Understanding the Difference Between Stock Risk and Portfolio Risk – Pt. 2
Last week, we looked at how to determine the risk you’re taking with individual stocks. This week, we’re going to follow up and look at how to determine overall portfolio risk.
Portfolio risk describes the overall risk that is inherent in your portfolio. This is determined by the individual stocks that you own and their correlation or lack of correlation.
When we use the term “correlation”, we’re referring to how each individual stock moves in relation to the other stocks in the portfolio. If you don’t understand what this term means now, you will by the end of this article.
TradeStops has three portfolio-level tools to help you manage your investments. These are the Asset Allocation tool, the Portfolio Volatility Quotient tool, and the Risk Rebalancer. We’ll be looking at the first two of these today.
We’ll also be looking at two different portfolios to show you how these tools work and to explain the correlation principles.
The first portfolio is a highly-diversified portfolio containing blue-chip stocks that are all a part of the DJIA. Here’s the makeup of this portfolio:
This portfolio consists of low-risk and medium-risk stocks.
The second portfolio is highly concentrated in gold and silver mining stocks. These are all high-risk stocks.
The first tool, the Asset Allocation tool, lets you x-ray your portfolio to see its diversification by both sector and industry. Here’s the sector breakdown of the first portfolio.
There are seven stocks in the portfolio and each represents a different sector.
Now let’s look at the second portfolio.
All nine of these stocks are in a single sector (Basic Materials).
This brings us to the Portfolio Volatility Quotient (PVQ). Similar to the Volatility Quotient that measures the risk of your individual stocks, the PVQ measures the risk of your entire portfolio based on the correlation between the individual stocks in your portfolio.
For instance, in the first portfolio, it’s unlikely that all of the stocks would move up or down together. An energy stock (CVX) is going to be affected by the price of oil. If oil is going down in price, CVX would likely be trending lower. But a technology stock (AAPL) is not going to be affected by the price of oil. AAPL could move higher and CVX could move lower. These stocks are not highly-correlated.
However, in the second portfolio, all of the stocks are gold miners. If the price of gold moves lower, most likely all of the stocks in this portfolio will move lower. These stocks are highly-correlated.
A portfolio of stocks that are not highly-correlated will usually have a PVQ that is relatively low. We can see that the PVQ of the first portfolio is only 12.04%. Of these 7 stocks, only KO has a VQ lower than 12.04%.
This shows the power of having a highly diversified portfolio. The majority of the stocks are designated as “Medium Risk” which means they have a VQ of greater than 15%. Yet, the overall risk of the portfolio is in the “Low Risk” category. This is because the stocks are not highly-correlated.
Now, let’s check out the PVQ of the second portfolio.
The stocks in the second portfolio are all considered to be “High Risk”. This means that the VQ of each stock is greater than 30%. And the portfolio reflects this high degree of correlation. The PVQ is 31.06% which is a high-risk portfolio. The portfolio is high-risk because all of the stocks have high risk and the stocks are highly-correlated.
Now, what happens if we were to put one of these high-risk stocks into the low-risk portfolio? One would think that putting a high-risk stock into the portfolio would cause the PVQ to increase. Let’s add FNV to the first portfolio.
The VQ of FNV is much higher than the other stocks in the portfolio.
Let’s check out the Asset Allocation of the new portfolio.
We now have eight stocks and eight sectors. The portfolio is actually better diversified now than it was previously.
Let’s go to the Portfolio Volatility tool and check out the new PVQ.
We’ve actually lowered the PVQ from 12.04% to 11.31%. And we’ve done that by adding a stock that is considered to be “High Risk”.
This shows you the power of having stocks in your portfolio that are not highly-correlated. You can hold a few riskier stocks and still have a very conservative portfolio.
Be sure to check out the short video that we created, Stock Risk vs. Portfolio Risk and let us know if you have any questions.
Successful investors understand the risk of both their individual stocks and their overall portfolios.
