You may be wondering whether diversifying trades using correlations is positive or negative. Most knowledgeable investors are aware of the concept of diversifying their investments.
This can mean placing money into different assets, such as money market accounts, savings accounts, certificates of deposit, shares of stock in individual companies, bonds, mutual funds, and even real estate.
Regarding investing in individual stocks, diversification refers to holding shares in companies that are unrelated to each other.
The idea is that if one industry or sector is experiencing a down turn, other unrelated industries may not be affected.
The “crowd” (stock market traders and investors) change their opinions and support of stocks and industries often, pumping up one group while other industries fall out of favor with them.
Diversifying a Stock Portfolio
By diversifying a stock portfolio, the portfolio may only suffer a little loss when one of it’s stocks drops in value. Perhaps this is the “don’t put all of your eggs in one basket” theory.
For long-term buy-and-hold strategies, this is quite common.
Active investors, namely those who buy and sell securities on a short-term basis, may invest more heavily in one sector than another, when they are of the opinion that a stock or sector is experiencing fast growth in the short term.
That can be more profitable, but of course, it does expose the portfolio to some risk.
Industries and Sectors
Let’s talk a moment about “industries” and “sectors”.
Sectors include: basic materials, communication services, consumer cyclicals, consumer defense, energy, finance, healthcare, industrials, real estate, technology and utilities.
Sectors can be broken down to more specific industries. For example, the energy sector is made up of oil and gas drilling, oil and gas equipment and services, and even solar.
Real estate is comprised of hotels/motels, residential, retail, and healthcare facilities.
Finding Sector Performance Correlations
Use the free website, www.finviz.com, and click on “Groups.”
Relative performance barcharts for common sectors are given for 1 day, 1 week, 1 month, 3 months, 6 months, 1 year, and year-to-date.
In the heading bar on that screen, click on “Charts” (to the right side of the screen) to see one-year line graph charts for these sectors.
This will give you an idea of how sectors have been performing in relation to each other. You can print these out to compare them.
How Do You Find Highly Positively Correlated Markets?
It can be most useful to know how a stock or a sector is correlated to the market as a whole.
The SPX is a stock market index that tracks the performance of 500 large corporations that are listed on U.S. stock exchanges.
This “basket of stocks” index is commonly used to track the performance of the stock market as a whole.
When it is said that the stock market is “up” or “down” people are referring to the value of the SPX, or the SPY.
The SPY identically tracks the SPX, but it is much less expensive and it’s value can be easily pulled up on any stock quote website or trading platform.
Either can be used to represent the general overall market direction.
Stocks that have a high correlation to the S&P 500 (the SPX or the SPY) will have their price move lockstep with the S&P.
When the SPY is moving up, the stock will most likely move up also.
Are Low Correlated Stocks A Good Investment?
Stocks that have a low correlation to the S&P 500 can be expected to have their price move only slightly in the directional move of the S&P.
Whether a stock has a high or low correlation to the S&P has nothing to do with the stock being good or bad, but simply how its price can be expected to move in relation to a move in the S&P 500 index.
The calculations that determine this correlation are based on historical measurements.
As you well know, the stock market is alive and active, and so correlations can change over time.
During times when the stock market experiences high volatility, as it did in the 2008 financial crisis and during the 2020 Covid pandemic, most all stocks tend to follow the S&P 500, namely down at those times.
Money can still be made in these “bear market” times, not by being long but rather by shorting stocks.
However, the stock market in general has historically had many positive days just after a bear market has occurred.
Exchange Traded Funds
For a simple way to trade a basket of stocks with one asset is to use exchange traded funds, or ETFs.
Typically, they track a specific index. You trade them just as you do any stock. This is an affordable way to access a variety of stocks all at once.
For example, if you want to have stock in the energy sector (oil, solar, etc.) use XLE. XLV will give you a basket of health care stocks, XLK for technology, and XLU for utilities.
To set up a diversified stock portfolio, you’ll need to determine the correlation among the stocks you want to include and/or the S&P 500.
Use the free online correlation calculator found at www.buyupside.com/calculators/stockcorrelationinput.php.
Just type in the ticker symbol of the two stocks (or one stock and SPY for the market).
The correlation coefficient will be between 1.0 and -1.0 where 1.0 is a perfect correlation and a -1.0 is a perfect negative correlation.
In Conclusion: Diversifying Trades Using Correlations
Holding stocks, ETFs, or any assets that have a low correlation with each other helps reduce a portfolio’s risk.