LENSELL EDUSeries: Episode 4 - Blue Chips

At LENSELL, our team strives to make financial literacy accessible to everyone so that you can make informed investment decisions and grow financially. In our last blog, we highlighted the question: Should you include Cryptocurrencies in your Portfolio?  This time, we will explore on the topic of Blue Chip!

Blue chip shares are investments in well-established companies that are leaders in their respective industries (usually mega-cap and large-cap stocks - that is, companies with a market capitalisation [1] of over $10 billions). Blue chip companies are generally considered to be financially stable, with a history of solid earnings.
Stock Images - Blog Banner-1If you looked around for advice before starting your investing journey, you must have heard things like “stick to the big names, they are stable and are not very risky” or “blue chip companies tend to be safer and less volatile than other stocks”. 

On the other hand, an optimally diversified portfolio cannot consist of just one category of stocks, even blue chips. As we’ll show in this article, having all-blue-chips portfolios leads to scenarios where diversification is not fully achieved. 

In this article, we will look at three random portfolios of ASX blue-chip stocks and analyse their expected performance and deep diversification.

Our three test portfolios will consist of 5, 20 and 30 stocks respectively. For each scenario, the stocks have been chosen using a randomizer function in Excel, from the top 54 ASX stocks having over AUD$10B market capitalization as at 6 July 2021 [2]. 

 

Portfolio 1

The five random stocks picked for the first portfolio were ALL, GMG, SYD, SHL and REA. For exemplification purposes they all have the same weight in the portfolio, 20% (see Figure 1).

Five random ASX blue chips stocks in Portfolio 1

Fig 1. Five random ASX blue chips stocks in Portfolio 1

 

Running a portfolio analysis in Diversiview [3] we obtain the following insights:

Portfolio indicators for Portfolio 1

The expected return of the portfolio is 17.58% and the volatility of returns (portfolio risk) is 22.8%. The risk being higher than the expected return, it indicates a potential loss in bear markets of approx. 5%. A Beta higher than 1 also indicates that the portfolio is more volatile than the entire market (represented by the All Ords index). Combined with the risk/return info it shows that the portfolio may suffer a rapid loss in bear markets.

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The allocation diagram shows us that we have diversified into five different industries (Consumer Services, Media & Entertainment, Healthcare Equipment and Services, Transportation and Real Estate).

From the granular diversification diagram [4] produced by Diversiview (see Figure 2) we can see that there are no strong positive correlations in our portfolio. We do not have any zero, negative or strong negative correlations either - all ten correlations between the pairs of securities in the portfolio are between 0 and 0.5 meaning that they are all low positives. Diversiview diversification rating in this case is 2.5 out of 5.

Granular Diversification Diagram for Portfolio 1

Fig 2. Granular Diversification Diagram for Portfolio 1

The correlations between pairs of securities are critical in calculating portfolio risk: lower the correlations, lower the total calculated portfolio risk, meaning that the diversification goal was achieved. Therefore the best diversification is achieved when as many correlations as possible are very low (close to zero) or even negative.

 

Portfolio 2

The 20 random stocks in the second test blue chips portfolio are shown in Figure 3. For exemplification purposes they all have the same weight in the portfolio, 5% each.

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Fig 3. Twenty random ASX blue chip stocks in Portfolio 2

Running this portfolio in Diversiview, we obtain the following insights:

 
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The expected return of the portfolio is 15.45% and the volatility of returns (portfolio risk) is 31.47%. The risk being higher than the expected return, indicates a potential loss in bear markets of approx. 5%. A Beta close to 1 indicates that the portfolio is as volatile as the entire market (represented by the All Ords index). So the portfolio will fall (or increase) pretty much in the same way as the entire market would do - not faster or slower.

The allocation diagram shows us that the portfolio is spread across 11 different industry groups.

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From the granular diversification diagram produced by Diversiview (see Figure 4) we can see that there are some strong positive correlations in our portfolio (represented by the bright red lines).

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Fig 4. Granular Diversification Diagram for Portfolio 2

Given that there are 190 individual correlations in this portfolio, difficult to assess all at the same time, we will use the filters available in Diversiview to look at different types of correlations in turn.

If we filter out all correlations but the strong positive ones, we can see that there are 18 of them (see Figure 5), the strongest being between BHP and RIO (0.83), followed by the strong correlation between WBC and CBA (0.79).

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Fig 5. Strong positive correlations identified in Portfolio 2

By using the filters available we can also see that we do not have any zero or strong negative correlations either, and we have one single negative correlation (between FPH and SCG). The remaining 171 correlations between pairs of securities are all low-positives (between 0 and 0.5).

The Diversiview diversification rating in this case is 2.2765 out of 5 (lower than the diversification rating for Portfolio 1).

