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Summary Even a smallish portfolio stock can be well diversified internationally. Individual investors typically do not rely on asset correlations in their investment decisions. Portfolio risk-return efficiency can be enhanced by exploiting asset correlations. An “optimized” portfolio doesn’t neutralize stock risk: returns are likely to issue from well-known risk factors. In previous articles, I have discussed both minimum volatility portfolios and domestic equity allocation . In the former article, we saw both that accounting for the volatility and correlation how expanding the equity set can lead to better investment outcomes in terms of terms Sharpe ratios (risk-reward efficiency). In the latter article, we saw how a collection of individual stocks with a bit of discretion can perform better than a portfolio of risk-diluted ETFs. This article blends the two approaches by creating a stock-based portfolio with some of the qualities of an allocation-based strategy, but using individual stocks. The goal is to develop a portfolio of 20-50 stocks – this is about the number needed to create a reasonably diversified portfolio whilst remaining tractable enough to manage. Individual investors with small portfolios typically reduce risk through large-cap and dividend stocks, emphasizing careful stock selection over portfolio construction. In contrast to that intuitive and legitimate approach, the idea here is to reduce risk by exploiting the statistical covariance of the entire global equity market. This will be done using constrained mean-variance optimization. The next section describes the process and structures that define the solution portfolio, but if you want to use this article as a “quick pick list” for risk-efficient stocks with low correlation, feel free to jump down to results and discussion. Investable Universe With over 37,000 equities to invest in worldwide, security selection is a daunting process. Like most ETF benchmark indices that number needs to be winnowed down for reasons of both tractability and investability. What might be considered the closest proxy for the world portfolio, (NYSEARCA: VT ), has only about 7,300 securities. In this exercise, the initial pool screened for stocks with at least 3 analyst estimates left about 6,200 assets. This screen acts as an implicit liquidity screen, and biases the sample toward large-cap stocks and well-followed small/mid-caps. The next screen limits stocks to those with dividend yield greater than the median (1.9%) and the forward earnings yield (EPS/price) is likewise greater than the median (5.25%). The expected dividend has to be less than expected profit, and book value must be positive. This leaves about 1,100 stocks. The equities are divided into 4 market capitalization based classes: micro ( Additional disclosure: I own some of the stocks in the solution portfolio as similar optimization techniques belong to my normal repertoire of security selection. Scalper1 News
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