Daily Gains Letter

Use This Measure for a Well-Diversified Portfolio and Ditch Unwanted Risk

By for Daily Gains Letter | Apr 2, 2013


No matter what the market conditions are, investors have one question in mind: how do I build a portfolio that provides me with the least amount of risk? There is a simple one-word answer to their question: diversification. With this said, investors might get the impression that if they buy a bunch of different stocks for their portfolio, their portfolio is adequately “diversified.”

This logic is false, and it may force you to take on unwanted risk in hindsight. Companies in the same industry usually react in a similar manner. Consider miners, for example; if the price of the commodity that a company mines for goes down, no matter how well the company’s financial position may be, it usually follows suit.

To build a well-diversified portfolio, investors can make use of a statistical measure called “correlation.” The term may give shivers to some, but at the very basic level, correlation provides investors with an idea of how a stock or any other financial instrument reacts to another.

Correlation ranges from positive one to negative one. If two securities have a correlation of positive one, then it is said that they move very closely to each other. In contrast, if both investment instruments have a correlation of negative one, then it is said they move in opposite directions of each other. A correlation of zero means that two securities don’t react the same way.

Chart courtesy of www.StockCharts.com

This chart depicts the price of gold bullion and Market Vectors Gold Miners (NYSEArca/GDX) exchange-traded fund (ETF). Looking closely, you will notice that they react very similarly. As a matter of fact, the Market Vectors ETF and the price of gold bullion have a correlation of +0.76—very close to one.

So, if you own physical gold or any other related gold bullion investment, then buying a gold miner ETF will only cause more harm to your portfolio.

The main objective of diversification is to have assets or investment instruments that don’t fluctuate in the same way—or else there isn’t any risk-reducing. When you use correlation, it gives you a better idea of how one security reacts to the other.

Investors should aim to hold securities that have close to zero correlation in their portfolios—finding two securities with perfect correlation (-1, +1, or 0) is very rare. The reasoning behind this is that if all the securities in that portfolio have no correlation among them, then wild swings in one market won’t cause the entire portfolio to fluctuate and leave an investor with a loss.

With this said, correlation is a very simple measure that investors can employ in pursuit to become better at investing. They also must keep in mind that correlation is not causation—it only compares the fluctuation in one security to the other. In addition, the correlation in securities might change over a period of time, due to economic conditions and other factors.

If investors hold different securities, then they have to use much more advanced portfolio management and diversification techniques to find how immune their portfolio is to different market conditions.

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