In this thread, I'll walk you through 2 key portfolio diversification principles:
(i) Minimizing correlations, and
(ii) Re-balancing intelligently.
You don't need Markowitz's portfolio theory or the Kelly Criterion to understand these concepts.
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Imagine we have a stock: ABC Inc. Ticker: $ABC.
The good thing about ABC is: in 4 out of 5 years (ie, with probability 80%), the stock goes UP 30%.
But the *rest* of the time -- ie, with probability 20%, or in 1 out of 5 years -- the stock goes DOWN 50%.
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We have no way to predict in advance which years will be good and which will be bad.
So, let's say we just buy and hold ABC stock for a long time -- like 25 years.
The question is: what return are we most likely to get from ABC over these 25 years?
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We know ABC stock goes UP 80% of the time and DOWN the other 20%.
So, the most likely scenario is:
During our 25 year holding period, we'll get 20 UP years and 5 DOWN years.
This gets us an annualized return of ~7.39%. Each $1 we put in becomes ~$5.94.
Calculations:
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Now let's bring in a second stock: XYZ Inc. Ticker: $XYZ.
Suppose $XYZ exhibits exactly the same statistical characteristics as $ABC.
That is, $XYZ also goes UP 30% in 4 out of 5 years and DOWN 50% in 1 out of 5 years.
But $XYZ and $ABC don't necessarily move *together*.
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In some years, *both* $ABC and $XYZ go UP.
In other years, they *both* go DOWN.
And in still other years, they move in *opposite* directions. That is, *one of them* goes UP and the *other* goes DOWN.
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The more often these stocks move *together* -- ie, *both* UP or *both* DOWN -- the more *positively correlated* we say they are.
And why do we care?
Because the MORE positively correlated our stocks are, the LESS benefit we'll get from diversification.
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Suppose our stocks *both* go UP together X% of the time.
Thus, higher X means higher correlation.
Simple probability math now tells us:
(i) Our stocks will go DOWN together (X - 60)% of the time, and
(ii) They'll move in opposite directions (160 - 2*X)% of the time.
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Also, the probabilities in our 2x2 diagram above cannot be negative.
That is, neither (80 - X)% nor (X - 60)% can be negative.
That means X has to lie between 60% and 80%.
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At X = 60%, our stocks are as *negatively* correlated as they can be.
And as we raise X from 60% to 80%, their correlation turns strongly *positive*.
The crossover from negative to positive occurs at X = 64%. At that point, there's *zero* correlation between our stocks.
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The central idea behind diversification is: everything shouldn't blow up *at the same time*.
In other words, we *don't* want our stocks all moving *together*.
That's why *negative* correlations are "good" and *positive* correlations are "bad".
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But to REALLY take advantage of negative correlations, we need another key idea: intelligent re-balancing.
Let's run some numbers to see why.
Suppose X = 60%. That is, $ABC and $XYZ are as negatively correlated as possible.
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Now, suppose we build a 50/50 diversified portfolio of $ABC and $XYZ.
We'll hold this portfolio for 25 years.
But we'll never re-balance. We'll just let each individual stock ride.
What will our most likely 25-year return be?
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Well, if we never re-balance, each stock is just going to do its thing individually.
Each is likely to give us 20 UP years and 5 DOWN years -- though not in the same order.
This will let us turn $1 into ~$5.94 -- the same ~7.39% annualized return we had before.
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Thus, the *negative* correlation between $ABC and $XYZ does NOT help us if we don't re-balance.
Whether we own:
- Just $ABC,
- Or just $XYZ,
- Or a 50/50 "$ABC plus $XYZ" combo,
we're likely to end up at the exact same place -- earning ~7.39% per year.
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What happens if we *do* re-balance our portfolio periodically -- say, every year?
For example, if $ABC goes UP and $XYZ goes DOWN during a year, we sell a bit of $ABC at the end of the year and use the money to buy a bit of $XYZ -- so our portfolio is again back at 50/50.
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With this re-balancing strategy in place, here are all the outcomes that can possibly happen during any given year -- along with their respective probabilities:
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For example, with X = 60% -- our strongest possible negative correlation -- our portfolio:
- Goes UP 30% in 3 out of 5 years, and
- Goes down 10% in 2 out of 5 years.
Over 25 years, our most likely outcome turns $1 into ~$17.85.
That's ~12.22% annualized.
Calculations:
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So, when X = 60% (ie, strongly negative correlation), we have:
*Without* re-balancing: $1 --> ~$5.94, and
*With* re-balancing: $1 --> ~$17.85 (>3x as much!),
over the same 25 years.
Thus, negative correlations + re-balancing can be a powerful combination.
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If we do this well, our *portfolio* can end up getting us a HIGHER return than any single stock in it!
We just saw an example with 2 stocks. Each got us only ~7.39%. But a 50/50 re-balanced portfolio of them got us ~12.22%.
When I first saw this, I couldn't believe it!
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This is the ESSENCE of diversification.
- We minimize correlations, so our portfolio nearly always has *both* risen and fallen stocks, and
- We "cash in" on this gap via re-balancing -- ie, we periodically sell over-valued stocks and put the money into under-valued ones.
In this thread, I'll walk you through one of the greatest qualities a business can have: a LONG RE-INVESTMENT RUNWAY.
If a business can plow its profits back into itself, to grow at a good clip for a long time, it can make its owners fabulously wealthy.
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Imagine that Alice wants to start a chain of laundromats.
She does some research.
She figures out some good locations around town for these laundromats: strip malls with high traffic, close to large apartment complexes that don't provide in-unit washers/dryers, etc.
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Say a commercial washer/dryer costs $10K.
Alice buys 100 of these -- putting in $10K * 100 = $1M of her own money to start her laundromat business.
So, right at the outset, Alice has a CASH OUTFLOW of $1M.
In this thread, I'll help you understand how the TIMING of Cash Flows within a business can have a BIG impact on the returns that shareholders get from owning the business.
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Imagine a big, highly sought after, university.
There are many departments in this university. They are spread out across a large and lovely campus.
5000 students study in this campus. Many of them stay in dorm rooms. Some of these dorm rooms even have windows.
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There's only ONE bookstore on campus.
EVERY semester, ALL 5000 students buy their textbooks from this bookstore.