Correlation is not price correlation
The topic is diversification and balance. Many investors have only a rudimentary understanding of diversification. They think diversification simply means spreading your investments between a certain number of stocks. As well, they give little thought to balance. In some ways balance is more important than diversification.
To introduce the subject let’s talk about Antonio’s portfolio.
Diversification and balance
Diversification has a long history. We need only refer to that wise investor William Shakespeare. Antonio declares in Shakespeare’s Merchant of Venice:
“My ventures are not in one bottom [a ship] trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year;
Therefore, my merchandise makes me not sad.”
Antonio spread his risks amongst different ships; amongst different places; and, amongst different years. He was well aware of not putting all one’s eggs in one basket. He used a number of ships to spread his risk of storms and sinking. He also makes clear that his ships didn’t only go from Venice to Alexandria, they also went to Constantinople and other ports. As well his fortunes did not ride on strength of trade in any one year. He was in there for the long haul.
But, the story does not have a happy ending. As the play, The Merchant of Venice, unfolds, all of Antonio’s ships sink, his business collapses and Shylock demands his pound of flesh. Leaving aside the poetic license that left poor Antonio facing simultaneous idiosyncratic calamities to all his ships, there are lessons to learn.
Antonio was diversified with a number of vessels, he had some time diversification and he also had provided geographic diversification. What he lacked was industry diversification and perhaps asset class diversification. He was too focused on shipping. His business lacked balance. He also seems to have lacked insurance. His risks were too correlated.
Investors cannot understand diversification without understanding correlation.
When most investors think of correlation they think of price correlation. That is, they think of it as the tendency of certain stocks or sectors to move together with each other or with the market as a whole. And, many portfolio management services offer price correlation charts. They will show in an instant the price correlation between stocks in the investor’s portfolio. They are of very limited use. I would even go so far as to say they are misleading.
For investors, what is more important is business correlation.
A simple example
We can understand this better by using a simplified example. Many of investors think that diversification means having a whole bunch of different stocks, the more the merrier. To make my point, let’s look at a portfolio that has lot’s of stocks but no real diversification.
Let’s say we construct a portfolio of twenty stocks. They are all U.S. based banks.
This is neither diversified nor balanced. I use the example simply to make the point that increasing the number of stocks in a portfolio does not necessarily increase diversification.
This portfolio provides some diversification because any one bank may blow up because of a rogue trader. This has happened. Our twenty bank stock portfolio does protect us against catastrophic idiosyncratic risk, that is, risk limited to one particular company that has the potential to destroy that company. Another example of this type of risk is the Deep Horizon oil well catastrophe. BP suffered a massive $40 billion charge for its ‘out of the blue’ oil spill in the summer of 2011. No doubt the reader can think of other examples of companies that, without any warning at all, suddenly implode.
But, this 20 bank stock portfolio is hopelessly lacking in diversification.
The twenty banks in our all bank portfolio may be spread across many regions of the United States. Thus if there was a housing melt down limited to the south east only banks in that area would be affected.
A country wide financial crisis might impact all banks. The latter might be thought of as systemic risk.
But we could reason that a financial crisis will affect all businesses, not just banks. That’s something to think about but it doesn’t solve our diversification problem.
Interest rates may be low and may stay low putting pressure on banks’ rate spreads – the difference between what they pay for money and what they charge their customers. Like almost all businesses, banks have input costs (typically rates paid on deposits) and prices for their products (rates charged on loans). In a low interest rate environment traditional banking suffer pressure on their profits. That is also a systemic risk.
Could we diversify by buying foreign banks? Perhaps, but interest rate levels have become quite international. Low rates in North America are often matched by low rates in Europe and Asia and elsewhere. Government policies to regulate banks can also crimp their profitability. This is also a systemic risk. The simple fact is that banks worldwide are correlated from a business point of view.
The reality is that an all bank stock portfolio lacks diversification because the businesses are correlated.
