Portfolio Management: Correlation
After the last post on risk, you are probably wondering how to evaluate your prospective portfolio for its risk? Well, we gave one way – check the beta of your investments and your portfolio as a whole. While it may be easy to look up beta of your individual investments, it’s harder to get a beta for your portfolio. And, ultimately, beta is based on past performance which may not be indicative of future performance. There is, however, a qualitative way for you to quickly assess your choices for your portfolio and that is through a little logic and some thought about correlation.
Correlation is essentially the qualitative idea behind beta. It describes the tendency for certain stocks to move in the same direction. For example, stocks in the same industry tend to be highly correlated since events in the world likely effect them in similar ways. On the flip side of that, an industry which benefits from creating high prices for another industry will have negative correlation – or they’re stocks will not move in the same direction. An example of this is the oil industry versus the airline industry. If fuel prices are high, the airline industry typically does poorly while big oil companies will make a lot of money. If you know basic statistics or linear regression, you can use software or your own analysis to do regression analysis of stock prices of two stocks or two industries to calculate a correlation coefficient usually given the variable, r. If it is +1, then they are highly correlated. If it is -1, then they are negatively correlated.
Now, mitigating risk is essentially a manner of a very popular term you’ve probably heard known as hedging. Choosing stocks without much correlation is typically a good way to insulate yourself from risk, but there is a downside. Often times, by hedging your bets with different classes of stocks that are highly negatively correlated, you will see that your returns on each individual investment are canceled out by the other. On the other hand, if you get very correlated stocks, then you will be much more sensitive on bad days.
My personal strategy is to attempt to build a portfolio of stocks which are as uncorrelated as possible – in either a negative or positve fashion. I tend not to play complimentary industries and even do my best not to invest in typically volatile industries like oil though once in a while I will invest in transportation stocks which are reliant on oil. After that, I expect that my overriding analysis will overcome whatever short term swings in the markets might affect my stock picks. Take some time to think about what industries or market events have high levels of correlation – negative or positive – with price movements in stocks. You’d be suprised how just a little common sense can improve the balance in your portfolio.
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