Evaluating My Stock Diversification

Two years ago this past August I decided to buy my first stocks. It seemed like a good idea; the market was down, I was an economics major-to-be, and I had just taken a personal finance class. I took about $300 and purchased 5 different stocks. Certainly not a complete portfolio, but enough to get me started I thought. The companies I purchased were: Advanced Micro Devices [AMD], Mistras Group [MG], Nevsun Resources [NSU], Pizza Inn [PZZI], and Aurizon Mines [AZK]. (Aurizon Mines was recently sold in the Spring to Helca Mining [HL].)

I won’t go into detail on what price I purchased these stocks, but if you were to look at the historical prices starting around mid-August of 2011 you can find out about how well I’ve done. The purpose of this blog post is to figure out how well I diversified my “portfolio”. (Hint: not well.) This post will look at three things: what sectors the stocks are in, what the “beta” of my portfolio is, and how correlated my stocks are to each other. In a follow up blog post, I’ll use some mathematics to see if the current market price of the stock is under or over valued, and we’ll see if I should sell any stocks. My prediction is my little “portfolio” will be changing dramatically in the next few weeks.

Let’s start by looking at where my stocks are in the industry. A well balanced portfolio will have stocks spread out in order to minimize risk. The exact order of how your stocks are spread out depends on several factors. For example, younger investors can put more money into stocks in small cap stocks. These are typically more risky stocks, so if the stock turns out to be a bust then the young investor has many years to make up the bad luck. An older investor may not want to be so risky and may have a portfolio balanced more with bonds, as these have a lower return, but also a very low risk. While the exact formula for portfolio balance is subjective, a portfolio should absolutely NOT be built as I am about to show you. Behold:

bad stocks

As you can see, 89.89% of my stocks are all in one category, “Cyclical”, which is further broken down by “Basic Materials” and “Consumer Cyclical”. I have the remaining 10.11% in the “Sensitive” category, which is “Industrials” and “Technology”. As you can see I have absolutely zero “Defensive” stocks, and those that I have in cyclical and sensitive don’t even span the entire category. Ladies and gentlemen, this is exactly how you’re not supposed to do it. In terms of spreading your stocks out over different sectors. The danger here goes without saying: if the cyclical sector is bad, then I am toast. Let’s take a look at the portfolio beta and see if that makes anything any better.

A stock’s beta is overly simplified as how risky the stock is. A beta of 1 means that the stock moves exactly with the market. So for example, if the stock market (as a whole) went up 3%, then a stock with a beta of 1 would go up 3%. Stocks with a higher beta than 1 are more risky and would go up more than 3% (and if the market would go down 3%, the stock would go down by more than 3%), and stocks with a lower beta than 1 would go up less than 3% (if the stock market went down by 3% this stock with a beta smaller than 1 would go down by less than 3%). Here I have a list of my stocks, and the percentage that they take up in my portfolio.

stock beta


The yellow highlighted “Sum” is how risky my “portfolio” is. 1.24 means of course that my portfolio (as a whole) has more risk than the overall market. Now the beta of stocks can change, and can be calculated differently depending on your “starting point” of measurement. I simply used the beta given to me by my broker, TradeKing.

The last thing I want to check is how my stocks are correlated with each other. The idea of building a portfolio is of course to minimize your risk. However, if you had a portfolio full of stocks that all moved with each other, than you would not be minimizing your risk at all. A good portfolio will have some stocks that go up while others go down. If two stocks are selected and one stock moves up the other moves down by the same amount these stocks are perfectly negatively correlated, and will have a value of -1 (this off-sets the risk). Two stocks that have no correlation will have a value of 0, and two stocks that move in sync with each other will have a correlation of 1. I won’t get into the math behind it all, but here’s a few examples of correlation between different stocks in my portfolio:


Now, ideally you would look at correlation between all your stocks you are purchasing as a whole (multiplying each stock by its weight in your portfolio). I simply just wanted to compare a few here, and especially make note of the dangers of stacking your portfolio with stocks that are positively correlated. Take a look at NSU and HL. They make up way too much of my portfolio AND are have correlation (which of course makes sense since they are part of the same industry). If you have stocks that correlate you better be pretty confident that they will do well, otherwise they will cancel out any other negative correlation you have (in my case because NSU and HL make up such a large percentage of my portfolio, it hurts even more if they don’t do well.)


Anyway, that’s the blog post for tonight. I hope you’ve found it interesting and have learned a thing or two. I know I have. Be on the look-out for a few more blog posts soon! I have drafts of minimum wage written and will be working on a post on faith.

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