| "When prosperity comes, do not use all of it." |
| -- Confucius |
F YOUR PORTFOLIO KEPT
PACE WITH S&P last year, you probably held a lot of tech stocks. If you
didn't, there was almost no way to keep up. That's why the NASDAQ had such a
great year -- it's overweighted in techs.
If you weren't in techs in 1999, should you jump in now? It's certainly tempting, after all, they've led the market for the past several years. In fact, they're probably the reason the U.S. economy has had an unprecedented expansion extending over an entire decade.
They also hold promise for the future as innovation continues at an exponential pace. The reawakening foreign economies only add fuel to the fire.
So back to the question: Should you be heavily invested in tech stocks? Probably so. But should you only be invested in tech stocks? Definitely not.
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The S&P 500 Index Sept. 1989 - Sept. 1999 |
 Source: Ibbotson Associates |
As you know, tech stocks aren't fundamentally different from other investments -- they don't just go up. Even blue-chip techs (such as Intel and Dell) can be extremely cyclical. While the long term trend may be up, the short term can be quite treacherous.
As always, the best approach is diversification. But who wants to buy low growth utility stocks or stodgy old basic materials? For that matter, who even wants to research them? They just don't make that much No-Doz.
Good News and Bad News
Fortunately there's some good news: You can achieve your desired end without researching and balancing stocks in all sectors. You wouldn't want to do that anyway, since it would negate the superior performance of your winning tech picks.Instead, you can just focus on one other sector: Energy. That's right, energy. A portfolio of both tech and energy stocks can outperform the overall market. The secret lies in the sectors' correlation.
If you read our previous quant piece, Do You Really Need Government Bonds?, you'll remember that returns aren't the only important factor in constructing a portfolio. The way differing assets perform in relation to one another has a more important bearing. This is their correlation.
Assets that mirror each other's performance are said to be positively correlated while those tend to perform differently are negatively correlated. According to modern portfolio theory, proper diversification allows you to reduce volatility without sacrificing too much overall return. Correlation plays a critical role.
The neat thing is you don't have to go out and buy 100 stocks, just a few of the right ones. And this is what brings us back to energy stocks. While the good news is you don't have to own a bunch of stocks from each sector, the bad news is you should balance your tech stocks with energy stocks. Here's why:
One Index, Eleven Sectors
While technology has led the pack, there are ten other sectors in the S&P 500. All of them behave differently.Their relations are fairly static and can be quantified over time. For example, Financials, Consumer Cyclicals, and Utilities are interest rate sensitive so perform best when inflation is low and rates are falling. Consumer Staples and Health Care stocks outpace the rest when the economy slows and rates rise.
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Correlation and Return |
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October 1, 1989 - September 30, 1999. Source: Ibbotson Associates |
As you'd expect, these relations are captured in the sectors' correlations. The accompanying table shows the correlations between Technology and the ten other sectors. It also shows the average annual return for each sector. (The complete correlation matrix for all sectors in the index is reproduced on the accompanying page.)
The first thing you'll notice is that there aren't any negative correlations. In other words, there aren't any sectors that tend to go down when techs are up, or vice-versa. Also, as is no surprise, the tech sector (like any sector) is 100% positively correlated with itself. It's a property of math, it has to be.
Cap Goods are most closely correlated with tech (0.710582) while Utilities (0.231354) and Energy (0.345953) are the least. No surprises here, either.
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and Return Efficient Portfolios |
 Source: Ibbotson Associates |
Even though the lowest correlation is with Utilities, this sector doesn't really provide adequate diversification for a tech portfolio. By their very nature, (with the possible exception of AES) utility companies are not growth oriented. They have very low correlations with seven of the index's sectors, but alone add little benefit in diversification.
Energy, the second least-correlated sector, can be used to temper a tech portfolio. On the face of it, this makes sense. Energy stocks usually shine in inflationary times when commodity costs are rising. On the other hand, that's when techs suffer since that's when no one wants to use today's dollars to buy tomorrow's earnings. Techs do best under conditions of low inflation and stable prices, precisely the worst environment for energy. This is the stuff of diversification.
