Podcast: Ep.4 Portfolio Diversification (Beta and Correlation)
This is the pilot episode of Tiingo Investing that explores what true portfolio diversification is, what metrics we can use to measure diversification, and how we can prevent misusing them. Understanding these concepts will help you create a more stable investment and retirement portfolio. This podcast later explores more advanced topics and is meant for the beginning investor to the professional.
This was a Pilot episode and was the first episode in the series. Tiingo started with Episode 4, Star Wars Style. The actual date of publication was March 1st, 2015 but is dated March 15, 2015 on the blog to keep chronology in tact.
With that! Here are the links.
If you have iTunes please use that as it helps my rankings within the store. Don’t forget to subscribe to stay updated on future episodes!
You can find the script of this podcast at the bottom of the E-mail.
Here is the script that was used in today’s episode.
Note: I don’t follow scripts word-for-word as they can sound unnatural, but the episodes do closely follow them.
This is a partial script:
The Beta Correlation podcast
Welcome to the Tiingo Investing podcast. Where we teach you how to make a better investment and retirement portfolio. Our goal is to explain everything, from basic to advanced concepts in plain language you can understand – whether you are a beginning investor, or a professional
—
Welcome to the pilot episode of a podcast series I call “How to create the best investment and retirement portfolio.” I’m starting this podcast to my friends, family, and the general public who ask me frequently how to handle their portfolios. In this podcast, I explain complex topics in very simple plain language that anybody, from the everyday person to the professional, can understand
This episode of Tiingo investing, we are going to talk about diversifying your investments and introduce you to two under-used metrics that can really help us make both our investment portfolios and/or trading strategies better. Many of us have heard of price/earnings ratios or price/book ratios, but what about beta and correlation? If you already know what these are, get ready because we are going to get funky and get you to think about these in a way you haven’t before. And if you don’t know them yet? Well we are going to explain it first and then get funky.
Not many people know this, but this topic hits home for me actually. When I first started on wall street, I traded stock correlation for a bit. Yes, turns out it’s possible to trade a statistic.
Almost all of you were taught to diversify your portfolios. It’s almost investing 101. You tell a friend you’re about to start investing and they always tell you at least 1 of 3 things
- stock tip
or
- how much money they have made or lost
- Diversify your portfolioi!
Many of you are thinking about diversifying your portfolio or feel like you already have. The key to creating a diverse portfolio is not having many different funds, etfs, or stocks in your portfolio. The key to creating diversification is understanding how all those pieces move together. So if you are an investor, or even a short-term trader, correlation and beta are important because they are diversification.
Anyway,, beta and correlation help tells us about the risks involved in our portfolios. We are going to cover what they are, why they are important, how to use them, and the dangers of misusing them.
To start, let’s begin with a few quotes stressing how important correlation and beta were in our most recent financial crises. If these quotes don’t make sense to you now, they will by the end of our discussion.
Tiingo Investing
“Investors who increased allocations to international stocks, emerging markets, real estate, hedge funds, high-yield bonds, and natural resources during the previous decade did so at least partly because these investments’ correlations to U.S. stocks, and to each other, had been low in the past. Unfortunately, the correlations increased significantly in recent years. As a result, an expected reduction in risk did not occur, and in the 2008 bear market investors suffered much larger losses than expected.”
MacBride, Forbes
“Equity market-neutral strategies tend to do well when stocks are not highly correlated to each other. Since 2008, stocks have shown increasing correlation, among and across sectors and geographies,
causing many equity market-neutral managers to struggle.”http://advisor.morningstar.com/uploaded/pdf/alt_marketneutralmfcs.pdf
—
So what is correlation and beta and how are they different?
Correlation measures the strength of how two stocks or other data series move together. Correlation can be a number between -1 and 1. -1 means the stocks are perfectly negatively correlated and 1, meaning perfectly correlated. 0 means no correlation.
Notice how I said correlation measures the strength of how the relationship moves, but not the actual relationship. In other words, correlation can’t tell you how much something moves relative to another, but whether, and in what direction, two things move together.
For example, if Apple moves 5% today and 10% tomorrow, and google moves 10% today and 20% tomorrow, they have a correlation of 1. Correlation is telling us they are strongly related in movement.
Let’s take another example
If Apple, again moved 5% today and 10% tomorrow, and google moved 15% today and 30% tomorrow, they still have a correlation of 1.
Correlation doesn’t tell us how much Google moves when Apple moves 5%, just that if Apple moves twice as much as it does from yesterday, so does Google.
So what can tell us how much something moves? This is where beta can come in
Whereas correlation tells us the strength of how two stocks are related, beta tells us more about the relationship. Beta tells us both the direction the two stocks move in and by how much.
