Diversifying Your Portfolio: Why Correlation Matters

Question of The Day

"Hi Hamish, there are a lot of growth companies in different sectors on the premium watchlist. Compared to an index fund, most of the underlyings seem to have historical volatility exceeding that of the S&P-500. Aren't these growth stocks risky for conservative investors? How can covered call writing reduce the standard deviation of our returns?"


This is a very relevant question as proper diversification is expected to lead to a lower standard deviation. Let's take a look at 10 high-quality positions, each of them active in a different industry, that currently earn a spot on our elite-performers watchlist based on quantitative analysis. Having on +/-20 equity positions should be sufficient.

(Source: Portfolio Visualizer)

Standard Deviation

From 2014 until April 2020, these positions had the following standard deviation. Their average volatility amounted to at least 22+ %, noticeably higher than the S&P-500.

(Source: Portfolio Visualizer)

Past Performance of The Portfolio and Drawdowns

As a result of industry diversification and putting on non-correlated positions, the standard deviation of the entire basket has been 14.7% over the past 6 years, which is in line with the S&P-500's. Stated differently, all these stocks together smooth the entire portfolio risk out. Moreover, the return differential is 3 times the index' return, while the maximum drawdown is half the index'.

(Source: Portfolio Visualizer)


If one adds AMT, NEE, DPZ and MKTX to his/her portfolio, the correlation with other underlyings will be reduced significantly, providing a cushion in declining markets or slowing a powerful rally.

(Source: Portfolio Visualizer)

Covered Call Writing As a Way To Reduce Volatility

Based on historical research, selling at-the-money covered calls agains the S&P-500 reduces the volatility by 30%. Since we're dealing with individual positions, it's less obvious to measure the impact of covered call writing. But let's say that you generate a covered-call return of 2% each month on your positions, all of which being extrinsic (time) value.

On a one-calendar day basis, that translates into a 0.066% return. Knowing that the S&P-500 has generated a long-term return of 0.03% every day, the positive theta (time value) we collect provides an accumulating cushion over the long haul, which is why your portfolio's standard deviation should decrease significantly. There is, however, one caveat: we have to know what underlyings to select, when to buy them (into VIX strength or not?) and what option strikes we should choose. Once these long-term positions are entered, rolling decisions on expiration Friday are the next step in writing our covered call success story.

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