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Late last week, I was in Las Vegas for a quantitative investing conference and a number of things happened to me. (Nothing dreadful, I promise!) And I know the saying about Vegas, but I'd like to share a few things anyway. I made a 34% return on my money playing dice (even though I'm a blackjack man), received the privilege of listening to a great presentation on seasonal anomalies and had a surprise encounter with Harry Markowitz, one of the original theorists on the effects of risk, correlation and diversification on portfolio returns.

Harry's like a member of the Rat Pack of Modern Portfolio Theory and it was a pleasure meeting him. Since Markowitz’s work centered on the role diversification plays in reducing risk, in this article I will show you how to implement a diversifying technique using the Research Wizard.

How to diversify?

Let's look at the possible ways to diversify your portfolio. The easiest way is to simply add more stocks. However, it's usually a good idea to be smart about which stocks to add. So you could add more stocks from different industries or sectors. Adding both large and small cap stocks in your portfolio is also an effortless method. Another good approach is to include stocks with differing betas in the portfolio.

I'll stick with the first suggestion to include stocks from different sectors since it's a good first step for any investor. Just taking that first step will reduce your portfolio's return volatility nicely.

Let's Take a Look at an Example

Since one of my favorite methods for picking stocks is a value and momentum combination, let's make a few tweaks to the strategy I discussed in December to see if we can maintain or improve the return while reducing risk.

As a refresher for you, the strategy includes the Zacks Rank, 52-week price momentum and the Price-to-Sales ratio. But, let's change the criteria to pick the best out of each sector and see how the results change.

I conducted tests from 2000-2011 using monthly holding period returns for the strategy using best-in-sector and without regard to sector. Since we're using 16 sectors, the best-in-sector approach selected 16 stocks each month and, as you might recall, the other strategy selected 10. Here are more details:

As the above results illustrate, using a best-in-sector approach for this strategy resulted in an annualized volatility of 25.9% versus 33.0% for the regular version. Less volatility means the portfolio returns will be more stable and consistent. You can also see that the average monthly loss for the best-in-sector implementation was -6.1% versus -8.0. So you can clearly minimize losses as well.

What's most surprising about the results is that the returns are significantly higher selecting the best-in-sector stocks. I had hoped that we could maintain the same level of returns while reducing risk, but did not expect to dramatically improve returns as well. My hunch is that this effect is dependent on the strategy and would not be the general rule for all strategies.

Here's a method for finding a diversified set of stocks that are rated as a "Buy," have good price momentum and a reasonable price:

  • First, start with only US stocks.
  • Next, create a liquid, investible set of the stocks with the largest 3000 market values and average daily trading volume greater than or equal to to 100,000 shares (if there's not enough liquidity, it'll be hard for you to trade it).
  • Add another filter by selecting those stocks with a Zacks Rank less than or equal to 2. (Let's stick with only the buy-rated stocks.)
  • Select the top 5 stocks with the highest return over the past 52 weeks in each sector. (We're looking for stocks with great price momentum over the last year.)
  • Select the top stock with the lowest price-to-sales ratio in each sector. (Lower means you want to pay less per unit of company revenue.)

There's not enough space to provide details on all sixteen stocks, but here are the best five (4/27/12):

CONN – Conn's Inc.

Conn's, a Beaumont, Texas-based company, engages in the specialty retail of durable consumer products in the United States. This non-food retailer is a Zacks #1 Rank, the stock is up 187% over the last 12 months and is experiencing good revenue growth. The stock is also a great value based on a 0.71 Price/Sales ratio.

HPY – Heartland Payment Systems, Inc.

Heartland Payment Systems has been a favorite stock of mine for a while. If you purchased it when I first recommended it, you'd be up over 23% by now. Heartland, a business service company, provides bankcard payment processing services in the United States and Canada. This Zacks #1 Rank has had good performance over the past 12 months, increasing sales over the last year and remains a great value with a P/S of 0.57.

MYE – Myers Industries Inc.

Myers is in the industrial products and services sector and manufactures and distributes polymer products for the industrial, agricultural, automotive, commercial and consumer markets, primarily in North, Central and South America. This is a stock I first recommended in mid-November and the stock is up over 65% over the last 12 months. With it having a good P/S ratio and Zacks Rank, there's still good indication the stock will continue to climb higher.

SXL – Sunoco Logistics Partners L.P.

Sunoco, an oil & gas production company, engages in the transport, terminalling, and storage of crude oil and refined products in the United States. This stock is up over 33% over the last 12 months yet remains a fantastic bargain based on its P/S of 0.36. If revenues keep increasing, expect the stock to as well.

ACAT – Artic Cat Inc.

Artic Cat designs, engineers, manufactures and markets snowmobiles and all-terrain vehicles (ATVs) under the Artic Cat brand name in the United States and internationally. This Zacks Strong Buy stock is up about 170% over the last year and its price is easily justified with strong revenue and income.

Find More Stocks to Diversify Your Portfolio

Hunter S. Thompson once said: "For a loser, Vegas is the meanest town on earth." Like Vegas, the stock market can be an unforgiving place too. So it's wise to have a well diversified portfolio to protect your wealth.

Want to pick a portfolio that has a good representation of both small and large cap stocks? How about selecting stocks that have a good cross-section of betas? These are all very easy to do with the Zacks Research Wizard.

Starting today, you are invited to use it free of charge. You'll have 14 days to create, tweak and backtest your strategies. At the same time, you can see the latest picks from pre-loaded winning strategies that average gains of up to +67.4% per year.

Learn more about your Research Wizard free trial >>

Finally, the title of this article is a modified line from a Vegas movie. Shoot me an email if you can name the movie and I'll see if I can get you extended backtesting history or a longer trial time.

Let's make some money,

Kip

Kip Robbins is a Quantitative Analyst with Zacks.com. He analyzes screens and strategies for Zacks customers and for use in Zacks Research Wizard which empowers individual investors to use market-beating screens, build their own, and backtest their results.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

Disclosure: Performance information for Zacks’ portfolios and strategies are available at: http://www.zacks.com/performance.

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