Most investors don’t understand the difference … and that’s a shame.
It’s absolutely critical that you understand the difference. It can make the difference between success and failure in the stock market.
By now you are probably familiar with my proprietary VQ indicator for volatility. VQ stands for Volatility Quotient – the one number you need to know about the volatility of any stock if you want to buy that stock and ideally hold it for a year or more.
The VQ tells you how much you should expect the stock to move up or down over a one to three year period just due to the noise in the stock. Sometimes I call it a noise-factor or even a wiggle-factor. It’s a measure of how much the stock can move without really telling you anything new about where it’s ultimately headed.
To illustrate the difference between individual stock volatility and overall portfolio volatility I’m going to us a simple portfolio consisting of high volatility stocks. We’ll start with two well-known stocks – JC Penney (JCP) and Tesla (TSLA).
Both JCP and TSLA are high volatility stocks. The VQ on JCP is currently 41%. The VQ on TSLA is 42%%. Both JCP and TSLA are capable of fluctuating over 40% in a year or more just due to the noise in each stock.
When we combine JCP and TSLA into a portfolio of two stocks, you might guess that the overall volatility of the portfolio would also be north of 40% but that’s not the case. The combined volatility of JCP and TSLA in an equally weighted portfolio is only 35%.
You can get an idea of why it works this way by looking at the following one year chart of both stocks. The chart shows the percentage change in each stock over the course of the past year:
A couple of key things to notice …
First of all, you can see why both TSLA and JCP have VQ’s in the +40% range. Over the course of the past year they both basically went nowhere. TSLA was literally unchanged after one year and JCP was down 10%. TSLA was, however, up as much as 40% and down as much as 5%. That’s a 45% swing. JCP was up as much as 32% and down as much as 12%. That’s a 44% swing.
The second important thing to notice is that they don’t both move up and down in lock-step together. Sometimes TSLA moves up while JCP moves down and vice versa. I’ve shown a couple of examples using bold colored arrows in the chart here:
When we combine TSLA and JCP into an equally weighted portfolio, those up versus down moves cancel each other out so that the combined changes are less dramatic than the changes in each individual stock.
In this version of the chart I’ve shown the combined TSLA plus JCP in black and left the individual series for TSLA and JCP grayed out in the background:
Can you see how the black line often splits the difference between the two gray lines? That’s why the combined volatility of TSLA and JCP is less than the volatility of each of them individually.
Remember how we saw above that over the course of a year TSLA had swung 45% from low to high and JCP had swung 44%?
When we look at the combination of the two as shown in the black line above we see a high of 30% and a low of about 8%. That’s a range of 38% which is less than the 44% to 45% range that we saw in TSLA and JCP individually.
This is, admittedly an extreme example. I just used it to illustrate a point.
Over the past year I’ve added several portfolio level volatility tools to TradeStops. I’m very proud of these new services because I believe that they represent the first time that individual investors have easy access to such sophisticated and powerful tools.
In the TradeStops Pro service you can easily see the overall portfolio VQ on any of your existing portfolios. We call this the PVQ for Portfolio Volatility Quotient. Here’s what the analysis looks like for our simple example:
Both TSLA and JCP are high risk stocks so 100% of this simple portfolio is in high risk stocks. The high risk section of this portfolio is equally weighted between TSLA (purple) and JCP (green). At the top right of the above screenshot you can see that the Portfolio level VQ for this portfolio is 35.2%.
If you’re not yet subscribed to our Pro service you really owe it to yourself to give it a try. I recently recorded a detailed webinar covering all the advanced features and benefits of our TradeStops Pro service. As a Pro subscriber you’ll get full access to the critical information in this webinar that will help you to navigate increasingly challenging markets.
Master the markets,
Richard M. Smith, PhD