Friday, 27 March 2020

Diversification of Equity Portfolios

Consider a portfolio of two stocks - Stock A and Stock B. Stock A gives a return of 25% and Stock B gives a return of 15%. Stock A has weight-age of 60% and Stock B has a weight-age of 40%. The correlation between these two stocks is -0.50!

The only problem is that it is difficult to find such stocks in real life with high negative correlations to balance your equity portfolio returns.

The chart below shows the correlation between the BSE Sensex and various BSE Indices since their inception.

The chart below shows the correlation between BSE Sensex and sectoral indices for the last five years. The correlation number has been computed using month on month change since Mar 2015.
While banks, financial institutions, manufacturing, industrials exhibit a high degree of correlation with the benchmark, healthcare, telecom and IT exhibit the least correlation.

Not one sector is negatively correlated to the broad market index. 

 Let us examine the inter-sectoral correlations using monthly changes in S & P BSE indices for the past five years.

Based on these observations no sector seems to have a negative correlation with any other sector.

Stock prices across companies and sectors are positively correlated to each other  and the degree of correlation varies from low to medium to high to perfect. But negative correlation seems to be a text book phenomenon.

So if you come across an imaginary portfolio with stocks that have negative correlations over long periods of time in your finance text book, you need to double check!

Investors need to look for other investment avenues if they really want to diversify their portfolios.

Data Source:

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