content and the Stock Market and built a platform that allows you to learn and compete against your friends to see who is the best at finding needles.
In order to field a complete roster, you need to select stocks each of the industries 10 in all, a few of which are shown below, in addition to the “wildcard” (MBLY).
When you choose certain stocks for an investment portfolio it is important to understand the potential risks and rewards of the individual stocks in addition to the effect the stock has on the overall risk and return characteristics of your portfolio.
Key idea – Although many people won’t admit it, it is very possible to diversify yourself into mediocrity and it is very easy to put together a portfolio that is highly correlated (very risky.) Managing the relationships between the individual stocks in your portfolio is paramount – and we have the perfect place for you to begin practicing.
If you have any questions / comments or general topics you would like me to discuss please let me know. Shoot me an e-mail at email@example.com
Thanks for reading!
I wrote this article myself, it expresses my own personal beliefs and opinions. I am long NFLX, MBLY, CYBR – I will not initiate or close any positions within the next 72 hours. Nothing contained herein should be considered actionable investment advice.
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