Expert: Paul Henneman - 9/15/2009

Question
Hello,

I am a beginner in investing. I have read in a book that one can reduce risks by having 2 stocks that  are negatively correlated. Can I ask, how can one earn returns when one stock is going up while the other stock is offsetting the potential returns?

Also, what industries are strongly positively (.5 to 1) and strongly negatively (-1 to -.5) correlated in the the commodities market, money market and and in the stock market.


Thank you.

Answer
Kris,
    Thank you for your question!
Yes, you are right that it is typically considered very favorable to have uncorrelated stocks in a portfolio. You make money in that you try to find stocks that are good investments AND not correlated. This would mean that over time, both stocks earn good returns. But it does mean that the stocks increase in price at different times. One stock may have a period of poor returns, while the other one is showing strong performance.
   To think of it another way: it does not make much sense to own two stocks that are perfectly correlated. If two stocks move exactly the same way, then you could achieve the same thing by putting all of the investment into just one of the stocks, rather than splitting the investment into two stocks. It would be easier to track, and save some trading costs.  This is why most long term investors look to invest in numerous industries, not just one industry. Specific industries go through cycles of good and poor performance, so a portfolio of stocks would theoretically be less correlated if stocks are pulled from a variety of industries rather than just one or a few.
    Your next question is difficult to answer.  To really find stocks that are not correlated, you should start by looking at different industries. But industry groups themselves are typically too large to be dramatically uncorrelated to the overall market.
    I am speaking here just from my experience in the stock market, I unfortunately do not have experience in commodities or other investments that could provide what you are looking for.

My overall suggestion would be to look to create a diversified portfolio. Invest across numerous industry groups, and if you have the knowledge in commodities, real estate, bonds, and other investments. By doing this, your investments will be relatively uncorrelated, so if there is a pull back in any one segment, your other investments could do better. For example, investors that had a significant amount of bonds in their portfolios were hurt much less (in fact made money) during the past terrible downturn in the stock market. Investors that were just in stocks lost half or more of their investments at one point, although the markets have recovered pretty signficantly (still down overall alot).

I hope this helps, please do not hesitate to follow up with me if I can be of any additional service,

Sincerely
Paul Henneman
President
ValuEngine Inc
www.ValuEngine.com