 

Portfolio 3

The 30 random stocks in the third test blue chips portfolio are shown in Figure 6. For exemplification purposes they all have the same weight in the portfolio, 3.33% each.

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Fig 6. Thirty random ASX blue chip stocks in Portfolio 3

Not all codes are visible in Fig6, so here is the full list of the 30 stocks:

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Running this portfolio in Diversiview, we obtain the following insights:

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The expected return of the portfolio is 17.93% and the volatility of returns (portfolio risk) is 30.25%. The risk being higher than the expected return, indicates a potential loss in bear markets of approx. 5%. Similarly with Portfolio 1, a Beta higher than 1 also indicates that the portfolio is more volatile than the entire market. Combined with the risk/return info it shows that the portfolio may suffer a rapid loss in bear markets.No alt text provided for this image

The allocation diagram shows that portfolio 3 is spread across 17 different industries.

From the granular diversification diagram produced by Diversiview (see Figure 7) we can see that there are some strong positive correlations in our portfolio (represented by the bright red lines). 

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Fig 7. Granular Diversification Diagram for Portfolio 3

Given that there are 435 individual correlations in this portfolio, we will use the filters available in Diversiview to look at different types of correlations.

Running the filters we can identify 17 instances of strong positive correlations in Portfolio 3 (see Figure 8) out of a total 435 correlations within the portfolio. There are no zero, negative or strong negative correlations. Therefore, all remaining 418 correlations are low positive between 0 and 0.5. The Diversiview diversification rating is 2.4 out of 5.

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Fig 8. Strong positive correlations identified in Portfolio 3

Summary:

In this article we have assessed 3 random portfolios of ASX blue chip stocks, of 5, 20 and 30 securities respectively, and looked at portfolio performance, benchmark to market and deep diversification. 

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The results for each all-blue-chip portfolio case are summarized in the table above, showing that:

  • In all 3 test portfolios, a positive Alpha indicates a potential of gain slightly above the entire market (less than 0.5% over the entire market's return);
  • In all 3 test portfolios, Beta is close to 1 (slightly higher in two cases) which indicates that the all-blue-chips portfolios are as volatile as the entire market (and not more stable as one may have expected);
  • In all 3 test portfolios, the volatility of returns is higher than the expected return, which indicates a potential of high returns in bull markets and a potential of loss in bear markets;
  • In the larger portfolios where we randomly picked 20 and 30 stocks respectively, there are several strong correlations between those securities;
  • Due to many positive correlations between stocks, all 3 test portfolios have a diversification rating of approximately half of the ideal rating of 5 (the ideal rating would see all correlations between securities being zero or negative).

From the above results, we can reach a reasonable conclusion that portfolios of all-blue-chip companies are expected to bring good returns but are not necessarily very stable and they may bring losses when markets take a downturn. They are also not diversified enough by a simple spread across many industry groups. 

Investors who are looking to reduce the risk of their all-blue-chips portfolios have two options [5]:

  • Option 1 - Try a different portfolio composition: Investors could select other stocks that have the returns they expect. Ideally, those stocks would only have only zero or negative correlations; if that's not possible, they need to have at least lower correlations than the correlations in the current portfolio, so the total portfolio risk is reduced.
  • Option 2 - Do the best they can with the selected securities: Our test portfolios had equal weights for the securities. Investors could hold on to the preferred securities and run the Diversiview Balancer to find that portfolio allocation (i.e. the weights) that would give the Minimum Variance Portfolio (that is, the portfolio with the lowest risk considering the selection of securities), or the Optimal Portfolio (that is, the portfolio with the maximum possible risk at a minimum possible return).

Both options can be addressed with Diversiview: investors can try multiple scenarios to find the portfolio composition and the outcome that suit them best, and/or use Diversiview Balancer to calculate the allocation for minimum risk portfolio or the Optimal Portfolio. 

Thank you for reading the article and we welcome your feedback. That's all for this time. Learn more about Diversiview®, and don't forget to subscribe to our newsletter for your regular dose of finance!

 

- Team LENSELL



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Special article offer: Refer 3 friends to use Diversiview and you get a free paid analysis for a portfolio larger than 5 securities so you can see how your portfolio is doing (let us know once your friends try it and we’ll send you the code for a free analysis).Refer Emails-2

Footnotes:

[1] Market capitalisation is the total dollar value of all outstanding shares of a company at the current market price.

[2] https://www.marketindex.com.au/asx-listed-companies

[3] https://diversiview.online

[4] The circles on the diagram represent the securities included in your portfolio, while the edges represent the strength of correlations between pairs of securities’ returns.

[5] We do not give financial advice. Do your own research or talk to your financial advisor should you wish to make any changes to your investment portfolio.