The matrix

  By Guest Blogger Doug Rowat

It’s been a great year for markets and most investors could probably rhyme off their 2019 winners at the drop of a hat—“my junior mining stocks are killing it!” It’s fun to brag. However, what’s less likely is that these same investors could tell you how these winning positions fit into their overall portfolio mix, how they control or contribute to volatility or how they improve or detract from downside capture. In other words, most investors have little to no idea how their portfolio positions are correlated to one another.

Why? Because discussing low-to-negatively correlated off-setting portfolio holdings, which are designed to control risk over the long term, is a far less sexy conversation than discussing a 25% one-month gain from a small-cap mining stock.

But if your risk tolerance is untested and you’ve never experienced a US recession with meaningful money at stake (and many haven’t—it’s been more than 10 years since the last one) then understanding security correlation becomes critical. It’s fun when all your holdings are moving higher together, but far less enjoyable when they all move down at the same time.

Many investors are aware that we experience portfolio losses much more acutely than gains. It’s irrational, but we can’t help it, and in down markets, we make terrible investing decisions as a result. Mainly, we sell at incorrect moments because the emotional pain of the losses becomes too great. Interestingly, the pain of losses is not limited to our investments—it actually infects almost every part of our lives. In fact, loss aversion is so ingrained in our DNA that it even affects the way we order pizza. Psychology Today highlights as much:

…consumers were asked to either build up a basic pizza by adding ingredients (e.g., sausage and pepperoni), or scale down from a fully loaded pizza by removing ingredients. Consistent with loss aversion, consumers in the subtractive condition ended up with pizzas that had significantly more ingredients than those in the additive condition.

So, there’s little we can do about losses having a much larger psychological impact than gains, but what we can do to assist with this psychological blind spot of ours is build a portfolio that limits losses. What is needed is a balanced portfolio that reduces emotional pain by limiting the downside in tough markets.

But how do we know that our portfolio is likely to do this? By building a correlation matrix of all holdings and examining how each piece of the portfolio is likely to move directionally with the price action of all the other pieces. All correlations range between 1 (components move in perfect lockstep) to -1 (components move in the exact opposite direction to each other). A correlation matrix is useful because it visually indicates the number of assets that are highly correlated and the number of assets that have low-to-negative correlations. If you want to avoid the dangers of loss aversion, a portfolio should have plenty of the latter assets.

To illustrate, the sample correlation matrix on the top suggests a portfolio that is much more likely to protect on the downside than the sample matrix on the bottom. Without overcomplicating the matter, to better control risk, you want a matrix that is more colourful. However, the main problem for most investors is colour blindness—they have no idea whatsoever how any of the securities in their portfolio interact with one another.

Which portfolio is better diversified?

Source: Vanguard

There are plenty of websites or software programs that can assist with building a correlation matrix. Or you can hire an advisor to do the work for you. This work can be painstaking especially when consideration is given to adding or subtracting positions, but it’s necessary to truly understand the exact kind of investment portfolio that you’re building for yourself.

It’s one thing to say that your portfolio is balanced and diversified, but it’s something else entirely to prove it.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.