Sharpe's Point
The numbers bear this out, too. Of course, you wouldn't think so based on the average returns of each sector. After all, over the past ten years, Tech has averaged 37.42% while Energy was 16.97%. The S&P 500 Index was in the middle at 22.85%. Given that, you might wonder why anyone would want to do anything to reduce Tech's stellar performance.The answer lies in the third element of modern portfolio theory -- risk. So far we've considered return and correlation, but risk is an equally important factor.
You probably already know that risk and return are directly related. You have to take on more risk to increase your potential return. But does the risk you assume provide commensurate return? Sometimes it does, sometimes it doesn't. A properly constructed portfolio balances one against the other to get the biggest bang for the buck.
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*Geometric average over the period October 1, 1989 - September 30, 1999. 185% S&P Energy/15% S&P Technology 250% S&P Energy/50% S&P Technology 330% S&P Energy/70% S&P Technology |
The Sharpe Ratio is a means of measuring the tradeoff between incremental risk and return. Without getting too technical, it essentially compares a portfolio's real return to its risk. The higher the value, the more efficient the portfolio.
If, by taking on more risk, the portfolio's return increases at a greater rate, the Sharpe Ratio will increase and the portfolio is more efficient. If the opposite occurs, you're better off with the original mix.
The accompanying table shows the geometric real returns for the S&P 500, the Energy and Technology sectors, as well as three different sector combinations. Standard deviations are used as a measure of risk, and the Sharpe Ratio for each is in the final column.
Surprisingly, the Sharpe Ratios of Energy and the Index itself are almost identical (67.56 vs. 67.81, respectively). Technology, despite its superior average returns, is much less efficient on a risk/return basis (36.38 vs. 67.81). Although Technology can provide higher returns, compared to Energy, they don't really offset the additional risk you must assume.
Mix 'n Match
By holding stocks in Energy as well as Technology, you not only increase your overall return but incremental return vs. risk as well. You can see this in the three portfolios illustrated in the above table. By the way, these are the three portfolios shown on the previous efficient frontier curve.The "S&P Risk" Portfolio is 85% Energy, 15% Tech. As its name implies, it's standard deviation is close to that of the S&P 500 (15.44 vs. 14.99). While its Sharpe Ratio is comparable to the index (65.78 vs. 67.81), the return is less than a point off the index (15.99% vs. 17.70%) and almost two points higher than Energy alone (14.07).
The Balanced Portfolio is a 50/50 Energy/Technology mix. As you'd expect with more Technology, the return is higher than the previous portfolio, but so is the risk as measured by standard deviation. The Sharpe Ratio also starts to go down since Technology does not efficiently balance risk and return.
If you add more technology, you diminish the benefit of diversification. You can see this in the Aggressive Portfolio -- 70/30 Technology/Energy. Although the mean return rises to 22.25%, risk, as measured by standard deviation, is almost 50% higher than the index while the Sharpe Ratio falls to 45.56. In other words, the higher return comes with disproportionately higher risk -- not a desirable situation.
OK You Can, But Why Would You?
Of course after the results of the past several years, tech investors might be questioning why you'd want to do anything to temper Technology. But this only focuses on the return, not a good idea in such a risky sector.As its relatively high standard deviation demonstrates, Technology is an extremely volatile sector. The past several years have resulted in above average returns, but there's certainly no guarantee that the next several will follow suit. In fact, if returns revert to the mean, the exact opposite may occur.
| The Long and Short of It | ||||||
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If you're a long-term investor and measure performance relative to the S&P 500, you can maximize portfolio efficiency by holding 50-85% Energy and the rest in Tech. No, your mix won't have the high average return of a pure Technology portfolio, but it won't have the volatility either. A little more stability can help you stay the course when markets are choppy.
Even though many of us invest for the long-term, we panic in the short-term. That's why for Tech investors, a little Energy goes a long way.
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