To successful investing,
Profiting from Unpopularity
Two months ago, I told you about an investment that the pundits hated. Since then, it has climbed 17% higher. I’ve spotted another opportunity … and the pundits hate it as well.
Back in mid-December, we looked at EWZ, the ETF for Brazil, and the potential for the Brazilian stock market to continue climbing even after already having booked a 100% gain in 2016.
Since that time, EWZ is 17% higher in only 7 weeks.
Before I reveal today’s subject, let’s see what the pundits have been saying about this particular opportunity.
“Adds yet another wave of uncertainty to sales and profits at the high end”
~ CNBC 24 Jun 2016
“If they vote to leave, the markets will probably never recover”
~ Former BP CEO, John Browne 23 June 2016
“Brexit could be really bad for the final two seasons of ‘Game of Thrones’”
~ CNBC 24 Jun 2016
Yes, we’re talking about the United Kingdom.
EWU is the ETF for the UK market. It was stopped out on the second day of the Brexit crash. It started moving back up and triggered a new SSI Entry signal in September. (Yes, whipsaws happen sometimes … but we err on the side of caution)
The price moved lower after the most recent SSI Entry signal and even dipped into the Yellow zone before the US elections. Since then, it has moved higher by almost 9%.
EWU is trading at the top of a very important resistance level. My volume-at-price chart shows that EWU is close to breaking above this level.
A break above the $32 level could send it up another 10% before running into resistance at the $35 level.
So far, it has touched this upper resistance level four times and has not broken through yet. Why do I think it could break through now?
This ETF covers 85% of the UK market. The top 10 holdings account for almost half of the ETF and eight of these are either in the SSI Green zone or Yellow zone. Having 80% of the largest companies in the UK with active SSI signals is bullish. We would expect these stocks to lead the UK market higher.
Finally, the time-cycle forecast is very positive for EWU. The forecast bottom is just a few weeks away, and a move higher is projected all the way through the end of October of this year.
Bottom line, EWU is solidly in the TradeStops’ Green zone and my other indicators are telling me that the UK market looks ready for more upside.
As always, I’ll continue to listen to the pundits, but with only one ear.
Sometimes it’s good to be a little hard of hearing,
Richard Smith, PhD
CEO & Founder, TradeStops
What is this Flag?
In the high-speed world of NASCAR, there are various flags to tell the drivers when to pay attention. In the high-speed world of investing here at TradeStops, we also use flags.
In racing, a red flag would indicate a stop. The driver should stop his car so he doesn’t get hurt. A green flag would tell him that the race is starting and he is good to go. We use the same concept.
What are the Flags?
Flags are a call to action. They let you know that you have to do something.
When you synchronize with your online broker, your positions will automatically be pulled into the TradeStops system. When our system detects new positions, it will notify you with a green flag in the Status column of the Positions & Alerts tab.
Sometimes, our system will have trouble detecting your positions at your brokerage. We will alert you of this via email, and you will see a red flag on your Positions & Alerts tab.
Can I organize these Flags?
It might be a little confusing if you see a bunch of red and green flags all bunched together. It could become difficult to keep track of which position is green flagged and which is red flagged.
It is super easy to organize your positions based on their flags!
- When you are on the Positions & Alerts tab, locate the Positions sub-tab.
- Locate the green Add Position button.
- Directly to the right of the Add Position button will be the word Status.
- Click on the word All, and a drop-down box will appear.
a. If you see the green or red flag in the drop-down, this means that some of your positions have either a green or red flag. (If you don’t see any flags, you have no problem, and you are good to go!)
(Green Flag organization)(Red Flag organization)
- Just click on the flag from the drop down, and your positions will be organized based on the flag.
What do I do with a Green Flag?
When you see that your position has a green flag, this means it is newly synchronized. You will want to make sure that all of the data came through for your position such as an entry date and entry price.
If your position is missing data, simply click on the edit pencil icon to the left of the ticker symbol.
You can read more about editing positions here.
What do I do with a Red Flag?
