Correlation…Schmorrelation!

Friday, Sep 21 2012 by
7

Personally, my focus over the summer’s been on correlation. Some investors are great at stock-picking, risk management & portfolio construction, while others are abysmal..! But, all too often, there’s precious little difference in respective performance. Because we’re all terribly correlated with the market, and with the economy – yep, we’re all making pretty much the same big bet! A preference for discounted assets, special situations & stocks with specific catalysts is my attempt to escape this correlation risk. Medium-longer term, I think this approach offers a genuine ‘edge‘ via lower beta stocks. Trouble is, shorter term, market correlation (especially in market setbacks) can simply trounce all other factors…

 Think of, say, a company with excellent results, or an oil major in a rising oil price environment. Now, picture the market dumping 25% – how well do you think those stocks are going to perform, regardless of their strong fundamentals..?! Unfortunately, if you’re a stock picker, it’s v difficult to avoid this short term market correlation. Unless you want to retreat into market-timing, trading and the weird & wacky world of specialist ETFs… For the rest of us, though, there’s some hope…

The logical & ultimate extension of my approach is to seek out investment ideas that are uncorrelated, or negatively uncorrelated, with the economy. Once you can shake off short term market correlation, this focus can offer a genuinely lower correlation/risk portfolio. There’s also the potential to earn better/decent long term returns even in an awful market/economic environment.

Ideally, I prefer uncorrelated to negatively correlated investments. The reason? Well, uncorrelated offers the possibility of sustained positive returns, while negatively correlated offers inverse returns instead. [People forget this. They add negatively correlated investments, and then grow increasingly frustrated with their losses - which are presumably offset by higher than normal returns elsewhere in their portfolio. This frustration (& over-confidence) ultimately boils over, and they dump these investments at probably the v worst moment...]. On the other hand, returns on many uncorrelated investments (e.g. Risk Arb.) are often competed away for this very reason – so annualized returns may still look attractive, but absolute returns can be positively anorexic (esp. from a private investor perspective).

From least to most attractive, I think there are three / four investment categories to be looking for:

i) Negatively Correlated Sector Stocks:  These stocks actually aren’t…

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. The author may own shares in any companies discussed, all opinions are his/her own & are general/impersonal. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


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1 Comment on this Article show/hide all

emptyend 21st Sep '12 1 of 1
3

Much of my summer’s been spent searching out more stocks that offer decent exposure to distressed consumers/companies/assets, particularly in Europe.

...mmmm....just a word of warning on that. When the financial brown stuff hit the fan a few years ago, my eyes alighted on a company with a good amount of exposure to insolvency work, restructurings etc. After all, we were bound to get loads of them, right?

That company was Begbies Traynor (LON:BEG) and their chart is here:

....which kind of speaks for itself!!

Fortunately I didn't buy any.

But you are certainly right to be worried about correlations - because plenty of babies have been sucked under as the bathwater has gone down the plughole. Trouble is.....I'm not sure that there is a foolproof way of sidestepping the correlation risks, even if one takes the utmost care and attention when stock-picking.

Good luck - I'll be interested in further comments on the topic  in due course.

ee

 

 

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About Wexboy

Wexboy

My personal investing career began with an emerging markets obsession. Investing in individual emerging market stocks was a much taller order then than today, so I gravitated towards investment fund shares and warrants. Little did I know that (despite the volatility involved) this would turn out to be a very fortunate approach – it pretty much saved me from the consequences of poor/misguided stock analysis, chasing stock tips and investing in garbage stocks all the way down to zero.... Only when I learned of value investing did I finally discover a quantitative approach, plus a set of tools, that appealed to me and equipped me better for investing. And I guess it appealed to my mathematical background and perhaps my natural scepticism. It also tempered my lust to dive into investment trends – in fact, I’ve come to realize that any decent secular trend will take many many years to play out and there will be cycles of booms and busts in any related stocks to exploit, so hold your horses, stick to value investing and your chance will come…!  more »


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