Your portfolio isn't as safe as you think it is...
Earlier this month we talked about "sector diversification." Every portfolio should have holdings spread across a few sectors. It's a simple way to protect against any one sector's downturn.
To dive a little deeper, when you diversify across sectors you also need to consider something called correlation.
Correlation is a statistic that measures the degree in which two stocks, or sectors, move in relation to one another. Any correlation must fall between -1 and 1.
A correlation of 1 means that when one asset moves, the other asset moves in the same direction, in tandem. A simple example of positive correlation in economics is airline tickets and the price of fuel. As the price of fuel increases, the price of airline tickets also increases.
A correlation of -1 means that two assets move in opposite directions of one another. An example of negative correlation is stocks and gold. Generally, as stocks fall, folks become worried and tend to buy more gold.
And a value of 0 means there is no correlation at all.
So, why is correlation important to your portfolio?
Even if you're diversified across multiple sectors, if the sectors have a high positive correlation, your portfolio will still be vulnerable to concentration risk. Concentration risk is when you sink too many assets in one boat... Think of it as buying all tech stocks or all shares of one company.
If your portfolio has a high negative correlation, you're limiting your upside potential. As one asset goes up, the other will go down, thus negating your gains.
Most stocks have a correlation between 0 and 1.
Over the past three years, the highest correlated sectors were technology and consumer discretionary. Companies in the technology sector include Apple (AAPL), Microsoft (MSFT), and Cisco (CSCO). Consumer discretionary stocks include Starbucks (SBUX), Carnival (CCL), and Comcast (CMCSA). The correlation between the two sectors is 0.85.
These are highly correlated because as consumers, we spend a lot of our extra money on tech gadgets. We need to have the latest and most advanced tech products. New smart TVs can cost a few thousand bucks... while the latest Apple iPhone starts at $1,000. And many consumers are willing to pony up the money (the first batch of iPhone X shipments sold out in about 15 minutes).
Folks who own stocks in these two sectors may think they are well diversified... But any negative swing in the technology sector probably means a similar decrease in the consumer-discretionary sector as well.
There is, however, one sector that is less interconnected than the others... the utilities sector.
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Traditional utilities have long been a cornerstone of retirement investing. And for good reason...
The highest correlation the utilities sector has is 0.57 with consumer staples. All of the other sectors' correlations with utilities are less than 0.3.
It's by far the least correlated sector.
Most important, the utilities sector has the lowest correlation to the broad market, as measured by the benchmark S&P 500 Index, with a value of 0.3. The rest of the sectors have a correlation of 0.65 or greater with the broad market.
That means no matter what the market does, utility stocks, for the most part, behave independently. That's why buying utility stocks is a great way to balance a portfolio and reduce risk.
It can also make you money. Here's how the utilities sector stacks up against the market...
Even with a small correlation with the S&P 500, utility stocks still managed to follow and even outperform the market.
In fact, in my options-trading service, Retirement Trader, we've made four trades on the utilities sector since 2015. It's been very profitable for us. We closed all four trades for gains with an average annualized return of over 14%.
What's great about the utilities sector is that it's viewed as relatively recession proof...
Let's remember what kind of companies are in this sector... electric, gas, water, and other infrastructure firms. Their revenues aren't significantly affected if there is an economic downturn because their products are essential to everyday life. Also, the stocks typically pay high dividends – which is attractive in any market condition.
But I've never heard anyone at a cocktail party get excited about an electric company.
As I've written before, cocktail-party gossip about stock tips is a sure sign of the top. It happened with real estate and it happened with tech. My father used to buy stocks only based on this kind of gossip.
But no one ever mentions utilities stocks. They're considered too "boring" for these tip-seekers.
And yet these boring stocks can help save your portfolio from a market downturn.
What We're Reading...
- Something different: Even hurricanes can't slow down the economy.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig and the Retirement Millionaire Daily Research Team
November 1, 2017
P.S. Selling options on individual sectors is a tool we use in my Retirement Trader service. It's one of the safest ways to earn additional income. We've sold options on individual sectors 67 times, and 65 of those trades earned profits. To learn more about Retirement Trader, click here.