Our assessment of the diversification of the twenty bank stock portfolio has focused on two things: first, proper diversification involves an analysis of the extent to which the businesses of the stocks in our portfolio are correlated; and second, we have noted that price correlation is not the same as business correlation.
Price correlation can give a false picture. It can suggest business correlation where none exists. It can fail to show business correlation where it does exist.
Our all bank portfolio suffers many of the same shortcomings as Antonio’s fleet.
Readers who invest in theme or sector ETFs such as: Real Estate, Industrials, Consumer durables, Consumer discretionary, Natural resources, Financials, Healthcare, Communication Services and Utilities might reflect on whether they suffer from the same shortcomings as our 20 bank portfolio.
Balance is a different idea from diversification. To simplify the discussion I will limit the topic to finance, insurance and real estate. Let’s look at some changes we can make to our all bank portfolio.
Let’s use interest rates to think about this. Interest rates affect companies, but not in the same way. To give our portfolio some balance it would help to find stocks in a sector that reacts differently to interest rates. Often what is bad for lenders is good for borrowers. The real estate sector which includes REITs, public commercial real estate companies, home builders, building supply stocks and so on, are a good candidates. They like low interest rates. When interest rates are falling REITs are able to renew mortgages at ever lower rates and their funds from operations improve even if they haven’t raised rents or increased profitability in other ways.
In that same falling interest rate environment banks’ interest rate spreads get squeezed more and more. This would be an example of an inverse correlation, or hedging, between sectors. But, it doesn’t exist all the time. Real estate developers and builders tend to over build. When a recession comes along a number of players in the real estate sector go bust and the banks are left holding the bag. In that case both the borrowers and the lenders suffer.
To balance our simplified portfolio we might think of broadening out into life insurance companies. That really doesn’t help as life insurance companies are also sensitive to interest rates and in the same direction as banks. When rates rise both banks and life insurance companies do better. When rates fall, both banks and life insurance companies do worse.
What our simplified example has also brought out is the idea of natural hedging between different stocks in the portfolio. That is to say, if we want to own companies in the real estate sector but are worried about interest rates going up, we can hedge that risk by a position in banking stocks. If we own bank stocks and we are concerned about interest rates going down, we can hedge that position with real estate stocks but, we must recognize that both get hurt in a recession.
To read further about balance involving natural resources, consumer discretionary and other sectors take a look at Section 36.05 Balance between sectors of the Motherlode.
Catastrophic idiosyncratic risk
In our discussion above I mentioned the idea of idiosyncratic risk. It is real.
Because of idiosyncratic catastrophic risk the writer will not let any stock grow to more than 15% of the portfolio. This may force the partial sale of a great winner when it is riding high. At that point it will generally be sold down to 10%.
Warren Buffett probably would disagree with this approach. He writes: “To suggest they have come to dominate his portfolio is akin to suggesting the Bulls trade Michael Jordan because he has become so important to the team.” (Buffett/Cunningham, 1998, p.91)
The writer’s answer is that Michael Jordan is only human and could be hit by the proverbial bus tomorrow. Furthermore, Michael Jordan is a member of a team. No individual stock position should be capable of causing serious permanent damage to the portfolio in the event the entire company goes down the tubes.
The number of stocks in a portfolio is a reflection of the investor’s treatment of idiosyncratic risk and ability to achieve balance. In my case a portfolio of between 15 and 20 stocks provides sufficient opportunities for balance and protection against idiosyncratic risk.
Readers wishing to dig further into the subject of diversification, balance and portfolio strategy might look at the following sections of the Motherlode:
36.02 Digression to idiosyncratic risks and unexpectables
36.06 An aside on industrial commodities and agriculture
36.07 Correlation and the business cycle
36.08 A sector rotation strategy
36.12 Thinking about currencies in the context of diversification
36.13 International diversification
36.18 Strategy for the individual investor
36.20 How many stocks to own – 1
36.21 Lessons from the world of gambling – betting your beliefs
36.22 How many stocks to own – 2
36.23 Conclusion – portfolio structure for the individual investor
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction
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