Stock Portfolio by Nick Youngson CC BY-SA 3.0 Alpha Stock Images
The more closely your investment portfolio resembles the stock market, the more likely your portfolio will produce results similar to the market. In finance, this concept is known as correlation, which is a measure of how a group of investments moves in value compared to a market index (such as the S&P 500).1 Understanding your portfolio’s correlation to the market is important, especially if you expect your portfolio to have less risk of loss compared to the market.
A helpful way to think about correlation for your portfolio is to consider the amount of your estate allocated to the stock market. This allocation may come from individual stocks and/or stocks held within funds you own (e.g., traditional mutual funds, exchange-traded funds (ETFs)). Consider this part of your estate as your equity portfolio. If the market declined 40%, how would you expect your equity portfolio to perform? If your equity portfolio was highly correlated with the market, a likely scenario would be at least a 40% decline in value. If, however, your equity portfolio had a weak correlation to the market, such a scenario could be less likely.
To help determine if your equity portfolio is highly correlated with the market, we recommend you first seek answers to these questions:
1) How many stocks do I own in my portfolio, both directly and indirectly (e.g., stocks held within mutual funds)? [The more stocks you own, the more likely your portfolio will be highly correlated with the market. Such a scenario becomes more likely if you own a diversified basket of at least 20 stocks.2]
2) How is my portfolio allocated across different sectors compared to the overall market, such as healthcare, technology, financial services, etc.? [The more closely your portfolio resembles the market in terms of sector allocations, the more likely your portfolio will be highly correlated with the market.]
When taking an inventory of your investments, keep in mind that each of your mutual funds and/or ETFs may hold hundreds of different stocks. As a result, your fund holdings can greatly influence how correlated your portfolio is to the market. On a related note, analyzing how your portfolio is allocated across different sectors (e.g., healthcare, energy, financial services, etc.) compared to the overall market can be the first step to improving your portfolio’s return potential.
Not only can the answers to the previous questions help determine if your portfolio is highly correlated with the market, they can also help you understand:
• If your return goals are realistic compared to the market; and
• If your expectations regarding the risk of loss are realistic compared to the market.
On a related note, some investors may expect their financial advisors or fund managers to move them out of the market before a sharp decline in value. In our view, such expectations are unrealistic because the future is always uncertain. We have never seen, for example, a mutual fund that embraces market timing as an investment strategy with a great long-term track record. Investors and their advisors may get lucky trying to time the market. However, the odds of success with market timing is like a casino, stacked in favor of the house.
In our opinion, investors decrease their odds of success when they have unrealistic expectations regarding the risk of loss, especially if they don’t understand how correlated their portfolio may be to the market. We believe the best way for investors to increase their odds of success is to be honest with themselves regarding their true comfort level with risk, expect markets to always be unpredictable and, therefore, cannot be timed, and adhere to a disciplined, long-term investment approach.
We offer a complimentary portfolio analysis that can compare your portfolio to different markets and benchmarks. To get your <b>Market Comparison Report</b>, just call us at <b>713-850-8900</b>. We would be happy to assist you.
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1 Correlation: What It Means in Finance and the Formula for Calculating, Investopedia, https://www.investopedia.com/terms/c/correlation.asp
2 Diversification And The Reduction Of Dispersion: An Empirical Analysis,, Evan and Archer, December 1968 https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1968.tb00315.x
About The Goff Financial Group: As a fully independent Registered Investment Advisor, the Goff Financial Group is not owned or controlled by any bank, brokerage firm, mutual fund company or any other company. The company does not receive any fees or commissions from any financial products and works solely for its clients on a fee-only basis. Disclaimer: This material was prepared using third party resources, and does not necessarily represent the current views of The Goff Financial Group which are subject to change without notice. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering tax or legal advice. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as financial, investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This document is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
