Have you ever found yourself adding stocks or ETF's to your portfolio, happy with your entries and your position sizes only to find that the overall movement of your portfolio is not enough to keep up with the movements of the markets, or even worse, the movement is more volatile than the markets? You likely have too many positions that are too closely correlated. The term correlated is just a fancy way of saying that your positions move too closely with the movements of the markets or to slowly with them. Today we look at correlations and portfolio balancing.
With the technology available these days you can quickly see how one position will move relative to the movement of another position. Usually the "other" position is some form of market ETF such as the (NYSE: SPY). For instance, if you owned Goldman Sachs (NYSE: GS) in your portfolio you could assume that for every percentage that the SPY moved that Goldman would move at least two thirds of that. Knowing this you would never have to wonder if your stock was weak because it only moved a fraction of what the SPY moved.
Not every symbol is the same though. Let's say you owned a stock in a sector that was not even positively correlated with the S&P 500. For example, gold and gold mining stocks are known to move in the opposite direction of the markets, or to be "negatively correlated". If you happened to own the popular gold mining symbol (NYSE: NEM) then you would already not expect it to move with the S&P 500 but what should you expect? Well this symbol would act as a small hedge having about a 1/5th of a percent drag on your portfolio. So if you were to own the SPY you know you could essentially hedge about 1/5th of that position by using an equally weighted position on NEM.
For most investors this may be a little over kill but for some it is a way to get a deeper understanding of the inner workings of a portfolio and how you can balance it out.