Broker Check

Close Encounters of the Uncorrelated Kind

March 22, 2016
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Let’s look at a story of a young, imaginary entrepreneur.

This fellow, let’s call him Joe, lives in a town by the ocean. Being an enterprising young man, he decides to start a business. He gets a permit from his town to sell some products on the beach.

Joe begins hauling around a cooler filled with ices and ice cream sandwiches. It is hard work because he has to lug his cooler across the sands in the heat. However, his hard work seems to pay off. He consistently sells all of his wares on the days he is out on the beach. For his efforts, he makes a handsome profit.

Joe is happy with what he is making, but he is not completely satisfied. He knows he can only carry so many ices and ice cream sandwiches to sell. Consequently, he does not see much room for growth.

He considers having other people work for him on the beach, but he does not think they will be as dedicated as he is. All he imagines is a bunch of unsold and melting ices and ice cream, because he figures his employee will not be as diligent as he is. Maybe he is right and maybe he is wrong. Whatever the case, this is what he believes.

One day, Joe has a wonderful idea. He will take some of his profits and invest them in a small surf shop in front of the boardwalk, by the beach. He figures he can hire someone to watch the shop. He is not too concerned about their work effort. After all, he figures, standing in a shop attending to customers is not the same as having to walk across hot sands under a searing sun, hour after hour.

Joe’s surf shop does well. He sells surfboards and specialty items for surfers, but the products that move the most are swimwear and sun tan lotion. Joe is pleased with his progress. Then, the winter comes.

Joe realized that selling ices and ice cream sandwiches on the beach would not be a good strategy in the winter. Barely anybody would be out and, certainly, they would not want freezing cold snack foods. Yet, he believed his shop would continue to thrive. “It is indoors,” he thought.

Well, he thought wrong. Unfortunately, almost all his customers stopped coming in the fall and winter. They were just not focused on buying sun tan lotion and swimsuits. Sure, some hard core surfers came in, but a sale of a surfboard here and there was not enough to keep the store open. The rent was too high to justify it.

Joe closed his shop.

The error in Joe’s planning, is that he focused on making money in areas that were almost completely correlated. In other words, he invested in two areas – ices and ice cream for sale on the beach and surfing stuff, tanning lotion and swimsuits – which are seasonal in nature. Good sales on the beach meant people were out on the beach. People out on the beach meant people who would come in and buy in his shop.

His beach sales and his shop sales were positively correlated. Sales tracked up and down in pretty much lock step.

Now, Joe might have attempted to diversify his entrepreneurial ventures by keeping his ice cream venture on the beach, but he also could have gotten a permit to sell roasted chestnuts on the street. He could have sold ice cream in the hot weather and roasted chestnuts in the cold weather. His ventures would be negatively correlated. Sales would go down in one venture while they would go up in the other venture.

Looking at this, it would seem that Joe might have been more diversified in his approach. He would have something that would sell well in summer and something that would sell well in winter. That seems to make good sense and in many cases it does.

However, imagine this scenario. Joe sells ice cream on the beach in summer and roasted chestnuts from a cart on the street in winter. It is great during hot summers and cold winters. But what happens if the summer is cold? What if very few people turn up at the beach owing to the bad weather? From time to time there are cold summer seasons.

To make things worse, imagine that the winter is not cold at all. I mean, it is cool, so no one wants to go to the beach, yet it is not the kind of freezing weather that makes roasted chestnuts an appealing treat. In this case, Joe would have been hit by a double whammy, doing poorly in both summer and winter.

And here is where things get really interesting. Imagine if Joe had the ice cream business and the chestnut business but in addition had one more business. Imagine the third business Joe opened was not seasonally based. Imagine if he opened a small kiosk in the local mall selling smart phones.

I am not an expert on smart phones. Yet I do not think it a stretch to believe that smart phones sold in a mall are less seasonal a product than ice cream sold on the beach and roasted chestnuts sold on the street. In this case, the smart phone sales would be relatively uncorrelated with the other things that Joe was selling.

When building a portfolio, investors often unwittingly put money into vehicles without contemplating the degree to which they are positively and negatively correlated. We certainly do not want to have all our eggs in one basket or all our baskets on one truck. And we certainly do not want all our investments to track in the same way when exposed to different economic factors.

Having some uncorrelated assets in a portfolio might just be an appropriate tonic to help safeguard against times that are economically erratic and challenging. After all, it is not impossible to have a cool summer and warm winter. It has happened. We just need to plan for it.

 

 

 

 

 

Scott McGimpsey- March 2016

 

 

 

 

This material was prepared by Scott McGimpsey and does not necessarily represent the views of the presenting party, nor their affiliates. All information is believed to be from reliable sources, however, we make no representation as to its completeness or accuracy. Neither Summit Brokerage Services Inc. nor Scott McGimpsey is engaged in rendering legal, accounting, or other professionally services. If such assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any federal, state, or municipal tax penalty. Moreover, a diversified portfolio does not assure a profit or assure protection against loss in a declining market. UNIFIED PLANNING GROUP is an independent firm with securities offered through Summit Brokerage Services Inc., Member FINRA, SIPC