As mentioned before, our sync process might not pick up on positions from your brokerage. If this is the case, you will see a red flag.
If the flagged position is one that you closed, you will have the option to manually close it. Just click on the triangle to the left of the ticker symbol, and then click close.
If the red flagged position is active in your brokerage account, leave it alone. We may pick up the data again. If it remains red flagged for 7 days, contact us at 866-385-2076. Our customer service team will be happy to help you Monday – Friday from 9:00 AM -5:00 PM EST.
Follow the Flags and Win!
Just like Dale Earnhardt Jr. follows racing flags to cross the finish line in first, you too should use our flag system to come in first in investing. Start your engines on green and stop on red!
To your 1st place investments,
Customer Success Team
Bull, Bear, or Sideways, you win!
We’ve shown time and again now that the TradeStops Stock State Indicator system (SSI) can make you more money and can do so under different market conditions. That’s impressive. What’s even more impressive, however, is that it can do so with less risk.
When you factor both reward and risk into the equation you see how truly powerful the SSI system is. Let me show you what I mean.
Last week we responded to a reader’s challenge asking us how the SSI works during periods where a market goes nowhere for a long period of time. To answer that question, we applied our system to the Dow Jones Industrial Average (DJIA) between the years of 1966 and 1984.
In 1966 the DJIA was at 1,000 and 17 years later in 1983 it was also at 1,000. It was nearly two decades of a whole lot of nothing.
We’ve shown numerous time how the SSI system can improve performance during bull markets. What we showed last week is that even during the 17 year long sideways market in the DJIA, the time the SSI system still outperformed a buy and hold strategy.
Just like we can measure a Volatility Quotient (VQ) on the price history of an individual stock, we can also measure it on the performance history of a portfolio or strategy. If we look at the two lines in the chart above, we can ask what the VQ is for each of these two strategies.
For buy and hold, the VQ is 12.2%. That’s how much random movement, up or down, occurred in the buy and hold strategy. The VQ for the SSI strategy, on the other hand, was only 7.5%. That’s a LOT less volatility!
It’s obvious when you look at the chart that the SSI strategy had less risk. It avoided the big dips of 1970 and 1974. Not only did the SSI system outperform buy and hold, it preserved capital during market downturns.
To capture both the impact of reward gain and risk taken, savvy investors look at what’s known as reward to risk ratios or risk-adjusted returns. I’ve written about risk-adjusted returns before. It’s critical for investors to understand the concept. At the simplest level it’s the reward gained divided by the risk taken.
Factoring in risk here together with reward shows how the SSI strategy outperformed buy and hold even more than we originally thought. If we look just at gains (rewards) the buy and hold strategy ended at a 35% gain whereas the SSI strategy ended at a 60% gain (see first chart above). The SSI did about 70% better than the original 35% gain for buy and hold.
Let’s look at the same chart that we looked at above but this time we’ll divide the gains (rewards) by the VQ (risk).
If, on the other hand, we look at the risk-adjusted performance, buy and hold managed 2.9 times the rewards per risk taken while the SSI strategy achieved 7.9 times the rewards gained per risk taken. That’s an improvement of over 170%.
For the record, that risk-adjusted outperformance has been sustained for not just the past 20 years … but for the past 50 years as well:
Pretty cool, huh?
Make more. Risk less,
Richard Smith, PhD
CEO & Founder, TradeStops
Understanding the Difference Between Stock Risk and Portfolio Risk
One of the questions that comes to us often is about the difference between stock risk and portfolio risk. We’ll look at the differences and the effect they have on your investment success.
In this article, we’ll focus on stock risk and some of the comparisons you can make between different stocks. Next week, we’ll look at portfolio risk and how individual stocks work together within a portfolio.
Individual stock risk is fairly straightforward and easy to understand. Each stock or fund has its own risk profile.
The term we use to describe this risk is “Volatility Quotient”. When looking at the Volatility Quotient (VQ) of a stock or fund, we talk about the VQ% of a stock. It represents the normal volatility one can expect over a one year or longer timeframe.
