Thursday, April 28, 2016

A Stock Solution; A Different Topping on Every Slice

When I was 14, my soccer coach would tell us that in order to be good defensive players we needed only to remember the three Ds: Delay, Direct, Destroy. Coincidentally, a similar axiom exists for investors hoping to maximize profits from a risk-averse portfolio: Diversity, Diversity, Diversity. Resource allocation, or where you choose to place your money, is one of the most fundamental cornerstones of investing, and rightfully so. Of course, certain types of investors or speculators have optimal portfolio compositions which are heavily skewed, and that works for their style. That being said, the average investor who is simply investing to grow their nest egg may be interested in the less risky investments.

At first blush it might seem like common sense. If your portfolio is composed solely of Nike, Under Armor, Lulu Lemon Athletica, and Adidas....
but of course, this is making a pretty big assumption that all of these companies essentially covary perfectly. We're assuming that when the whole athletic wear sector goes up, they all go up by the same number of points, and that when one has a successful period, they must naturally be taking an equal amount of value from their competitors. In addition to this concern, we should also consider more diversified companies, holding companies, and any other assets whose impact on a portfolio is not necessarily obvious. For example, how much do Amazon and Google co-vary? Facebook and Google? And now that Google is developing self-driving cars, are they in competition with the auto industry too?! When you take some of the projects at many companies into account, it can become overwhelming. Thus, in order to relax some assumptions and to account for complex contributions to a portfolio, we can use a number of statistical tools, the primary and most simple being a correlation analysis.

Correlation describes, on a scale of -1 to +1, the change in two stock's prices or one stock relative to an index (SP500, DJIA, etc.). In terms of readout, a +1 represents perfectly positively correlated stocks, a -1 would be a perfectly negatively correlation, and 0 indicates no correlation. In the case of constructing your portfolio, stocks with very little correlation to stocks you already own, as well as a stock with negative correlation to your other stocks are lend to the overall diversity of a portfolio. Perfectly positively correlated stocks do not complement each other and as a result provide zero diversity to a portfolio. Calculations such as these help investors to determine the diversity of a portfolio, but ultimately much more information and expertise go into determining the weighting of different sectors in a portfolio, as well as what price is a good price for a stock you are looking to add (asset pricing analysis is discussed in my previous post, if thats how you feel like spending the next 10 minutes of your life)


  1. Statistics on the stock market for personal investing seems like a good way to feed a machine that is far savvier at taking your money than giving it back. Not that statistics are not useful, far from it, but that there are a host of well trained extremely well compensated people devoted to manipulating the system better than you can. It seems better on the low level I (and I'd guess many other grad students) are at to just grab an index fund and hope the market does ok overall.

  2. An interesting point Paul, although I would argue that individual investors are not as powerless as you suppose and regularly have success based on the aforementioned indicators. One thing which can really screw with these statistics, however, is of course the prevalence of HFT, making up more than 50% of trading on the market. One of the most prolific investors and teachers of investing theory, Ben Graham makes the distinction between these two types of investors. An individual investing in an ETF or index fund which they essentially would not need to manage it at all (something very risk averse for people who want to just throw money into a fund and leave it) could expect a return of about 5% on investment while a more active investor, willing to more closely monitor the market, can expect returns of upwards of 8-10% depending on a variety of factors. My point is, Graham doesn't believe that the difference in the best investment options is based on income level or capital, but rather on which of these two styles of investing you are most comfortable with.

  3. I would also argue that if it were really as easy as you believe to "manipulate the system" then you'd also have to show that their manipulations are also directly related to an individual investor performing poorly on the market. You aren't alone in your cynicism: millennials are notably distrustful of investing on the market. And no wonder: we were brought up in the era of Enron, we lived through a recession, and we're constantly told that "the big bad banks are cheating you out of money" (not that they aren't). If I might provide a few counterpoints, there are arguments made by many top analysts that randomly choosing stocks can generate a portfolio which does better than the majority of investors, regardless of their style. This is goes against the idea that one needs a huge amount of expertise, training, and savvy to do well in stocks. Secondly, the top performing mutual funds of 2015 returned about what I quoted above, although they actually did worse because most brokerages will charge you a certain percent for managing your portfolio (you didn't think they did it out of the goodness of their hearts did you?). This resulted in a return of ~4% for some of the best index funds. If your mutual fund tracks the S&P500 like many of the biggest ones do, you lost 8% from 2015-2016. Alternatively, I began investing less than 6 months ago. My current return is almost a positive 8% (7.93% specifically) and my portfolio is (by my fairly uninformed assessment) rather risk averse. My post-doc who has made some extremely volatile bets has a current return of ~20% over the past 3 months. Trading is, no argument here, complex. It's that precise reason that there isn't a silver bullet (like just putting something in a mutual fund) which works for everyone our age.