Achieving True Diversification

 | Oct 02, 2013 | 11:00 AM EDT
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I was inspired by Real Money contributor Kate Stalter's provocatively titled and insightful post, "Rules of the Game: Earnings Don't Matter," and wished to build upon her argument with some additional rules. As regular readers know, I am a strong advocate of only owning stocks whose earnings estimates are on the rise, so if I see any post telling me earnings don't matter, it will catch my attention!

Her argument is that, while earnings matter to individual stocks, they don't when you hold a portfolio of many stocks. Instead, she argues, what matters here is the overall behavior of the portfolio. I could not agree more! In fact, while I research companies individually before I put them into my fund, much of my research centers on how the incremental addition of a name will influence the characteristics and behavior of the overall portfolio.

(As an aside, I am so adamant about the "portfolio view" that I rarely even look at individual stock performance. What does it matter? If I have a name that is a triple, for instance, but the portfolio is down 10%, who cares about that one name?)

We all know that diversification is a "free lunch" -- that, by being effectively diversified, you can reduce the total risk of your portfolio without reducing the return potential. So this is an important consideration when I contemplate a new purchase. In order to evaluate the diversification value of a name, I examine how its stock-price movement correlates with other names I already own.

Most people think of diversification informally, and usually implement it by buying names across a range of industries. However, other factors besides sectors can create correlations -- for instance, homebuilders and financial names might seem relatively unrelated, but they both move to the tune of interest-rate changes, so there is little diversification value in building representation across those two groups. That is a simple and obvious example, but many other theoretical yet impractical diversification strategies are more subtly wrong.

Below is a stock-price correlation matrix of the current holdings of my "growth at a reasonable price" (GARP) strategy (recall that I run two strategies, GARP and dividend-capture). As I look at a new name, I want to see how its price movement correlates with existing holdings. If the correlation is high, I may like the name but still know that it is not doing a lot for my risk profile. Low correlations are the best, since they mean I have a high return potential and that my risk is reduced.

In the table I've highlighted several pairs that are especially good. I noticed that VMware (VMW) is an especially capable diversifier -- its correlation to almost everything is quite low.

Dvorchak Portfolio -- Disciplined Growth Price Correlation Analysis
Source: Gary Dvorchak

Obviously many of our readers, if not most, will not have access to the tools to run this sort of analysis. If you use an outside financial advisor, they certainly will (or should!). Ask them to run a similar analysis on your current holdings, and see what it shows. Ask him or her, "Am I diversified?"



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