The VQ can be used to understand the volatility of a single stock and it can be used to compare the volatility of different stocks. An example that we use often is comparing a stock with a low VQ% to a stock with a high VQ%.
You can easily find the VQ% of any stock by using the Stock Analyzer. Start by clicking the “Research” tab and then on the “Stock Analyzer” tab that opens from there.
Type in a ticker, in this case JNJ (Johnson & Johnson), and the VQ pops right up.
Of course, JNJ is a fairly conservative stock and has a low VQ. From an investor’s point of view, the VQ of 11.58% means that if you own JNJ, it can move against you by 11.58% and still be within its normal range of volatility. If it moves against you by more than this amount, then that is the signal to exit the position.
The gold mining stocks are more volatile and their higher VQs reflect this. Here’s a look at the volatility of ABX (Barrick Gold).
The VQ of ABX is 41.99%. This means that if you own ABX, a move of almost 42% against you is to be considered normal.
What is the takeaway here? Let’s assume that you normally use a 25% trailing stop. If you invest in JNJ, then you’re letting the stock run more than double its normal volatility before it hits your stop. This could really damage your portfolio.
On the other hand, if you use a 25% trailing stop for ABX, you risk stopping out while the stock continues to trade within its normal range of volatility and negate the potential upside of stocks with high VQs. This could limit the potential profitability of your portfolio.
One of the important decisions for you as an individual investor is to determine how much risk you’re willing to take in any stock. If you make the decision that you’re not willing to take on too much risk, the VQ can help you with your investments.
Let’s assume that you have made the decision not to take on more than 20% risk in any one position. By knowing that the normal volatility of ABX is almost 42%, it’s easy to make the decision to not invest in ABX as its volatility is more than double what you’re willing to risk.
The Volatility Quotient is a dynamic number and it changes every week. The changes aren’t large, but you can track them on the same Stock Analyzer page. Over the course of time, though, the changes can be significant.
Here’s the 3-year chart for ABX. We’ve highlighted the historical VQ. In early 2014, the VQ was under 30%. Today, the VQ is almost 42%.
Knowing the direction in volatility and if a stock is becoming more or less volatile can help you with your decision-making.
As the VQ% is adjusted each week, so is the underlying stop loss on each stock. For instance, if a stock becomes less volatile over time, then the stop loss for that stock will be adjusted upwards automatically. However, if a stock becomes more volatile, there will be no adjustment made to the stop loss.
Next week, we’ll focus on portfolio risk and look at the portfolio tools that are available on TradeStops. In the meantime, we have created a short video that discusses the difference between stock risk and portfolio risk. Here’s the link: Stock Risk vs. Portfolio Risk in TradeStops
If you have a question, please send it to firstname.lastname@example.org and we’ll get you an answer quickly.
To understanding and controlling your risk,
Education Director, TradeStops
Why the S&P 500 Could Surge Higher this Year
A new chart unexpectedly grabbed my attention this week because it has such big implications for the future of the US stock market. Let’s get right to it.
For the most part the USD and the S&P 500 move in broadly opposite directions. Stocks in the S&P 500, just like gold and oil, are priced in USD. When the USD is increasing in value, it takes fewer US dollars to buy assets priced in US dollars … so the prices of those assets tend to fall.
Below is a comparison chart of the S&P 500 and the USD for the past 30+ years. The gray highlighted areas show the times when these two important assets were moving in opposite directions from one another.
There are also times when the S&P 500 and the US dollar both move up together. These are usually times of economic recovery … when everything is going right. The chart below highlights such times over the past 30 years.
What’s extremely uncommon, however, is to see both the S&P 500 and the US dollar moving down together. That has only happened a handful of times over the last 30 years … as seen in the gray highlighted areas of the chart below.
What’s striking about the times when both the S&P 500 and the USD are moving down together is that they haven’t lasted long … and the stock market has been significantly higher shortly thereafter.
