Apples and oranges for your portfolio
Jack Ohayon CFA, April 28, 2017, 4:52 p.m.The old adage of don’t put all your eggs in one basket is one of the cornerstones of investing but there are other pitfalls that investors need to be aware of.
As an Apple enthusiast, you own all their products and decide to take the plunge by buying their stock. Since it is the only stock in your portfolio, if a competitor releases a product that is better or makes their product obsolete your portfolio will most likely have a sharp drop in value. Many investors make the counterargument by saying” If they release a product that blows away the competition my portfolio will have great returns!”
The flaw is that it only takes one event to wipe your portfolio out. The downside risk is simply not worth it.
Below is a diagram with 3 portfolios:
Portfolio 1 is heavily concentrated with 2 fierce competitors. If something happens in the industry, for example there is a supply shortage in a shared part used to manufacture phones both stocks will drop in value.
Portfolio 2 is still concentrated. There is a positive relationship between the price of tires and cars; when profits of car companies rise, profits of the tire company will also rise.
Portfolio 3 is diversified. There is no relationship between McDonalds and Dupont Chemicals. Events that affect one company will have no bearing on the other. Optimally, a portfolio that consists of companies that are not correlated has the most stable performance by reducing the portfolio's sensitivity to market swings.
Obtaining diversification by holding bonds and stocks is also very effective since the bond and equity markets move in opposite directions – they are negatively correlated
Helium Investments uses complex statistical analysis to search for uncorrelated or negatively correlated assets that diversify the portfolio hence lowering the portfolio’s risk.
There are a couple of issues with correlations.
- Correlations can change over time and need to be calculated frequently
- When the market is undergoing stress, e.g. the 2008 housing crash, all assets become positively correlated, rendering sector selection useless
How many securities are needed for maximum diversification?
Many professionals agree that an optimized portfolio needs between 30-40 securities to achieve diversification. More than that yields diminishing returns.
The right mix of apples and oranges
Once a portfolio is properly diversified, it is also important that the weightings in the portfolio do not become lopsided. Over time, a stock that performs, balloons and tilts the weight of the portfolio to that stock; over-exposing you to undesirable risk of that particular stock’s performance which can impact on whether you will meet your financial goal.
Portfolio rebalancing resolves that by realigning portfolio weights to appropriate allocations.
Helium Investments automatically rebalances client portfolio’s once every 6 months.