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Am I Diversified?

If you watch Jim Cramer’s Mad Money show on CNBC, he has a segment called Am I Diversified?  This is where callers name their top 5 holdings in their portfolio and Cramer tells them whether they are diversified based on the sectors that the companies are in.  For example, if you have two stocks that are in semiconductors like Intel and AMD, then you are definitely not diversified and the importance of this is that if people stop buying computers, then both of these companies will suffer severely and for the same reason.  You want to be diversified so that even if one sector goes down, your other stocks will be little to not affected at all.

In the last epsiode that I watched, I took those same stocks that the callers had and charted them in Yahoo to compare the price correlation.

Here are the 2 examples from the show aired on 7/30 where both groups were considered “diversified” based on the sectors that the companies belonged to.  I created the 6 month and 12 month chart and I included the DOW as well.

On 7/30

Kinder Morgan (KMP) – Pipe line
Omega Healthcare (OHI) – real estate investment company for health care
Pennantt Park(PNNT) – investment company
Windstream (WIN)- Telco
Linn Energy (LINE) – Exploration Energy

6 Months

1 Year

Altria (MO) – Tobacco
Vodaphone (VOD) – Telco
Abbott (ABT) – Pharma company
Yum (YUM) – fast food restaurants
Copano Energy (CPNO) – energy

6 Months

1 Year

You’ll notice that in both cases there is a lot of the same price movement for each stock.  Look at how each of the stocks have their major dips and spikes at the same time.  I realize that picking the best stock or the best of breed is the way to go, but if all the stocks move in the same direction, on the same days,  then are you really diversified?  If you look at longer term performance, the best companies will definitely succeed but if you’re a shorter term investor then I feel that diversification is much harder to come by using this strategy of trying to be in different unrelated sectors/industries.
One of the main reasons why I blame the similar price movement the introduction of ETFs.  ETFs encompass encompass so many different groupings of stocks and their trade volume is huge.  Some ETFS are matched to the S&P, the DOW, or the Nasdaq, others might be small cap, medium cap, country specific, growth, income generating, or based on different sectors.  There’s even at least one ETF  just for casino gaming, a very clever name too, BJK – as in Black Jack.  When all these ETFs are being traded, the stocks within the ETF follow a closer correlation.

For example, one of the most popular ETFs is SPY which is tracks the S&P 500 index.  The average daily volume is 260 million.  Compare that with Apple (AAPL), the average volume is 26 million which is one tenth and Apple is already a very popular stock.  The more ETFS we have and the higher the trading volume, the more closely the prices will correlate.  Think about what we’re really doing here when we want to invest in the SPY ETF. We’re saying that the holdings within SPY are going to go up. If everyone agrees with this, as more money enters SPY, more money is distributed to each of the stocks and as a result, the price of these companies will go up.  The opposite is true if investors want to sell SPY because they’re bearish.  Some of the holdings in SPY include, Microsoft, Exxon, AT&T, etc.  Here is where you can find the details:

http://finance.yahoo.com/q/hl?s=SPY+Holdings

Now think about what we’re doing if we ONLY buy Apple (AAPL) stock.  We believe that Apple stock will go up. We’re not saying that AT&T, Exxon, Microsoft, etc. are going to go up too and therefore there is no price correlation between our purchase of Apple stock and any other stocks in the market.  We might think that Microsoft will go up too but we’re not putting money into it unless we actually buy that stock as well individually.  ETFs create the correlation and the more that investors or institutions trade these, the closer the correlation will be.

If you really want to diversify your stocks in the short term, pick stocks that do not have price correlation with each other and I think a good way to do that is by just drawing the charts in Yahoo Finance.

Here is a chart comparing the performance of the DOW and NASDAQ with the most popular Gold ETF, GLD.

Gold compared with the Dow and Nasdaq

My recommendation is to diversify using different asset classes and but I’d like to save this for my next post since it is a lot to talk about.

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Categories: Uncategorized
  1. January 3, 2013 at 2:02 am

    Good article. Your readers might benefit from a free tool I have created which calculates the correlation among stocks. The tool is available at http://low-risk-investing.com

    Jake

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