It’s easy to understand the risk of an individual stock, but understanding the risk of an entire portfolio is a little more difficult. There are several things to take into consideration when looking at the risk of a portfolio.
For instance, the VQ on Facebook (FB) is currently 18.67%. This is how it appears on the TradeStops website.
It’s a simple number. The VQ allows you to compare different stocks in different sectors. It delivers an apples-to-apples comparison regarding which stock is more volatile – and which one is less volatile.
But portfolio risk is different. Portfolio risk not only considers the VQ of the individual stocks, but also considers the correlation between the stocks that make up the portfolio. It’s easy to understand this when you see a couple of examples.
Here’s a portfolio of 9 well-known stocks. It includes stocks with low and medium volatility. In this example, we’ve sorted the stocks by their VQ%. Coca Cola (KO) has the lowest VQ and Netflix (NFLX) has the highest VQ.
Now let’s look at the volatility of this entire portfolio.
The Portfolio Volatility Quotient (PVQ) is the term we use that measures the risk of the overall portfolio. The PVQ looks at the correlation between the stocks to make this determination. What is this correlation?
Stocks don’t move up and down at the same time. A large pharmaceutical stock like Pfizer (PFE) is not normally going to move in the same direction and by the same amount as an online retailer like Amazon (AMZN). We measure this correlation going back 3 years.
Of the 9 stocks in this portfolio, 6 of them have a VQ greater than the PVQ of the portfolio itself. This shows the power of having a well-diversified portfolio.
It’s now the most volatile stock in the portfolio.
By adding GG to the portfolio, we added another sector to our portfolio. GG is in the Materials sector. Now we have investments in 10 stocks and 8 sectors.
And because of the different correlation between GG and the rest of the portfolio, the PVQ actually dropped to 15.08%.
We’re going to have a special educational webinar next week that discusses these concepts in greater detail. Be on the lookout for the announcement and the link to register.
Education Director, TradeStops