One of the factors that can help or hurt a portfolio’s performance over time is how the individual securities within the portfolio are correlated. Understanding these correlations is not difficult, but let’s start at the beginning.
When we discuss the topic of correlation, we’re looking at how stocks trade under different market conditions. Stocks that go up at the same time and go down at the same time (and by similar percentages) tend to be highly correlated.
Think of a couple of gold mining stocks. They’re in the same sector and the same industry. It would make sense that they would move up and down similarly, especially as the underlying price of gold moves higher and lower.
For example, below is a portfolio with two gold mining stocks. AngloGold (AU) and Kirkland Gold (KL) are both component members of GDX, the ETF for the gold miners. Both have Volatility Quotients (VQ) above 30%, which makes them high-risk stocks according to TradeStops. Both are in the Stock State Indicator (SSI) Green Zone.
While you may want to include one (or both) in a larger portfolio, it would be very risky to build an entire portfolio out of all one type of stock — or stocks that all had high risk, especially if the stocks are highly correlated.
You can get a picture of just how much risk you’re taking on by reviewing the Portfolio Volatility Quotient for your portfolio. Below is the PVQ for the sample portfolio described above. Again, these stocks are highly correlated so we would expect the PVQ to be high. The reason it’s a little lower than either of the two individual stocks is because the stocks are not perfectly correlated. That makes sense, as they’re two separate businesses with two separate business models.
What would happen if we replaced KL in the portfolio above with another stock that is also high risk, but is uncorrelated to AU? We replaced KL with ATNX, a healthcare/biotech stock that has a VQ of 38.81%. The new stock is still high risk, but look what happens to the PVQ of this new portfolio once we’ve diversified into an uncorrelated sector (and industry). The overall portfolio volatility dropped by almost 20%, just by replacing that one stock.
So how can you lower your overall risk by building a well-diversified portfolio? With TradeStops, of course!
The TradeStops Pure Quant tool is a powerful portfolio builder that can pull from a wide number of data sources, including your newsletter subscriptions as well as investment and watch portfolios and even Ideas by TradeSmith for those who have subscription access to that product.
In the last six months, we’ve added something to the Pure Quant tool for our Platinum and Lifetime customers that will allow you to build your portfolio with diversification in mind. We wrote about it in February; it’s a small button, but it has a lot of power as you’ll soon see.
The button to Maximize Diversification runs your Pure Quant results through an additional screen to ensure that the output has, well, maximum diversification. You can see the results below.
In this portfolio, we ran the stocks of the S&P 500 through the Pure Quant tool, allocating $100,000 to the portfolio with 20 stocks. You can see that the overall portfolio volatility is 9.47%.
When we run the same data through Pure Quant, but we check the button to maximize our diversification, we get a different result. You can see in the chart below that now our overall portfolio volatility is 8.68%. We’ve reduced overall portfolio volatility by nearly one percentage point.
But, take another look at the two charts shown above and notice another number that is called out. It’s the Diversification Quotient on our dashboard for each of the two portfolios. This number represents the amount of diversification in your portfolio. The higher the number, the greater the diversification.
You can see that the portfolio that we created without max diversification has a Diversification Quotient of 1.75, while the portfolio created with max diversification has a DQ of 1.85.
TradeSmith often references the work and methods of Ray Dalio, the billionaire founder of Bridgewater Associates, a successful hedge fund. Dalio referred to diversification as the “Holy Grail of Investing” in his book, Principles. He said that investing in six uncorrelated assets reduces risk by nearly 60 percent. That was the inspiration for TradeSmith and Porter Stansberry to team up to create this tool and integrate it into his software. And now, you can use it to reduce risk and increase your portfolio’s potential, all in one easy click.
Want to learn even more about correlations and how they apply to your portfolio? Well, make sure to join us next week, July 31 at 1 PM Eastern. During that webinar, we’ll show you all the ins and outs of creating a fully functional, un-correlated portfolio. Register now!
TradeSmith Research and Education Specialist