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,
Tom Meyer
Education Director
TradeStops.com
