Intelligent Investor's buy list is bursting with attractively priced investment ideas, many of which are blue chips and some less so.
But how do you know which ones to buy for your portfolio and which ones to ignore?
Well, there's a simple tool to help you assess whether your portfolio is well or more risky than you think.
Diversification entails investing in a range of different assets. It reduces risk by ensuring that no single event or situation poses a large threat to your portfolio.
Though a greater number of stocks will usually afford you greater diversification, it's no guarantee. Rather, understanding correlation is crucial to diversifying intelligently.
Two businesses are positively correlated when, if one is doing well, the other is also likely to be doing well. Likewise, if one is struggling, so is the other.
If two businesses are uncorrelated, there will be no relationship between their respective performances.
And if they're negatively correlated, when one is doing well, the other is likely to be doing badly.
When evaluating correlation, concentrate on the relationship between businesses' respective earnings power rather than their share price movements. Although prices tend to move together during bull and bear markets, that doesn't mean all businesses are correlated.
Sensible diversification means avoiding too many positive correlations. That way, only small parts of your portfolio will be exposed to any individual risks.
Businesses are correlated when they're affected by macro-economic developments or other events in the same way as other businesses.
In practice, stocks in the same industry are usually correlated. Retailers, for example, are affected by retail conditions and consumer sentiment in much the same way.
Geography also plays a big role. Businesses that are sensitive to economic conditions in the same location will be correlated.
Owning too many businesses in the same industries, or operating in the same region, can lead to a portfolio with poor diversification.
The way to test for correlation in your portfolio is to imagine many different scenarios and their likely effects on your stocks (positive, negative, or little effect) and to see which ones show similarities.
To help, we've created a sample portfolio from our current buy recommendations. For brevity, the columns above represent only four possible eventualities but you can come up with as many as you like.
These scenarios are macro-economic in focus. Stock-specific risks are not represented.
This portfolio has obvious problems. First, financials weigh too heavily. This is shown by the ominous arrows in the "Financial market meltdown" column.
Second, a huge chunk of this portfolio is correlated to the Australian dollar. If the dollar falls (which we believe it will), it would be fantastic for this portfolio.
A continued appreciation, however, poses a substantial risk.
The portfolio is better diversified in respect of oil prices.
A higher oil price might reduce passengers through MAp Group's airports but this would be offset by the higher prices Santos would receive for its oil and gas.
Likewise, though higher interest rates would increase interest costs for the indebted businesses, QBE and Computershare would benefit from higher fixed-interest returns on their float.
Investing entails risk but there's no reason to shoulder more than necessary and there's no excuse not to understand the types of exposure.
Apply this risk-matrix process to your portfolio to see whether it's diversified properly. If not, now is the time to act.
Frequently Asked Questions about this Article…
What is portfolio diversification and why does it matter for everyday investors?
Portfolio diversification means investing across a range of different assets so no single event or situation poses a large threat to your holdings. For everyday investors, good diversification reduces overall risk and helps ensure that poor performance in one stock or sector doesn't derail your whole portfolio.
How does correlation between stocks affect my diversification?
Correlation describes how businesses move relative to each other: positively correlated stocks tend to do well or poorly together, uncorrelated stocks show no clear relationship, and negatively correlated stocks move in opposite directions. If many holdings are positively correlated, your diversification is weaker, even if you own many stocks.
How do I test my portfolio for correlation and hidden risks?
Use a simple risk-matrix exercise: imagine a range of macro scenarios (e.g. market meltdown, weak Australian dollar, higher oil prices, rising interest rates), note whether each stock would be positively, negatively or hardly affected, and look for patterns. Stocks that react the same way across scenarios reveal correlations and concentrations.
Why should I focus on industry and geography when diversifying my portfolio?
Stocks in the same industry are often affected by the same forces (for example retailers by consumer sentiment), and businesses exposed to the same country or region move together when local economies shift. Owning too many companies in one industry or region can create poor diversification and concentrated risk.
What are some common hidden exposures investors might overlook?
Hidden exposures include heavy weightings to a single industry (the article’s sample portfolio was too heavy in financials) and currency concentration (large exposure to the Australian dollar). These can magnify losses if that sector or currency moves against you.
How can changes in oil prices or interest rates affect different stocks in my portfolio?
Higher oil prices might hurt airline- or airport-related businesses by reducing passengers but benefit oil and gas producers like Santos through higher commodity prices. Higher interest rates increase borrowing costs for indebted companies but can benefit insurers or firms holding large cash floats (for example QBE or Computershare) by increasing fixed-interest returns on that float.
Should I judge correlation by share price movements or by businesses’ earnings power?
Focus on the relationship between businesses’ earnings power rather than short-term share price moves. Share prices often move together in bull and bear markets, but similar price movement doesn’t necessarily mean the underlying businesses are truly correlated in how they’ll perform economically.
What practical steps can I take now to shield my portfolio from unnecessary risk?
Apply the risk-matrix process: list realistic macro scenarios, map how each holding would be affected, identify clusters of similar reactions, reduce overweight positions that create positive correlations (industry, geography, currency), and rebalance to spread exposure so you’re not shouldering more risk than necessary.
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