When it comes to the world of investing, it is often said that a rising tide raises all boats. The idea behind this is very simple: if a stock market, or any other market for that matter, is experiencing a bull run, an investor who is bullish will make money. A good example of this phenomenon would be the “dot-com” period, when investors made money on whatever they bought—even the companies that didn’t even have any revenues.
Unfortunately, all parties must end. The dot-com bull run ended, as well, with the NASDAQ falling from its all-time high of 5,000 to below 1,200 in the period from 2000 to 2002.
Warren Buffett explained this phenomenon best. He said, “Only when the tide goes out do you discover who’s been swimming naked.” (Source: Brainy Quotes, last accessed April 11, 2103.)
Those who continued to believe the NASDAQ would make a comeback were wrong. The index is still trading below its all-time high 13 years later, and some of the well-known companies during that period are no longer even in business today.
Making money when the overall market is headed upward can be easy if investors follow the market, but keeping those gains is the most difficult task.
With all this said, how can an investor make their portfolio immune to the market’s swings to save what they have?
To make sure your portfolio doesn’t swing with the overall market, you have to make sure the correlation between your portfolio and the market is zero (an ideal situation that’s rare to see) or close it. On one hand, you can do this by … Read More
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 … Read More