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.
At TradeStops, we define the risk of an individual stock by using the Volatility Quotient (VQ). It’s a straightforward number representing the normal volatility inherent within an individual stock.
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.
This portfolio is well-diversified. Using the Asset Allocation tool, you can see that the 9 stocks represent 7 different sectors.
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.
By looking at the different correlations, we can determine what the normal portfolio volatility should be. In the case of the above portfolio, the PVQ is only 15.43%.
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.
When you have a portfolio that is well-diversified, you can actually add a stock that is more volatile, yet take less overall risk in your portfolio.
Let’s add one of the gold miners to this portfolio. Goldcorp (GG) is one of the few gold miners not in the SSI Red Zone. Its VQ is 36.65% which is considered high risk.
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%.
Think of it, we added a stock with a VQ above 36%, yet the overall PVQ dropped. That’s powerful.
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.
Cheers,
Tom Meyer
Education Director, TradeStops