For example, in the above statement we said if Apple moved 5% today and 10% tomorrow, Google moved 10% today and 20% tomorrow. We can say that Google has a beta of 2 to Apple. So to figure out Google’s move, you take Apple’s move of 5% and times it by the beta, which is 2. This gives 10% for Google. In other words, Google moves twice as high as Apple does.
Now beta is more commonly reported metric on many websites. But usually it just says “beta.” Generally, when websites show beta they show how the asset moves to the S&P.
If you still don’t have a grasp of what these are, that’s okay. You’re going to hear these descriptions throughout and by the end of it, I promise you will have understand the basics.
—
So why are these metrics so important?
http://arxiv.org/pdf/1102.1339.pdf
These metrics are important because they are diversification. Let me explain,
As we mentioned at the beginning of the podcast, every investor has wanted to diversify their portfolio. But if we ask ourselves, what is the point of diversification? And the reason for that is uncertainty.
If we knew a stock like Coca a Cola would return 10% every year, no matter what, what would you do? The logical thing would be to take out as many loans as you could. sell your house, and put all your investments into Coke. There would be no point in needing diversification because you knew the return you would get every year.
But the reality is that we don’t know how much a stock or asset will give us each year – we live in a world of uncertainty, but we generally do know how things react. For example, usually, but not always, bonds will perform better than stocks in times of recessions. At the same time, bonds still give us a return in the good times as well. Because of this, they tend not to be as correlated as stocks. In other words, they tend not to move in the same direction as stocks all of the time. In addition, bonds tend to have a lower beta than stocks. This means that they tend to give us lower returns than stocks in good times and higher returns than stocks in bad times. So we can see, bonds generally give us a lower reward but are also lower risk. This is what correlation and beta tell us.
So the key to creating a diverse portfolio is NOT having different stocks, bonds, etfs, commodities, etc. The key to creating a diverse portfolio is having different assets that are uncorrelated and also give you positive expected value. Hollld up, what does positive expected value mean? Positive Expected Value, or positive EV means you expect the asset, a stock or mutual fund in this case, to make you money. It’s the reason we invest in things, because we expect that they will give us money.
And many of you think professionals have mastered this technique, but if you look at any major financial crises, it has brought down banks and hedge funds, those who are supposed to be the most intelligent and well-versed investors. And actually, a lot of them understand correlation and do diversify their risk. The problem that many of us make though, including professionals, is that we underestimate how correlated assets can get in recessions and downturns. And actually sometimes it’s not intuitive.
Let’s take 2008 for example. We started this podcast with a quote describing how correlation among stocks increased rapidly. So if you were in a utility company, and S&P, they went from a low correlation in good times to an incredibly high one. And this is one of the most important things we need to understand about beta and correlation: they are constantly changing. And not only are they changing, they can change incredibly rapidly in a short amount of time.
If we want to take a look why, think about what us investors do in time of panic. We sell and we sell immediately. We don’t care what we’re selling, we just want to get out of stocks before others do so we don’t lose as much. Some of us may not sell, but many of us have seen what happens on either side. So in times of panic correlation can go from .2 or 20% to 80% or higher. Those 20 stocks you thought were diversified in the good times? well now they’re all moving in the same direction!
And not just stocks, but even stocks and bonds. During panic sell-offs, the correlation of stocks and bonds also become incredibly elevated. For example, the S&P and long-term US treasuries, which many people argue are the safest bonds in the world, weekly correlation went from a negative correlation of -30% to almost a positive 70% in a little over 2 months. In other words, we think bonds protect us in the bad times…which they did in 2006. But as soon as panic set in, they moved in the same direction as stocks!
And not only this, sometimes correlation moves can be unintuitive. In 2011, correlation among stocks in the S&P went higher than they did in 2008. In August 2011, there was panic regarding the Eurozone and whether or not Greece or other countries would leave the Eurozone, but the panic only led to a much much smaller sell-off in the S&P and DOW than 2008. A 16% sell-off led to higher correlation among stocks in the S&P than did a sell-off greater than 50%. Nuts huh?
So what can we do about this? First we will quickly go over tools on how to calculate these values and then how to use them to protect our portfolios.
How do you calculate beta/correlation?
Let’s take a moment and discuss some tools e can use to calculate beta and correlation. And for the record, we’re going to skip the mathematical explanations here and instead focus on what you need to calculate the statistics and how you can do it. I’m going to bring up Tiingo’s tools and tools other websites offer. I’m not trying to sell or push you anything – in fact Tiingo is free. The reason I am using Tiingo’s products is that I made these tools because I realized no other website or service let you do this. And the ones that already had them calculated? Well their calculations are wrong and they don’t show you the numbers you need!
