How to add Growth Stocks to a Portfolio
If we add some high growth stocks, something I have also referred to as conviction stocks, to our portfolio (and they do well), it is possible that we can raise our ROI without raising our volatility, or decreasing our safety against unanticipated economic crises. Consider a portfolio over the past 15 years containing 12.5% OAKLX, a concentrated value fund, 12.5% AAPL, Apple corporation stock, 25% VUSTX, the Vanguard Long Term Treasury mutual fund, 25% VFISX, the Vanguard Short-Term Treasury Fund and 25% CEF, the Central Fund of Canada Limited which holds precious metals. This is the Permanent Portfolio we saw previously but with the equity investment split between the Oakmark Select fund and Apple’s common stock. As I stressed before, it’s best to combine all equities into a single bucket unless you have good reason not to. This portfolio would have returned an average ROI of 14% with a maximum draw down of 19% and a Sharpe ratio of 1.36. It’s the blue line below.
This is the best we’ve seen yet but it’s not something we can invest in with any expectation of the performance continuing – it’s just an example to illustrate a point. But notice that Apple’s stock (AAPL) didn’t exactly rise monotonically. In fact, as we can see from looking at the red line below, it was extremely volatile. At different times it suffered draw downs of 50%, 80%, 40%, and 60%. And yet the portfolio, the blue line, was relatively steady.
We can see that the portfolio apparently acted as a buffer against the wild swings in Apple’s stock while taking advantage of its impressive growth. This is one way of including a volatile asset such as growth stocks or a commodities trend following system, etc, in a portfolio. And, obviously, it would be better to diversify over a number of assets rather than just one.
Can we do better than this? From a risk adjusted standpoint, it’s possible. By hedging a growth stock against the overall market we potentially create an new, uncorrelated asset, raising the number of diversified assets from 4 to 5.
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How to add Hedged Stocks to a Portfolio
We can create a new hedged stock asset by purchasing equal dollar amounts of the stock and, for example, an inverse index fund such as the Rydex Inverse S&P 500 Strategy (RYURX) or the ProShares Short S&P 500 ETF (SH), by shorting an equal dollar amount of a security that tracks the S&P index such as the SPDR S&P 500 (SPY), or by purchasing put options on the index. Purchasing an inverse index fund is the simplest to understand so we’ll assume we are using the Rydex fund in the following example.
Treating a hedged AAPL stock as our fifth asset, our portfolio becomes 20% OAKLX, 20% VUSTX, 20% VFISX, 20% CEF, 10% RYURX, and 10% AAPL. This portfolio would have returned a ROI of 12.1% with a maximum draw down of 15.7% and had a Sharpe ratio of 1.46. This is the red line below, which is just under the un-hedged portfolio. Again, we assumed that the OAKLX fund and the hedged AAPL were not correlated, which allowed us to divide our portfolio into five equal parts of 20% each and, presumably, this increase in diversification helped our portfolio’s performance.
At this point we should review our assumptions. First of all, we used Apple’s common stock, which we now know performed very well over the 15 year time period in question, to obtain a portfolio which returned an average ROI of 14%. We don’t know how to select the next Apple stock for the next fifteen years, but we now know how to include a volatile, high growth stock in our portfolio if, as a result of careful research by ourselves or our adviser or luck, we come across one.
In the real world, it’s not easy to discover the next Apple, so we need to diversify our 12.5% holding of volatile assets to more than a single security. One way of doing this is to use a stock screen, especially one that can be back tested, such as the one found at portfolio123.com, or one of its competitors. As an example, our screen might result in 5 or 6 reasonably liquid small caps with positive cash flow and upward momentum. Every quarter we would have to rerun the screen and make any necessary adjustments.
Second, we assumed that the hedged AAPL stock and the concentrated mutual fund OAKLX were uncorrelated and could be treated as separate assets, thereby raising the value of N in our 1/N portfolio from 4 to 5. We might have reasoned that the value of the hedged Apple stock was going to depend on how innovative their products were versus their competition, and not so much on the economy as a whole, and thereby justified this assumption from the beginning.
And if we look at the historical correlation of S&P 500 hedged stocks against the S&P 500, we’ll find that they are typically not very correlated, so this assumption seems reasonable. The following is a correlation matrix for hedged versions of some popular stocks against the S&P 500 index fund VFINX over the last fifteen years. Blue implies a perfect correlation, black is zero correlation and yellow is perfect negative correlation. The dark blue and yellow shades in the matrix show the correlations between the hedged stocks and the S&P 500 are low, as are the correlations between the hedged stocks.
This seems to suggest that we can include as many hedged stocks in our portfolio as we want and just count each as an uncorrelated asset, thus raising the N in our 1/N portfolio from 4 or 5 up to 20 or 500 if we want to. Unfortunately, if we perform a more careful analysis or just observe the market for a little while, we’ll find that high growth stocks tend to overreact in unison (relative to the index) during high market stress situations, so hedged stocks really aren’t that uncorrelated when we need them to be. Many investors borrow money to add hedged securities to their portfolio because of the low returns and the belief that they are relatively safe, but forgetting that the hedged stock could plummet while the market shoots upwards, leaving them with a large loss. It’s best to either treat hedged stocks as a subset of your equity asset and not use leverage or hedge a good sized basket of stocks in case a few of them do take a nose dive. Finally, note that if you invest in a S&P 500 index fund and an inverse S&P 500 fund at the same time, they just cancel themselves out.
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The big advantage of a hedged stock is that the combination will maintain more of its value during a financial crisis. The disadvantage is that if your growth stock fails to perform better than the market, your hedged asset will not climb in value.
Continuing to increase the number of uncorrelated assets in your portfolio is desirable, but increasingly difficult beyond the assets we have discussed. Commodity ETFs are available, but most are correlated to the overall economy, as are stocks. Hedge fund ETFs have only recently come on the market and thus have short track records and low liquidity. You may be able to find uncorrelated assets such as hedge funds, managed futures, private equity, foreign currencies, fixed annuities, etc, but it’s becoming increasingly difficult.  In general, the more money you have to invest, the more options that are available because many alternative investments are open only to a limited range of professional and/or wealthy investors.
- How to Invest in the Stock Market
- Investment Portfolio Examples
- Adding Gold to a Portfolio
- Example of a Talmud Portfolio
- The Permanent Portfolio
 R. Bernstein, Diversification remains difficult, Richard Bernstein Advisors (2012) [pdf]