Relationships between unrelated markets

Diversification is an important issue for anyone who holds a portfolio of stocks.

 
 

 

The equity portfolio

Diversification is an important issue for anyone who holds a portfolio of stocks. This is particularly the case when such a portfolio is the basis of a long-term investment strategy. The aim is to get the right mix of stocks to pick up income along with growth, and this mix will shift towards a “safety first” approach the older one gets and so the closer to retirement. Typically, such a portfolio will include some solid dividend paying stocks, and probably some government or investment grade corporate bonds for yield. But it will also include growth stocks. These companies often look expensive by many measures, typically having a relatively high P/E ratio as earnings have yet to come through. Usually they don’t pay a dividend but are seen as having real potential due to the nature of the product or service they offer. Examples include Amazon and Tesla.

Of course, there are plenty of other ways to diversify a portfolio in addition to mixing up growth and value stocks. You should also have some diversification across sectors for instance. After all, it would be very high risk to only own mining stocks just as it would be rather unadventurous to hold just household goods and utilities. Investors can also diversify geographically, perhaps by owning the stock of companies that operate in South America, China, Africa and or India in addition to European, North American and UK-based companies. It can also be sensible to include both cyclical and defensive stocks. This means companies whose fortunes ebb and flow along with the business cycle as well as those that should perform steadily no matter how the underlying economy is behaving. It can also be worth owning some small caps along with the big caps. It’s more than likely that a company will fall under more than one category, in which case it could tick two boxes at once. However, the most important point is to pick good companies with solid management. And if they are carrying a large amount of debt, then there should be a good reason for it.

 

How this relates to spread betting and CFDs

CFDs and spread bets should never form the basis of a long-term investment strategy. Both are margined products which employ leverage. These products are speculative in nature and suited to shorter-term positioning. Consequently, it would seem that portfolio diversification isn’t really an issue for anyone holding a spread bet or CFD account. Not only that, but there are so many stock indices and ETFs around that it seems very easy to pick up a diversified exposure to, say, the UK equity market simply by taking a position on the UK100 index. This is true to some extent. However it’s also vitally important to have some understanding of what goes into a stock index. Just considering the UK100 for a minute, it is estimated that around 70% of earnings from the index’s constituents come from overseas. This is one of the reasons why the sharp sell-off in sterling which followed the UK vote to leave the European Union back in June 2016 helped to boost the UK100 index. The cheaper pound was a direct benefit to any UK company who manufactured their products domestically (with relatively little reliance on imported raw materials) and then sold these overseas. Not only were their goods cheaper for foreign buyers, meaning higher sales, but the foreign currency proceeds showed up as higher earnings when translated back into sterling. So, this example alone shows not only how important it is to know what companies are in a particular index, but also how a big currency move could affect the index itself. After all, you may have sold the FTSE100 ahead of the referendum expecting a “no” vote, only to lose money thanks to the direct effects of the currency move on the index. For comparison, the more domestically-focused FTSE250 had a markedly smaller reaction to the fall in sterling.

But there are plenty of other examples where it’s important to be aware of possible correlations, both positive and negative. A well-known example of this is the negative correlation between the dollar and dollar-denominated commodities, such as gold. Typically, any weakness in the dollar translates directly into strength in the gold price. This is because a falling dollar means it is cheaper for non-dollar holders to buy dollar-denominated commodities. But in addition, gold is still considered as an alternative currency by many investors. This means that gold priced in dollars acts much like a currency pair in many regards, although there are times when this relationship breaks down. The dollar is the world’s reserve currency while gold is considered the ultimate safe haven. Consequently, in times of severe economic stress it’s possible to see the dollar and gold rise in tandem as investors rush to convert their funds into the deepest and most liquid currency available, while moving into the safety of physical gold as well.

Interestingly, it’s possible to see a similar inverse relationship between the dollar and crude oil. Between June 2014 and March 2015 crude oil lost around 75% of its value. This coincided with a 25% rally in the Dollar Index over the same period. Yet there’s been little evidence of any correlation, positive or negative, between the two over the past year or so.

All this is important as it is often the case that spread betters and CFD traders will have a number of positions open at any one time. It is extremely common to hold positions on stock indices and currency pairs simultaneously, for instance. But in such cases try to ensure that you understand what the fundamental drivers are for a particular market. Then think these through to see if these are at odds with your other positions. It’s surprisingly easy to have open positions in seemingly diverse financial markets only to find that they correlate closely - either positively or negatively - particularly where the dollar is involved. So it’s extremely important to have a good idea at any one time how markets inter-react, and how a particular financial instrument is exposed currency-wise. Bear in mind that markets can become correlated in minor ways and that seemingly correlated markets can suddenly diverge. This is why it is important to use careful money and risk management on each and every one of your trades.

 
 
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