Why does that matter? Because I’ve been telling you for the past month that I expect both the US dollar and the S&P 500 to start downward corrections by late January or early February.
If we do see both the USD and the S&P 500 correct over the next few months, I’ll be eagerly awaiting the start of a new rally in the S&P 500 because I think it could be a very powerful one.
My time cycles analysis on the S&P 500 suggest we could see that rally start to unfold by the middle of this year.
Richard Smith, PhD
CEO & Founder, TradeStops
You’re Stopped Out. Now What?
You just imported your positions from your brokerage. As you look through your positions, you notice that some of them are stopped out based on the Stock State Indicators (SSI). This upsets you because you like some of those positions. Don’t despair! You can still invest in your position even if it is in the red zone.
Let’s look at an example
You are invested in Silver Wheaton (SLW), and you notice that it is stopped out. You decide to investigate further, and click on the ticker symbol from the Positions & Alerts page.
This brings you to the Position Card page. You notice that SLW is NOT stopped out based on the Volatility Quotient (VQ%).
(You can tell if something is stopped out based on the VQ% when the VQ box is highlighted purple.)
At this point, you could set up a VQ% alert on the position. This would allow you to stay in the position until it hits its VQ Stop Price.
(Click to enlarge picture)
How Do I Add an Alert?
The process of adding an alert is easy, and it takes only a few simple steps.
- Go to the Positions & Alerts page in your TradeStops program.
- Locate the Actions column on the far left side of the page.
- Check the white box in the Actions column to the left of the position you want to add the VQ alert to.
- On the bottom of the page, click Add Alert.
- In the pop-up window, click on the drop down box. Select “VQ Trailing Stop,” and then click Add.
- You will now be alerted when SLW gets stopped out based on the VQ%.
Keep in Mind
You may not want to invest too heavily in your red positions because it may throw off your portfolio balance. Be sure that you take an equal risk per position. This means having more money invested in your conservative stocks and less money in your riskier stocks.
If you want to read more about investing in the Red Zone, please revisit Dr. Smith’s editorial from January 10th here.
If you decide to stay in a stopped out position, keep in mind that there could be a potential loss. The VQ% will do its best to safeguard you against any further losses. So long as you follow the stop out strategies, you will find yourself as a successful investor.
To Your Successful Investing,
Customer Success Team
SSI Stock Signals During the Lost Decade
I showed you last year how the SSI stock price signals crushed the S&P 500 for almost 20 years. How did they do during the lost decade of the 1970s?
One of our TradeStops members, Harold R., recently sent us an email wanting to know how the TradeStops SSI system would have done 40-50 years ago when the markets went nowhere for a long period of time.
I wanted to know that answer too.
Many of you have seen the study I did demonstrating that by simply applying the SSI stock signals to the S&P 500, you could have crushed the returns S&P 500 itself. If you haven’t seen it, go here.
Here’s the most recent chart that shows these results.
At the time, I explained that the meat of the outperformance came from avoiding the huge losses from 2001-2003 and 2008-2009. I called that “winning by not losing.”
The investment landscape of the late 1960s through the early 1980s was much different than today’s landscape. The stock market basically went nowhere with the DJIA first closing above 1000 in 1972 and then falling back and not crossing the 1000 mark for good until 1982.
So how did the TradeStops Stock State Indicator (SSI) signals fare during this lost decade?
The black line is the DJIA and its historical movement. The blue line is the DJIA according to the TradeStops SSI stock signals. This is another great example of “winning by not losing.”
During this period of time, the DJIA was mostly in negative territory, but by using the SSI signals, an investor would have had a positive return the entire time.
At the end of 1983, using the SSI stock signals, an investor could have been up almost 60% vs. only 35% for buy and hold. This is a significant difference during a difficult time for investors.
It required a lot of patience to invest during this period of time. Had we been using the SSI signals, we would have been out of the market and waiting in cash half the time (of course, we could have made a nice return on cash as interest rates were a lot higher then).
