At the core of constructing a portfolio lies the principle of diversification. but what is portfolio diversification?
Diversification is an investment strategy that involves spreading your investments across a variety of assets or asset classes to reduce risk.
The main idea behind diversification is that by holding a mix of different types of investments, you can potentially lower the overall risk in your portfolio because different assets may respond differently to various economic and market conditions.
Diversification aims to achieve a balance between risk and return.
Example:
Imagine you believe that a single stock, AAPL, represents a fantastic company and you anticipate that it will thrive in the future. You decide to invest all of your funds into this particular company.
However, it’s important to acknowledge the inherent risk in this strategy. What if AAPL faces challenges such as producing subpar products, encountering new competitors, or dealing with changes in taxation laws, among other potential issues? In such cases, if the company does not perform well, you stand to lose your entire investment.
This is why it is crucial to adopt a diversified approach, where you don’t concentrate all your resources in one investment. The underlying principle of diversification is that by spreading your investments across different assets or securities, you mitigate the risk associated with the failure of any one investment.
Diversification can take various forms. You can diversify within a specific asset class, such as stocks, by holding multiple stocks simultaneously. Additionally, you can expand your diversification beyond stocks by incorporating various investment assets into your portfolio. This includes bonds, gold, real estate, and crypto, providing you with multiple avenues for diversifying your investments.
There are individuals who prefer not to embrace diversification. For them, the rationale is as follows: they might have a strong belief in the potential of a particular company, and they anticipate it will yield the highest returns. Consequently, they question the need to divide their funds among multiple companies and instead propose concentrating all their capital in the one company they believe will perform the best.
Once again, it ultimately comes down to an individual’s risk tolerance. Consider someone who, back in the early 2000s, exclusively invested in AAPL stock. They would likely have accumulated substantial wealth by now. If you genuinely believe that a particular company will prosper in the future and are willing to take on the risk of losing your entire investment if it fails, then it’s your choice to proceed. If your assessment turns out to be accurate, you will undoubtedly be grateful to yourself for making that decision.
What is correlation?
Correlation in stocks refers to the statistical relationship or degree of association between the price movements of two or more stocks in a portfolio. It measures how closely the prices of these stocks move together over a certain period of time, and it is an essential concept in the field of portfolio management and risk assessment.
Correlation is typically measured using statistical methods, and the result is expressed as a correlation coefficient, which can range from -1 (perfect negative correlation) to 1 (perfect positive correlation).
Positive Correlation: When two stocks have a positive correlation, it means that their prices tend to move in the same direction. If one stock goes up, the other is likely to go up as well, and if one stock goes down, the other is likely to go down too. A correlation coefficient for positively correlated stocks will be greater than 0 but less than 1. This suggests that they are moving somewhat in sync but not perfectly.
Negative Correlation: Conversely, when two stocks have a negative correlation, their price movements move in opposite directions. If one stock goes up, the other is likely to go down, and vice versa. A correlation coefficient for negatively correlated stocks will be less than 0. This suggests that they tend to move in opposite directions.
No Correlation: When the correlation coefficient is close to 0 or very low, it indicates that there is little to no linear relationship between the price movements of the two stocks. In other words, the movements of one stock do not provide any meaningful information about the movements of the other.
You can use TradingView to visually analyze correlations among your stocks, or you can calculate them using their price data.
It’s important to note that correlation does not imply causation. Just because two stocks are correlated does not mean that one stock’s performance directly influences the other. Other factors may be at play, and correlation should be used in conjunction with other tools and analyses when making investment decisions.
The significance of understanding correlation in stocks lies in portfolio diversification and risk management. By including stocks with different correlation patterns in a portfolio, investors can reduce overall risk. This is because if one stock in a diversified portfolio performs poorly, the impact on the entire portfolio is mitigated by the performance of other stocks with different correlation characteristics. Diversification seeks to balance the risk-reward trade-off and potentially enhance portfolio stability.
Stocks within the same sector tend to exhibit some level of correlation, while stocks within the same industry often have a strong correlation. Therefore, if you’re selecting stocks within the same asset category, such as sectors or industries, you may not achieve effective diversification.
This is because if the specific sector encounters a downturn, all the stocks within that sector are likely to decline, resulting in a decrease in your portfolio’s value. This occurs because you’ve chosen stocks that are closely correlated. To mitigate this risk, it’s advisable to opt for assets that exhibit minimal correlation with each other.
The lower the correlation between your assets, the more secure your portfolio becomes.