Correlate this - when is buying more stocks not enough?

In the mid-1990s a pharmacist from west London called Jayesh Manek won the Sunday Times Fantasy Fund Manager competition two years running. So when he started the Manek Growth Fund shortly afterwards, some big name investors were willing to back him. The fund was successful for a couple of years but with around 75% exposure to tech stocks it crashed badly when the the dot com bubble burst. In the years that followed Manek kept taking positions in high risk shares and became a case study in how under-diversification can destroy long-term returns.

Diversification doesn’t just mean ‘more’

Ed recently wrote about how investors tend to hold too few stocks in their portfolios. But effective diversification is not just about having more stocks in a portfolio. Simply adding more stocks is known as naive diversification, but to diversify skilfully, it’s important to understand the central concept of correlation. In simple terms, correlation measures how the returns of two assets (like two stocks) move together, up or down. Mathematicians will recognise this this type of measure of movement by another name - covariance.

Highly correlated stocks move in the same way as each other while those with low correlation move in opposite directions. It is measured quite simply on a scale from -1 (low correlation) through to 0 (neutral) to +1 (high correlation). And it’s calculated by studying past returns.

The advantage of examining correlation between stocks is that investors can diversify much more effectively than by just adding more shares. Finance geeks will tell you that this means you are improving your chances of getting a better return for the same risk or the same returns with less risk. It does this by helping to capture a wider range of stocks that do better at different moments in economic and market cycles. In other words, when one stock zigs, another will zag.

Most investors don’t get correlation

In an epic 2008 study of more than 60,000 trading accounts, US academics Kumar and Goetzman endeavoured to get to the bottom of why investors are so under-diversified. What they found was that the average number of stocks in a portfolio increased from four to seven between 1991-96. But this diversification benefit was naive. There was no evidence that those investors were using any skill to ensure those extra stocks were uncorrelated:

We do not find evidence of diversification improvement by active means, where investors select less correlated stocks.

The researchers found that the least diversified 10% of the group of investors earned 2.40% lower return annually than the most diversified 10% in the group on a risk-adjusted basis. They concluded that it was older, wealthier, more experienced, and financially sophisticated investors that hold relatively better diversified and uncorrelated stock portfolios.

How to pick uncorrelated stocks

In The Little Book That Makes You Rich, US growth investor Louis Navellier - a self-confessed numbers person and computer geek - describes using optimization models to find stocks that zig when the market zags. Unfortunately that software is out of reach of most private investors. But he insists a lot of the analysis comes down to common sense - that a portfolio should be diversified across different industries and risk categories. For instance, he notes that retail stocks have a tendency to do well when the economy is strong so its worth having others - like drugs, utilities and food stocks - when conditions slow.

But Navellier’s zigzag approach doesn’t end there. The same rules apply to risk categories. He breaks exposure into three sections: conservative, moderately aggressive and aggressive, with an exposure of 60%, 30% and 10% respectively. He reckons this mix produces smoother, steadier returns. When markets dip, the 60% exposure to resilient, conservative shares offsets weakness in more aggressive shares. When conditions are steady, all the shares perform well and when markets soar, the aggressive stocks fly.

Uncorrelated investing strategies

A final thought here is that is tackling the issue of correlation can mean looking beyond the relationships between stocks, sectors and markets. Mixing and matching different investing strategies has been shown to be extremely effective. Perhaps the most powerful example is the combination of Value and Momentum. Ex-Goldman Sachs analyst Cliff Asness has built an entire hedge fund at AQR Capital on the back of research that value and momentum are a potent combination - because the two styles are uncorrelated. When one zigs, the other zags. You can read much more about that here.

How do you measure correlation in your portfolio?

Diversification means more than just increasing portfolio breadth - simply adding more stocks to a portfolio. Finding those that are more likely to behave differently at different times is shown to help reduce risk and smooth returns over time. So the next time you think about loading your portfolio with tech stocks at the height of a technology bubble, think of Jayesh Manek. Stockopedia’s forthcoming Portfolio Management package will enable you to see zigzag potential of your portfolio in an instant. In the meantime, it is possible to calculate correlation using an Excel spreadsheet.