Another thing I like about this chart is that for most of the time, as new SSI Entry signals were triggered, they did so at higher levels than the previous times. Only once did the SSI plateau at a lower level.
In a difficult environment for investing, the TradeStops SSI signals greatly outperformed the underlying index.
Richard Smith, PhD
CEO & Founder, TradeStops
Setting Up Investment Portfolios
One of the most powerful features of TradeStops is the ability to synchronize your portfolios with a large number of online brokerage firms. This makes it easy to follow your investment portfolios on the TradeStops site.
But it’s also easy to set up and follow your investment portfolios even if you don’t synchronize them with your brokerage firm.
We’ll show you how to do both.
Whether you’re going to synchronize with an online brokerage firm or set up your portfolio manually, the first thing is to click on the “Create Portfolios” icon on the TradeStops home page.
This opens up a new window and it’s here that we start for either synchronizing a portfolio or setting one up manually.
For those wanting to synchronize their portfolio, our system works with the following brokerage firms:
Capital One Investing
T. Rowe Price (Investment)
If you have one of these brokerage firms, you’ll then go to the next step which is to enter the User ID and Password of your brokerage account.
Be sure that you are logged out of your brokerage firm account so that the bank-level encryption can exchange information with your brokerage firm.
It takes just a few minutes for this to occur and when it is finished, you’ll receive a notification that the account has been synchronized.
Your portfolio is now set up in TradeStops showing the last four numbers as the identifying characteristic.
For those wanting to set up a manual portfolio, you’ll start by clicking on the “Manual” tab in the new portfolio window. Then you’ll fill in the name of the portfolio, how much cash (or money market) you’ll be holding, and any notes about the portfolio.
After you save the portfolio, this is how it will show up on your TradeStops portfolio page.
You can then enter the positions in your portfolio by going to the “Positions and Alerts” tab, choosing the portfolio from the dropdown on the upper left, and then clicking on the green “Add Position” button.
We created a short video to show you the steps on the TradeStops website itself. Here is the link for the video: Creating Investment Portfolios in TradeStops
For the questions you have, please check out our Help Center which is accessible from either of these two links.
The most successful TradeStops members are those who take the time to use the Help Center. The answers to most of your questions are there and they’re easy to find. Just click and search.
We’ve made it simple for you to set up your portfolios. It will take a little time at the beginning if the TradeStops site is new to you, but will become easy as you get used to it.
And we’re here to help you along the way.
Education Director, TradeStops
Updated Gold Price Forecast
Back in December I outlined what I thought it would take for gold to form a bottom and start its long awaited ascent. I’m seeing several encouraging signs that the bottom may be taking hold.
The big issue for gold of late is the strength of the US dollar (USD). I shared this chart last month which shows how gold has been consistently moving in the opposite direction of USD for the past year.
In the past couple of weeks, the US dollar has finally started to reverse its climb and, sure enough, gold has been heading straight up.
Another strong indicator gold may be kicking off a sustainable long-term uptrend is that the big boys appear to be getting on board. It’s been very encouraging to see that even during the rise in the price of gold over the past few weeks, the commercial hedgers have continued to be buyers of gold.
It’s still very early in the gold-rally game. I wasn’t really expecting a top in USD until late January to early February. We still could see one more burst higher for USD before it has a more sustained fall back to earth.
The time-cycles on gold suggest that we could see a final drop lower for gold in late February before gold rallies through 2017.
Overall, however, I’m very encouraged by the signs I’m seeing for gold. It tells me that my core thesis is intact and the train is on the tracks. I have been dipping my toes into new gold investments to make sure that I don’t get left behind should the rally happen a little sooner than I am expecting.
I’ll continue to watch the US dollar and the buying patterns of the commercial players in the gold market as I plot my own strategy for benefiting from a sustained rally in the price of gold.
Have a golden weekend,
Richard Smith, PhD
CEO & Founder, TradeStops