1/22/14 – Correlation and Furniture

I had an interesting learning experience this past week.

It all began a little over a month ago when my dear wife, decided that our living room needed updating, so she invited a friend over (who also happened to be an interior decorator).  I’m sure you can guess where this is going…

The decorator came over to the house and analyzed the space. All of the pertinent data, including dimensions, were loaded into her special design application. Shockingly, she concluded that we needed a furniture upgrade—exactly what my shopaholic wife was hoping for.  Off to the furniture store!

She called and said, “I found a perfect sectional and chairs!”

“I’m so relieved,” I said through a thick wall of sarcasm.

But when she arrived home, I was thrilled to discover that she didn’t actually make any purchases. This euphoria quickly turned to despair when she informed me that I would be joining her at the furniture store the following day to finalize the deal.

To me, a sectional or sofa is a sofa, and the one we already had worked just fine, but I wasn’t about to get in the way of my wife and our decorator friend. Decades of marital bliss have taught me when to retreat from an unwinnable conflict, so I dropped my head and mumbled something like, “Sure.”

Her excitement was palpable as we entered the store the following afternoon. She pranced over to her new sectional. There they were: my new (likely uncomfortable) sectional and chairs.

Apparently, my expression must have given away my thoughts: “What’s the matter?” she asked, perturbed. 

“Are you sure this sectional isn’t going to take up too much space in the living room?”

She laughed. “Of course it won’t, silly. It’s all laid out on the designer’s app, but we need to select matching fabrics.”

“You have absolutely no interest in my opinion on fabric, so please choose whatever you want within the next three hours. I’m going to take a nap on that Lazy Boy in the corner. Wake me when the damage is done.”

Fast forward to this holiday weekend.

Our new furniture was scheduled to be delivered within a few weeks, so last Friday evening I took it upon myself to check the layout of the new sectional and chairs.

Guess what?

I escorted my wife into the room and pointed. “You need to stop the sectional order. It’s not going to fit!“ 

“It does fit and we can’t cancel because there is a 30% cancellation fee,” she replied calmly.

“WHAT?  Why?”

“Because we ordered custom fabric.”

A small tear began crawling down my right cheek as I ruminated over paying a 30% fee and receiving nothing in return. She nonchalantly left the room and returned with a computer printout containing all of the furniture comfortably arranged. I checked the calculations.

“There’s good news and bad news,” I informed her. “Given the dimensions of the room, the printout is accurate. The bad news is that you definitely have to cancel the order.”

“WHAT?  Why?” she asked incredulously, mimicking my earlier agitation.

“Because according to this, the space available to walk by the couch and into the kitchen is around 12 inches!”

She then called the furniture store to deliver the bad news. She also invited their salesperson to come to our house to perform her own analysis. 

Who was going to win this battle? Drum roll, please.

The pleasant representative informed us that the sectional would not “work or fit” in the room, and management generously waived the 30% cancellation fee! Whew!!!

So what, you may be wondering, does this little domestic tale have to do with retirement planning?

Good question.

My sister-in-law told me that when adding furniture to a room, a designer must consider room dimensions, angles, wall colors, natural lighting, lamps, coffee table, ottoman, flooring, and more. Too bad my wife didn’t double-check dimensions to see if everything would fit. 

In a similar fashion, we all need to double-check that the securities in our portfolio are a good fit, too. One important method that can help determine what fits in a portfolio is called “correlation analysis.”

 

Let’s imagine that you are considering adding a new stock in your portfolio. Check out its pattern. Does the security consistently increase and decrease in price with the other positions in the portfolio? If the answer is yes, then it may be highly correlated with other positions.

In a nutshell, all the positions in your portfolio moving in the same direction are the equivalent of a guy wearing a blue suit, blue shirt, blue tie, blue socks and brown wing tips.

Just not cool.

So, is the stock a good buy? It may be a great stock, but it may not work in certain portfolios. Does it duplicate another investment? Does the security increase or decrease diversification, thus increasing or lowering volatility?  (And note that just because an investment carries higher-than-average risk doesn’t mean it will increase the overall risk of a portfolio. Actually, a high-risk investment may lower the risk of a portfolio! Why? That thing called correlation.)

Here’s an example. Gold potentially carries a high level of volatility, but the fancy metal is likely to lower the volatility of a portfolio because it is not highly correlated to either large, mid, or small-cap stocks.

To clarify, when stocks are up, gold may actually fall. When stocks are down, gold could increase. Gold is probably not negatively correlated to stocks, but the metal typically does not follow the movement of stocks or bonds. Consequently, even though the metal may possess a high level of volatility on its own, when integrated into a diversified portfolio, the portfolio may actually become less volatile. 

It’s sort of like matching furniture fabric to wall paint, flooring, and natural lighting: everything has to fit.

Exactly duplicating sofa fabric to wall color and wall-to-wall rug color will simply make for an uninteresting and static room, but only holding highly correlated investments may cause a significant level of discomfort and unnecessary losses in a down market. 

My wife attempted to utilize a “Feng Shui” approach to “harmonizing” the layout and air flow within our living room. I view correlation analysis to be the Feng Shiu of portfolio design.

Yes, harmony does make sense in a marriage and in a portfolio.

By | 2014-01-22T18:07:00+00:00 January 22nd, 2014|Client Conversations|0 Comments

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