Recently I had a portfolio consultation with a new client. This very lovely lady has been in the market for years and wanted my feedback on her current holdings.
One of the first questions she asked me was…
Am I diversified?
She referred me to a video she had watched which made her wonder if her portfolio was diversified or not.
I gave it a watch.
As if anyone needed another excuse to not trust financial media these days, the host in the above clip cannot wait more than a minute before promoting his own book signing.
Mr. Cramer claims
Diversification is simple…In a nutshell you are diversified when no more than 20% of your portfolio is in one sector.
He also recommends having at least five stocks in order to keep the 20% rule. He recommends the following in the video above:
- An oil and gas company – EOG Resources (EOG)
- A tech play – Google (GOOGL)
- An industrial – Johnson Controls (JCI)
- A retailer – Costco (COST)
- Healthcare – Merck (MRK)
But this is where Wall Street always leaves you…
This is all very nice in theory. A little bit of this, a little bit of that. But with the following holdings, how diversified are we really? Wall Street will not tell you exactly because you should be happy enough to just be in different sectors right!?
A real investor needs to go a step further…
Not listen to conference calls.
Not buy his book.
Not spend all of your free time reading balance sheets.
What an investor must do, before making any trade, is find out how correlated the potential position will be to the S&P 500.
What is correlation?
Correlation is simply a comparison of price movements.
The more similar the price movements are compared to another stock, the more correlation.
Correlation my friends, is completely product or sector agnostic in which is ONLY is concerned with price.
Why correlation to the S&P 500?
Because the S&P 500 is the largest and most traded index in the world. Thus true correlation can be found when measure any other security against the big daddy of them all.
Here is the correlation of the “diversified” portfolio recommended by Mr. Cramer compare to the S&P 500:
- EOG Resources (EOG): 60%
- Google (GOOGL): 70%
- Johnson Controls (JCI): 77%
- Costco (COST): 57%
- Merck (MRK): 69%
Uncorrelated securities are those 50% and under…
Is this portfolio diversified? According to Mr. Cramer it is.
But is it actually diversified?
YES. But we want uncorrelated!
The suggested portfolio above is too correlated…
In fact, the suggested holdings combine to have a 66.83% correlation to the S&P 500.
All of these positions are very positively correlated to the S&P 500. You want a portfolio that is NOT correlated.
Diversification – What a diversified and uncorrelated portfolio looks like…
Let’s use Mr. Cramer’s example of a diversified portfolio and substitute holding that are actually uncorrelated to the S&P 500:
- An oil and gas company – Silver Wheaton (SLW) – 15%
- A tech play – Twitter (TWTR) – 36%
- An industrial – Cummins (CMI) – 57%
- A retailer – Macy’s (M) – 34%
- Healthcare – Humana (HUM) – 40%
Only one position correlated to the S&P 500 (Cummins)…
And a total portfolio correlation to the S&P 500 of 37%.
Moving forward as a rule of thumb, anything over 50% correlation is NOT diversified.